Race to recovery: Who is entitled to insurance proceeds when an insured professional declares bankruptcy?

In the case of Bankruptcy Hanson, 2022 ONSC 6591,^[1] the Ontario Superior Court of Justice dealt with access to insurance proceeds in the case of a bankrupt professional. The key questions to be decided by the Court were:

1. whether proceeds of professional liability insurance were subject to relief under section 38 the Bankruptcy and Insolvency Act ("BIA"), which allows a creditor of a bankrupt estate to pursue estate litigation in place of the estate trustee; and
2. when and in what circumstances a creditor who takes an assignment of a claim from a trustee in bankruptcy can do so to the exclusion of all other creditors.

The Court found that the proceeds of professional liability insurance were subject to section 38 relief, but that other creditors (even those who had not yet obtained judgment against the estate) were entitled to participate and share in the proceeds payable by the insurer.

Background facts

The motion arose out of the bankruptcy of an Ontario lawyer, Dana Bruce Hanson ("Hanson"). Hanson was the law partner of Bradley Duby ("Duby") in a personal injury law partnership, Hanson Duby Lawyers. Mr. Duby died on Jan. 28, 2021.

Loans had been made to clients of their law firm, which were funded by Lifeline Litigation Loans Inc. ("Lifeline"). Following Duby's death, Lifeline discovered that many of the client signatures on the loan agreements had apparently been forged and fabricated by Duby as part of a scheme to defraud Lifeline.

Hanson filed an assignment into bankruptcy on Nov. 18, 2021 and a stay of proceedings pursuant to section 69 of the BIA was issued on Nov. 24, 2021.

Lifeline obtained a lift stay order on Jan. 11, 2022, commenced an action against Hanson, and obtained judgment against him on Jan. 21, 2022. Lifeline requested that the trustee in bankruptcy commence an action against LawPRO, Hanson's professional liability insurer, in order to allow Lifeline to recover on its judgment. The trustee refused to commence the action on the basis that the bankrupt estate could not sustain protracted litigation. Lifeline brought a motion for leave to commence its own action against LawPRO under section 38 of the BIA, and also any order obtained against LawPRO be for the benefit of Lifeline alone, and that no other creditor of the bankrupt estate would be permitted to share in any recovery.

The trustee consented to the relief sought by Lifeline under section 38 of the BIA.

However, the latter part of the motion was opposed by Bridgepoint Financial Services Limited Partnership ("Bridgepoint"). Like Lifeline, Bridgepoint alleged that Duby fraudulently arranged for clients of the firm to execute loan agreements with Bridgepoint. Unlike Lifeline, however, Bridgepoint had not obtained judgment against Hanson at the time of the hearing of Lifeline's motion. Bridgepoint took the position that while it had not yet obtained judgment, its claim against Hanson was materially the same as that advanced by Lifeline, such that Bridgepoint should be entitled to share in the relief obtained by Lifeline.

Also of relevance to the issues before the Court was the generally accepted "first-past-the-post" principle – holding that an insurer otherwise liable under a policy cannot delay paying out the entire policy limit to a plaintiff who had obtained judgement simply because a second claimant has advanced a claim to which the policy may respond, but did not have judgment.^[2]

The law

Under section 38 of the BIA, a creditor of the bankrupt estate can obtain the trustee's right to pursue estate litigation where the trustee refuses or fails to pursue such litigation. A creditor may obtain an order authorizing them to bring a proceeding in their own name and at their own risk and expense, and on such other terms and conditions as the Court may direct. A creditor may only obtain such an order, however, where the creditor requests the trustee to take a proceeding that in their opinion would be for the benefit of the estate of a bankrupt and the trustee refuses or neglects to do so.^[3] Where such an order is made, the trustee shall assign and transfer to the creditor all right title and interest in the chose in action which is the subject matter of the proceeding.^[4] However, any benefit derived from such a proceeding, to the extent of his claim and the costs, belongs exclusively to the creditor instituting the proceeding, and the surplus, if any, belongs to the estate.^[5]

The Court of Appeal has clarified the three conditions that an applicant must satisfy to obtain a section 38 order:

1. the applicant must be a creditor of the bankrupt at the date of the bankruptcy;
2. the applicant must have requested that the trustee commence the proceeding now sought to be commenced; and
3. the trustee must have refused.^[6]

Lifeline relied on Adler, (Re), 2008 CanLII 47017 ("Adler") and Meisels v Lawyers Professional Indemnity Company, 2015 ONCA 406 ("Meisels"). In Adler, the Registrar in Bankruptcy permitted the former client of a bankrupt lawyer to bring an action against LawPRO pursuant to section 38, finding that it is in the interest of the creditors generally to be able to advance its claim, as any monies recovered under the policy will reduce its claims as an ordinary unsecured creditor in the Estate, thereby necessarily benefiting the other creditors.^[7] The Registrar in Adler concluded that no other creditors ought to be permitted to join in the proceeding or share in any recovery.^[8]

In Meisels, the Court of Appeal concluded that proceeds of a LawPRO policy that insured a bankrupt lawyer do not form part of the estate of the bankrupt that vest in the trustee. However, the right to bring an action to enforce the terms of the policy do vest in the trustee and can be assigned by the trustee.^[9] The Court of Appeal held that the insurance proceeds do not form part of the estate of a bankrupt since the insurance policy provided that the [insurer] was to pay out an indemnity on behalf of the insured, rather than directly to the insured.^[10] The Court of Appeal in Meisels agreed with the conclusion of the Registrar in Adler that the right to claim an indemnity and enforce that claim by bringing an action is the right of the trustee in bankruptcy, and that right belongs to the trustee whether the indemnity is payable directly to the insured bankrupt or to a third party.^[11] Lifeline relied on general authorities supporting the first-past-the-post principle described above.

Bridgepoint argued that the purpose of a section 38 assignment is to ensure that the bankrupt's assets are preserved for the benefit of creditors by providing a mechanism for creditors to proceed with an action when the trustee refuses or fails to act. In response to the first-past-the-post point, Bridgepoint argued that in a bankruptcy setting, judgment creditors remain unsecured creditors in the same class and with the same priority as other unsecured creditors.

Holding

On the first issue, the Court agreed with the reasoning in Meisels and Adler: notwithstanding that the proceeds of the professional liability insurance would not be payable to the insured Bankrupt himself, the right to claim under that insurance policy is capable of an assignment under section 38. However, the proceeds payable pursuant to that insurance policy could not be property of the Bankrupt nor form part of his estate. The Court's conclusion on this point was in part owing to the nature of the insurance policy which provided coverage for professional negligence (i.e. a liability policy in which recovery under the policy flows to a third party (or parties), rather than to the insured). The Court expressly found that the result might be different for first-party insurance policies (where recovery flows directly to the insured), where the insurance proceeds could form part of the bankrupt estate.

The Court held that Lifeline met the test and that an order authorizing it to bring the claim against LawPRO pursuant to section 38 should be granted.

The second issue was whether the Court should impose, as a term and condition of the order, that Bridgepoint should be permitted to join in the action and share in the proceeds. Although Bridgepoint did not yet have a judgment, it was in the process of issuing a claim and seeking a lift stay order. The Court explained that once those steps are taken, it will be in the same position as is Lifeline, although it will have arrived at that position later in time: both will be judgment creditors of the Bankrupt, and both are unsecured creditors.

The Court cited "the overarching objectives of the bankruptcy regime of efficiency, equitable treatment of like claims and fairness"^[12] in finding that Bridgepoint is entitled to participate and share in the proceeds payable by LawPRO pursuant to the responsive policy or policies.

Key takeaways

The key takeaways from this decision are:

• A creditors right to claim under a professional liability insurance policy is capable of an assignment under section 38 of the BIA;
• Where certain types of insurance (largely first-party insurance) may form part of a bankrupt's estate, third party liability policies likely do not; and
• Unsecured creditors, in an equal position, may be afforded the same opportunity to advance their claims, even where one party is not yet a judgment creditor.

Should you have any questions or require assistance regarding this article, please feel free to reach out to the authors or a member of our Insurance & Professional Liability Group.

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