California Workers Compensation Self-Insured Bonds and the Principal's Bankruptcy

Statutory Background of Self-Insured Bonds

California law requires that every employer provide for payment of workers compensation claims either by obtaining insurance or obtaining a certificate to self-insure from the California Department of Industrial Relations (DIR). Self-insured employers are required to deposit security in a prescribed amount and acceptable form. The security deposit ensures payment of the self-insurer's "incurred liabilities for the payment of compensation and the performance of the obligations of employers imposed" under the workers compensation code.

Incurred liabilities for the payment of compensation are defined as:

the sum of an estimate of future compensation … plus an estimate of the amount necessary to provide for the administration of claims, including legal costs. ²

If a self-insured fails to pay workers compensation, the DIR may use the self-insured's security "to administer and pay the employer's compensation obligations."

A self-insured employer may provide any combination of authorized forms of security, so long as the DIR deems the deposit adequate. The DIR permits surety bonds from admitted sureties on DIR-provided bond forms.

Extent of the Surety's Obligation

The DIR bond form provides that the surety's obligation:

shall cover and extend to all past, present, existing, and potential liability of said principal as a self-insurer, to the extent of the penal sum ¼without regard to specific injuries, date or dates of injuries, happenings or events. ³

The surety's obligation under the bond may only be exonerated when the self-insurer has substituted another deposit. ("Exoneration" here is synonymous with discharge or a complete release compared to "termination" or "cancellation" where the surety's liability is discontinued only on a going forward basis.) Thus, the bond remains in force for any liability incurred as of the cancellation effective date until new security is deposited, then the original surety's liability is extinguished.

Short of exoneration, the bond may be terminated "in the manner provided by law." Termination occurs in the event of (1) change in the principal's proprietorship, (2) appointment of a receiver or trustee, or (3) the Certificate of Consent to Self-Insure is revoked. Unlike exoneration, in these three circumstances, the surety's obligations are terminated "save and except as to all past, present, existing and potential liability of the principal...." A self-insurer incurs "potential" liability on a workers compensation claim as soon as claim is made.

Under the DIR regulations, bond cancellation is an additional means for the surety to terminate its liability. A surety can cancel its bond upon 30 days' written notice. The self-insurer then has 30 days to obtain substitute security. The DIR cannot exonerate the original surety from liability until it receives such substitute security, despite the fact that the original bond is canceled.

California Code of Civil Procedure section 996.330 governs the surety's liability after the cancellation effective date. That section provides:

If a surety cancels or withdraws from a bond:

1. The bond remains in full force and effect for all liabilities incurred before, and for acts, omissions, or causes existing or which arose before, the cancellation or withdrawal. Legal proceedings may be had therefore, in all respects as though there has been no cancellation or withdrawal.
2. The surety is not liable for any act, default, or misconduct of the principal or other breach of the condition of the bond that occurs after, or for any liabilities on the bond that arise after, the cancellation or withdrawal.
3. The cancellation or withdrawal does not effect the bond as to the remaining sureties, or alter or change their liability in any respect.

Thus, cancellation stops the accrual of any liability under the bond arising from an injury occurring after cancellation.

Sureties may argue that cancellation relieves them of liabilities that the employer incurred prior to termination, so long as the employer's obligation to pay has not arisen. In fact, the DIR cannot use the security deposit until it determines that the self-insured has failed to pay. Thus, a surety will argue that a self-insured has an incurred estimated future liability but no obligation to pay. Accordingly, sureties will argue that a self-insured's failure to make payments after bond cancellation, even for preexisting estimated future liabilities, constitutes default after cancellation for which the surety is not liable.

Needless to say, the DIR will take a contrary position. The law is not clear on this point, but the DIR's position has merit. Pursuant to the bond form and applicable law, the surety bond covers the self-insured's total incurred workers compensation liability, including estimated future liability for existing claims. The purpose of that security is to protect the state from bearing the burden of those injuries already incurred, but unaccrued. It would, therefore, be counter to public policy and the statutory scheme to allow a surety to escape already incurred liability by terminating its bond before the principal's payment actually becomes due.

In fact, California's bond form is referred to as a "last surety on" form because the surety is arguably obligated thereunder until replaced. ⁴ No California case specifically addresses this issue, but one New York court held in dicta that the surety is obligated to pay any past, present, or future liabilities that arose while its bond was effective, even if the principal's default does not occur until after bond termination. ⁵

The DIR's position on this issue is significant because it resolves any dispute regarding liability arising out of a self-insurer's security deposit. A surety can only appeal the DIR's decision by filing a petition for writ of mandate. ⁶

An Employer's Bankruptcy

Even when a corporation is in a Chapter 11 bankruptcy reorganization, it will probably pay its workers compensation obligations without interruption in order to continue in business. Thus, bankruptcy will not necessarily impact the surety's bond exposure. The surety's obligation to pay does not arise unless the employer fails to pay.

Nonetheless, most sureties prefer not to continue their bond exposure if their principal is in bankruptcy. In that regard, a surety's ability to terminate a bond is arguably not jeopardized. Bankruptcy imposes an automatic stay, which would prevent the surety from canceling the bond; however, there are very good arguments for granting the surety relief from the automatic stay.

Bankruptcy Code section 362(d)(1) provides that upon request of a party in interest and after hearing, a bankruptcy court "shall" grant relief from the automatic stay of Bankruptcy Code section 362(a), "for cause." Such "cause" exists as a matter of law where a creditor seeks relief to terminate an agreement that the debtor is prohibited from assuming or assigning. ⁷

A creditor seeking relief on this basis has the initial burden of producing evidence sufficient to establish a prima facie case that the debtor may not assume or assign the agreement. ⁸ Once the creditor establishes a prima facie case, however, the burden shifts to the debtor to prove that the creditor is not entitled to relief. ⁹ An employer is prohibited from assuming or assigning a surety bond absent the creditor's consent because such a bond is a "financial accommodation." The Ninth Circuit defines "financial accommodation" as "the extension of money or credit to accommodate another." ¹⁰

A workers compensation self-insured surety bond, is an extension of credit in the form of an agreement to stand for the debt of another. ¹¹ When the surety has not consented to provide post-petition financing, the surety is entitled to relief from the automatic stay to terminate the surety bond.

In these situations, unless the bankruptcy court grants retroactive relief, the surety will arguably have been forced, without its consent, to provide post-petition financing. A court can remedy such prejudice by annulling the automatic stay, allowing the surety to terminate the bond as of the Bankruptcy Petition Date. Bankruptcy courts have "wide latitude" in determining the scope of relief, including granting that relief retroactively. ¹²

Surety's Recourse upon Making Payment

Upon making payment, the surety is entitled to statutory and contractual indemnity from the employer. Admittedly, such indemnity is of dubious value.

One 1996 Ninth Circuit Court of Appeals decision, Industrial Commission of Arizona v Camilli, 94 F3d 1330 (9th Cir 1996), certiorari denied 519 U.S. 1113 (1997), found that an employer's reimbursement obligation to the Industrial Commission of Arizona for workers compensation benefits which the commission paid was in the nature of an excise tax and, therefore, was non-dischargeable under Bankruptcy Code section 523(a)(1)(A) and 507(a)(8)(E). There are a number of later lower court cases that have refused to follow Camilli. ¹³ Thus, while possible, it seems remote that an employer's indebtedness to its surety could be non-dischargeable.

The Surety's Priority Rights in the Employer's Bankruptcy

A surety is statutorily entitled to the same priority over the principal's other creditors as is are employees entitled to workers compensation. However, the Bankruptcy Code does not give such an employee priority because payment of pre-petition injury claims provide no benefit to the estate. ¹⁴ On the other hand, post-petition injury claims are entitled to priority. ¹⁵

The Surety's Subrogation Rights

The surety is subrogated to any claims it pays. ¹⁶ No cases address whether a surety paying post-petition injury claims is entitled to the priority workers' claims enjoy in bankruptcy. Two cases hold that state trust funds guaranteeing post-petition claims are entitled to priority. ¹⁷ A surety would arguably be entitled to the same priority.