As a result of the economic fallout from the coronavirus outbreak, a number of businesses will struggle to survive. Some may wind up in bankruptcy. Indeed, a May 28, 2020 Harvard Business Review article (here), suggests that there could even be a “bankruptcy pandemic” – an “explosion” of bankruptcy proceedings that could “overwhelm” the bankruptcy courts. A number of companies have already filed for bankruptcy, and there undoubtedly will be more to come.
D&O insurance underwriters are well aware of these concerns, and are taking these possibilities into account, both with respect to the financial underwriting they are requiring, and with respect to the terms and conditions they are offering. In some instances, the D&O underwriters are including bankruptcy exclusions or creditors’ claims exclusions among the terms offered. These exclusionary provisions potentially represent a significant diminution of coverage. However, a recent law firm memo raises the question whether or not the type of bankruptcy exclusion that some carriers are offering are, in fact, even enforceable.
In June 4, 2020 New York Law Journal article entitled “COVID-19 Coverage Fight: Will Bankruptcy Exclusions Be Enforced?” (here, subscription required), Peter Halprin, Pamela Woods and Vincent Xu of the Pasich law firm examine recent case law that “supports the notion that such exclusions may constitute unenforceable restraints on the operation of the bankruptcy law.”
Yessenow v. Executive Risk Indemnity
The first of the cases the authors review is a 2011 Illinois Intermediate Appellate Court decision, Yessenow v. Executive Risk Indemnity (here). In the Yessenow case two former directors of a bankrupt company sought a judicial declaration that the company’s D&O insurer was obligated to defend them in an adversary proceeding that the Trustee brought against them. The insurer had denied coverage for the claim against the directors in reliance on a bankruptcy exclusion in the policy.
The bankruptcy exclusion provided, in relevant part, that:
(1) In the event that a bankruptcy or equivalent proceeding is commenced by or against the Company, no coverage will be available under the Policy for any Claim brought by or on behalf of:
(a) the bankruptcy estate or the Company in its capacity as a Debtor in Possession; or
(b) any trustee, examiner, receiver, liquidator, rehabilitator, conservator, or similar official appointed to take control of, supervise, manage or liquidate the Company, or any assignee of any such official (including, but not limited to, any committee or creditors or committee of equity security holders).
The directors took the position that the exclusion was unenforceable because it violated Section 541(c) and Section 365(e)(1)of the bankruptcy code. The trial court concluded that the exclusion was unenforceable under Section 541(c), and the insurer appealed.
Section 541(c)(1) of the Bankruptcy Code provides that:
(1)Except as provided in paragraph (2) of this subsection, an interest of the debtor in property becomes property of the estate under subsection (a)(1), (a)(2), or (a)(5) of this section notwithstanding any provision in an agreement, transfer instrument, or applicable nonbankruptcy law—
(A)that restricts or conditions transfer of such interest by the debtor; or
(B)that is conditioned on the insolvency or financial condition of the debtor, on the commencement of a case under this title, or on the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement, and that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.
Much of the appellate court’s opinion addresses the insurer’s argument that the directors, as non-debtors, lacked standing the challenge the enforceability of the bankruptcy exclusion. The court concluded that policy was a property interest of the debtor (that is, the bankrupt company) from which the directors benefit, and therefore that the directors had standing to challenge the exclusion.
The court then considered whether the bankruptcy exclusion applied to preclude coverage or whether rather the exclusion was unenforceable under Section 541(c). The court agreed with the directors that the exclusion was unenforceable. The court reasoned that the D&O insurance policy was property of the debtor’s estate, and Section 541(c)(1) invalidates contract provisions “that are conditioned on the insolvency or financial condition of the debtor [or] on the commencement of a bankruptcy case.” Here, the court said, “because the bankruptcy exclusion is conditioned on the commencement of bankruptcy case, the trial court did not err in finding that the bankruptcy exclusion in this D&O policy is unenforceable under section 541(c).”
Because the Court concluded that the exclusion was unenforceable under Section 541(c)(1), it did not reach the question of whether Section 365(e) precluded enforcement of the exclusion.
In re Community Memorial Hospital
The second decision that the authors’ memo reviews is the July 23, 2019 ruling of Eastern District of Michigan Judge Mark A. Goldsmith in connection with the bankruptcy of Community Memorial Hospital. The Community Memorial Hospital decision considered the Section 365(e) issue that the Yessenow court had not considered. I discussed the Community Memorial Hospital ruling in a prior post (here). In his decision, Judge Goldsmith affirmed the ruling of the bankruptcy court that a bankruptcy exclusion found in the bankrupt hospital’s D&O insurance policy was a prohibited ipso facto provision under Section 365(e) of the Bankruptcy Code and therefore was unenforceable.
The bankruptcy exclusion in the hospital’s policy provided that the insurer “shall not be liable to make any payment of Loss in connection with any Claim against any Insured: (1) alleging, arising out of, based upon, attributable to, or in any way involving, directly or indirectly: (1) any Wrongful Act which is alleged to have led to or caused, directly or indirectly, wholly or in part, the bankruptcy or insolvency of the Organization.”
Section 365(e)(1) of the Bankruptcy Code provides that:
Notwithstanding a provision in an executory contract or unexpired lease, or in applicable law, an executory contract or unexpired lease of the debtor may not be terminated or modified, and any right or obligation under such contract or lease may not be terminated or modified, at any time after the commencement of the case solely because of a provision in such contract that is conditioned on—
(A) the insolvency or financial condition of the debtor at any time before the closing of the case;
(B) the commencement of a case under this title; or
(C) the appointment of or taking possession by a trustee in a case under this title or a custodian before such commencement.
Much of Judge Goldsmith’s analysis turned on the question of whether the hospital’s D&O insurance policy was an “executory contract” within the meaning of the policy. The insurer had tried to argue that the tail coverage endorsement, which contained the bankruptcy exclusion and which was only put into force after the hospital filed for bankruptcy, was not an executory contract.
Judge Goldsmith rejected these arguments, ruling that the policy was a single executory contract with “pre-petition roots,” and that given this “business reality,” the insurer’s declination of coverage in reliance on the bankruptcy exclusion “impeded an executory contract, in violation of the Bankruptcy Code’s prohibition on enforcement of ipso facto provisions.”
Discussion
The extent of the possible coming bankruptcy wave remains to be seen. But for now the present reality is that some D&O insurance buyers are being presented with renewal terms that include a newly added bankruptcy exclusion or creditors’ claim exclusion. If these insurance buyers are unable to find alternative options, they may be forced to accept a renewal policy with an exclusion of this type.
In the event that these policyholders eventually wind up in bankruptcy and have D&O claims, their insurers likely would contend that coverage for the claims is precluded by the bankruptcy exclusions in their policies. The law firm’s memo, and the cases discussed in the memo, suggest that the policyholders in that position may have grounds on which to argue that the exclusions are unenforceable.
The comfort for the policyholders from the fact that they may be able to argue that the exclusions are unenforceable comes with several important caveats. A close reading of the cases discussed in the law firm memo shows that the outcomes of those cases were very much a factor of the specific factual circumstances involved in those cases as well as the specific wordings of the exclusions at issue. Those case-specific features suggest that the possibility a court in another case considering different circumstances and different policy exclusion wordings might reach a different conclusion. In that regard it is worth noting that in both cases, the insurers involved cited cases to the court in which bankruptcy exclusions had been held to be enforceable.
The other thing about these cases is that the parties seeking coverage had been able to establish that the exclusions were unenforceable only after a substantial fight. (Both opinions cited above involve appellate consideration of initial determinations by courts of first instance.) It may be reassuring that the courts ultimately concluded that the exclusions at issue were unenforceable, but the fact that it took a protracted battle at multiple levels of the court system to establish the unenforceability may be cold comfort to other policyholders, who want reassurance that their policies will cover claims that may arise.
Even if policyholders may have arguments that bankruptcy exclusions are unenforceable, the fact is that every possible step that might be taken to avoid getting a policy with a bankruptcy exclusion should be taken.
All of that said, it is still important that in the event an insurer tries to deny coverage for a D&O claim in bankruptcy in reliance on a bankruptcy exclusion, there are substantial grounds on which the policyholder can argue that the exclusion is unenforceable. Given the likely number of coming bankruptcies and the number of policies being placed with bankruptcy exclusions, these issues could become a significant D&O insurance battleground in the months ahead. Policyholders whose insurers have denied claims based a bankruptcy exclusion do not just have to take this pronouncement; the policyholders have substantial grounds on which to fight. This fact could be important to both policyholders and insurers alike.
More About Ipso Facto Clauses in Bankruptcy: For those interested in learning more about Sections 541(c) and 365(e) of the Bankruptcy Code, there is a good succinct resource describing these clauses and their role in the bankruptcy framework; the April 12, 2019 memo, entitled “Proceed with Caution! Understanding Ipso Facto Clauses in Bankruptcy” can be found here. The memo explains that:
The phrase ipso facto is Latin for “by the fact itself.” Ipso facto clauses are sometimes included in lease and purchase contracts, and they assert that if the lessee or purchaser becomes insolvent, or files for bankruptcy protection, then the contract has been breached. In other words, under such a clause the very act of filing for bankruptcy protection constitutes a breach of contract that absolves the other party of any further contract obligations. Such clauses are not valid in bankruptcy.