In Hawthorne Savings FSB v. Reliance Ins. Co., (9th Cir. Aug. 24, 2005) (amended Jan. 13, 2006), which as the court notes involves a matter remotely connected to the criminal prosecution of Mr. Orenthal James Simpson, the policyholder brought a coverage action against Reliance, which (after some corporate transactions and bad underwriting) became insolvent. The matter was in federal court on diversity-of-citizenship grounds (it having been removed by Reliance) with California state law providing the substantive rule of decision.

Under 11 USC 109(b)(2)-(3), Congress disavows any significant federal interest in the bankruptcy of insurance companies, a view consistent with the (current) tenor of federal involvement in the insurance industry, which (generally) defers to state regulation of the activities of insurance companies as they relate to that business as such.

Under the McCarran-Ferguson Act, 15 USC 1011, generally state law reigns triumphant over federal law in insurance-regulatory matters, and the odd scenario is sometimes presented where the parties argue about “reverse preemption,” that is, they argue that state law displaces federal law. E.g., Love v. Money Tree (Ga. June 6, 2005).

In Hawthorne, the insurer argued that federal diversity jurisdiction (28 USC 1332) was displaced by the Pennsylvania state insurance regulatory regime, thus divesting the federal district court of subject-matter jurisdiction. The Ninth Circuit, following Fourth Circuit authority, held that, while Pennsylvania properly maintained exclusive jurisdiction over the liquidation of the insurer and its assets, federal jurisdiction on the breach-of-contract claim and its merits was retained. Slip op. at 11355. Indeed, the court point out the reductio ad absurdum conclusion of the insurer’s argument that no federal court sitting in diversity would have jurisdiction over any insurance dispute and easily rejected that contention. Id. (citing prior authorities). The court furthermore finely argued that the diversity-jurisdiction statute did not “invalidate, impair, or supersede” the state’s liquidation effort. Accordingly, the court held that the federal diversity jurisdiction statute, 28 USC 1332, was not reverse preempted by the McCarran-Ferguson Act.

Reliance next argued that, even if there were federal-court jurisdiction, the court should abstain from its exercise on the ground that federal involvement would be inconsistent with a comprehensive state regulatory proceeding. After reviewing prior authorities, the Ninth Circuit rejected the argument for abstention under the principles of Burford v. Sun Oil Co., 319 U.S. 315 (1943) (and Quackenbush v. Allstate Ins. Co., 517 U.S. 706 (1996)) or under Colorado River Water Conservation Dist. v. US, 424 US. 800, 813 (1976). The Ninth Circuit reasoned that the decision in a single case of breach of contract posed no threat to the development of state policy or regulation overall. This was true even though the breach of contract action, if successful, would affect assets under the control of the supervisory court.

Reliance further argued that the court was required to give full faith and credit to the stay order. The Ninth Circuit easily disposed of the issue, arguing that the question of full faith and credit was dependent on the enforceability of judgments in general, and that the policyholder was neither a party nor in privity with a party in the rehabilitation proper – accordingly, the terms of the order did not apply to it. Moreover, the state court lacked power directly to enjoin the federal court from proceeding. And the Ninth Circuit likewise did not find that generalized notions of comity required any different result.

The court thus held there was no basis why a federal court in particular was required to abide by the stay order. The Ninth Circuit next considered, however, whether a state court sitting in California would abide by the stay order.

This question turned in part on construing the Uniform Insurers Liquidation Act (UILA), which requires that the enacting states abide by the insolvency and rehabilitation processes of another enacting state. Within the terms of the UILA, deference is required for a “reciprocal state,” and because the Pennsylvania scheme differed somewhat from the uniform act (as passed by California), the Ninth Circuit was required to evaluate the substance of the Pennsylvania regime. In concluding that the Pennsylvania scheme was close enough to the UILA, the Ninth Circuit then was faced with the question of the interpretation of the California-version of the UILA and whether it required that the Pennsylvania court’s stay be respected.

The Ninth Circuit concluded, however, that the UILA required deference only to the rehabilitation proceeding as such and did not apply to in personam actions, such as a claim for breach of contract. As the court concluded, “reciprocity does not apply to the determination of in personam legal rights, as opposed to the enforcement of any resulting judgment against the estate of an insolvent company in state court proceedings.” Slip op. at 11375. In particular, the UILA makes this distinction clear by specifying that an action in the non-rehabilitation state could not be maintained if it was “in the nature of an attachment, garnishment, or execution.” Cal. Ins. Code 1064.9. Accordingly, the Ninth Circuit concluded that either a California state court or a federal court sitting in diversity was free to reach the merits of the breach-of-contract action against Reliance, even if that court could not issue execution.

While possessing a judgment for coverage without a right or power of execution might be a pyrrhic victory in other circumstances, that wasn’t the case for the policyholder in Hawthorne. Once it appeared that Reliance was heading towards insolvency, the policyholder compelled Reliance to post a bond, pursuant to state law requiring that nonadmitted insurers post bonds as a condition to filing an answer. (The Ninth Circuit’s opinion did not address whether this statute applies in a federal-court action sitting in diversity, but long-established authority holds that pre-answer security statutes do apply in federal court. E.g., Akron Co. v. Fidelity Gen. Ins. Co., 250 F. Supp. 201 (N.D. Ohio 1964).) Accordingly, the policyholder’s trial victory was upheld and the judgment ordered to be satisfied from the bond.

A version of this article was published in 22 Tolley's Insolvency Law & Practice 22 (London 2006).