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Bankruptcy Court Rejects Unfair-Practices Claim Against Insurer Accused of Aiding and Abetting Conversion of Trust Funds

Ellis Winters

Ellis & Winters

A recent decision reminds us that North Carolina’s bankruptcy courts often rule on claims under N.C. Gen. Stat. § 75-1.1.

In re NC & VA Warranty Co. was an adversary proceeding in the bankruptcy of a warranty company. The company’s bankruptcy trustee tried to amend her complaint to assert breach-of-contract and 75-1.1 claims against the company’s insurer. The bankruptcy court, however, held that the proposed 75-1.1 claim was futile. The court reasoned that the claim didn’t allege egregious or aggravating circumstances in connection with the insurer’s alleged breach of contract.

A Trust Account Gone Bad

NCVA was a North Carolina-based company that sold extended car warranties to consumers. It contracted with an Ohio-based insurer to back up its obligations to pay claims. NCVA paid the insurer a monthly premium based on the number of extended warranties that NCVA sold. It deposited the premiums into a trust account.

NCVA and the insurer had a contract that governed the trust account. The contract barred the insurer from withdrawing funds from the account except to pay warranty claims or to reimburse itself for paying claims.

Despite this contract term, the insurer allegedly allowed the son of NCVA’s owner to divert $4 million from the trust account to an account that the son controlled. This alleged diversion of funds led to NCVA’s bankruptcy filing.

On behalf of NCVA’s bankruptcy estate, the trustee filed an adversary proceeding: a bankruptcy-court lawsuit that is meant to recover assets from third parties for the sake of the bankruptcy estate.

During that adversary proceeding, the trustee sought permission to amend her complaint to add claims—including a 75-1.1 claim—against NCVA’s insurer. The trustee alleged that the insurer knew that the funds had been diverted from the trust account, but took no steps to recover the funds or to alert NCVA that the funds had been transferred.

The bankruptcy court allowed the trustee to add breach-of-contract claims against the insurer. The court, however, rejected the trustee’s proposed extracontractual claims, including her 75-1.1 claim, as futile.

Nothing More Than a Breach-of-Contract Claim

First, the court rejected the trustee’s proposed claim for breach of fiduciary duty. The court held that the insurer’s status as a beneficiary under the trust agreement did not, by itself, give the insurer any fiduciary obligations. Likewise, the insurer’s alleged breaches of the trust agreement did not turn a contractual relationship into a fiduciary relationship. The court also noted that the insurance agreement imposed fiduciary obligations on NCVA, but not on the insurer.

The court also rejected the trustee’s fraud claim against the insurer. The court treated the fraud claim as one based on nondisclosure: the insurer’s failure to disclose that it had breached the insurance contract. This claim failed because, under Ohio law, the insurer had no specific duty to disclose the withdrawal of funds from the trust account.

The trustee’s 75-1.1 claim fared no better.

At the start, the court asked whether the 75-1.1 claim was viable under a per se theory. The court stated that a breach of fiduciary duty “is sufficient to support” a 75-1.1 claim and that fraud “necessarily” establishes a 75-1.1 claim. In this case, though, both of those predicate claims had already failed. Thus, a per se theory under section 75-1.1 had no way to proceed.

The court then asked whether the claim could survive on a non-per-se basis. It could not. In the court’s view, the claim alleged no more than an intentional breach of conduct—one lacking any “egregious or aggravating circumstances.”

The court analogized the case to Broussard v. Meineke Discount Muffler Shops, Inc., a key Fourth Circuit decision that condemns treating intentional breaches of contract as sources of treble damages under section 75-1.1. Broussard, like NCVA, involved allegations that a party withdrew trust-account funds in breach of a contractual limit on the use of those funds. The Broussard court rejected that claim with ringing language:

It has been said that because “[p]roof of unfair or deceptive trade practices entitles a plaintiff to treble damages,” a [75-1.1] count “constitutes a boilerplate claim in most every complaint based on a commercial or consumer transaction in North Carolina.” To correct this tendency, and to keep control of the extraordinary damages authorized by [section 75-1.1], North Carolina courts have repeatedly held that a “mere breach of contract, even if intentional, is not sufficiently unfair or deceptive to sustain an action under [section 75-1.1].” Even though “[i]n a sense, unfairness inheres in every breach of contract when one of the contracting parties is denied the advantage for which he contracted,” North Carolina law requires a showing of “substantial aggravating circumstances” to support a claim under [section 75-1.1]. Given the contractual center of this dispute, plaintiffs’ [75-1.1] claims are out of place.

(Citations omitted.)  The NCVA court quoted and followed this reasoning when it held that the trustee’s proposed 75-1.1 claim was futile.

NCVA shows that even intentional misconduct, if it is bound up with a contract, often cannot support a 75-1.1 claim. This is especially true where a contract defines the parties’ obligations to each other. In those cases, the search for “substantial aggravating circumstances” will decide whether a 75-1.1 claim stands or falls.

Author: George Sanderson

July 26, 2016
Posted in  Creditors Rights, Lender Liability, and Bankruptcy