COVID-19 Coverage Fight: Will Bankruptcy Exclusions Be Enforced? Companies, large and small, are in trouble.
This is the second article in a series discussing COVID-19 bankruptcies and insurance coverage.
In addition to the horrific loss of life, COVID-19 is wreaking havoc on the economy. Companies, large and small, are in trouble. Recently, major oil and gas drillers, retailers, entertainment companies, and restaurants groups have filed for bankruptcy. Hank Tucker, “Coronavirus Bankruptcy Tracker: These Major Companies Are Failing Amid The Shutdown,” Forbes (May 3, 2020).
According to a recent report from the Brookings Institute:
The current crisis could bring a much greater surge in business bankruptcy filings than either of the two most recent recessions. Prior to the current crisis, businesses took on an extraordinary amount of debt—$15.5 trillion, according to one estimate, a 52% increase since its high point during the 2008 crisis. This debt, coupled with the nearly complete shutdown of the economy and the fact that the revenues of many businesses will be slow to recover, even after economic activity resumes, suggests there will be a surge of business bankruptcies. Businesses also may be less hesitant to file for bankruptcy than they otherwise would have, given that some debt is now guaranteed by the government and the distress has been triggered by a crisis outside their control. At the very least, regulators need to assume that a bankruptcy wave is coming.
David Skeel, “Bankruptcy and the coronavirus,” Economic Studies at Brookings (April 2020).
A side-effect of this anticipated surge in bankruptcies is likely to be a wave of D&O claims filed by creditors or bankruptcy trustees. Kevin M. LaCroix, “Coronavirus and D&O Insurance: The Latest Interim Update,” D&O Diary (May 10, 2020); Pasich LLP, “Legal Alert: Insurance Coverage for Losses and Claims Associated with the Coronavirus,” (May 18, 2020). D&O claims are expected to arise out of a combination of suits alleging misstatements in company reporting on the impact of COVID-19, mismanagement, or a board’s breaches of the duty of care or breach of the duty of oversight. Id.
Insureds and trustees seeking to utilize this asset should bear in mind that D&O policies sometimes contain so-called bankruptcy exclusions purporting to limit or eliminate coverage. The language of these exclusions and applicable statutes should be closely evaluated as there is case law, discussed below, which supports the notion that such exclusions may constitute unenforceable restraints on the operation of bankruptcy law.
In Yessenow v. Executive Risk Indemnity, Inc., 953 N.E.2d 433 (Ill. App. Ct. 2011), former directors of two Chapter 11 bankrupt Indiana corporations sought a declaration that their insurer was obligated to defend them in underlying bankruptcy actions brought by a trustee. In trying to avoid its obligations under the operative D&O policy the insurer asserted a bankruptcy exclusion. The former directors filed a motion for partial summary judgment arguing that the exclusion was unenforceable because it violated 11 U.S.C. §§ 541(c) and 365(e)(1) of the Bankruptcy Code (the Code). The trial court agreed with the former directors that the exclusion was unenforceable under §541(c) and found in favor of coverage for the former directors. The insurer appealed.
On appeal, the Appellate Court of Illinois first addressed whether the former directors, as nondebtors, had standing to challenge the validity of the bankruptcy exclusion under the Code.
Section 541(c)(1) of the Code provides:
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
The insurer argued that the former directors were not “debtors” under the Code because the action did not arise from their own bankruptcy filing, and therefore they should not be afforded the protections offered by the Code. The appellate court disagreed, finding that the D&O policy was an asset of the estate, and the trustee could not obtain the possible benefits of indemnity without permitting the directors to access defense costs under the policy. Yessenow, 953 N.E.2d at 439. The appellate court noted that “[a]lthough coverage inures to the benefit of [the former directors], it arises from the D&O policy which has become a property interest of … the debtors. Therefore, that property interest is protected by § 541(c) and because any benefit to the estate will be realized only if [the former directors] may seek coverage under it, they have standing to challenge the exclusion.” Id.
The court then determined that, based on the legislative history, §541(c) invalidated contract provisions that are “conditioned on the insolvency or financial condition of the debtor, [or] on the commencement of a bankruptcy case.” Id. at 441. Accordingly, because the bankruptcy exclusion was conditioned on the commencement of a bankruptcy case, the bankruptcy exclusion was unenforceable under §541(c). Id.
Because the appellate court’s decision found the exclusion unenforceable under §541(c), it did not reach the issue of the enforceability of the exclusion under §365(e)(1). Id. at n. 4.
‘Community Memorial Hospital’
In In re Community Memorial Hospital, Case No. 16-cv-14434, 2019 WL 3296994 (E.D. Mich. July 23, 2019), the issue of enforceability of a bankruptcy exclusion under §365(e)(1), left unexamined in Yessenow, was addressed.
Section 365(e)(1) of the Code provides:
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.
The issue arose here after a Chapter 11 debtor’s assignee initiated an adversary proceeding against a D&O insurer. The assignee argued that the bankruptcy exclusion was an ipso facto clause prohibited by §365(e)(1).
The bankruptcy court initially found that the bankruptcy exclusion was not a prohibited ipso facto provision, because it did not purport to make the entire D&O policy ineffective as a result of the bankruptcy filing. On appeal to the district court, the district court held that the ipso facto prohibition may be triggered even if the challenged prohibition invalidates only part of a contract. The district court remanded the case back to bankruptcy court to determine whether the exclusion constituted an unenforceable ipso facto provision, which included ascertaining whether the D&O policy was an “executory contract” to which the prohibition applies.
On remand, the bankruptcy court determined, among other things, that the D&O policy was an “executory contract to which protection against ipso facto provisions applies.” The insurer then filed objections to this determination to the district court.
In analyzing these objections, the district court began by considering whether the D&O policy should be deemed an “executory contract”—a term the Code does not define, but which has been interpreted by courts to mean a contract “under which the obligation of both the bankrupt and the other party to a contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other.” In re Community Memorial Hospital, 2019 WL 3296994, at *3 (internal citations omitted).
The district court found that this dispute was not whether obligations remained unperformed, but whether the term “executory contract” should be applied to the run-off endorsement that contained the bankruptcy exclusion. Although the run-off endorsement was added during the term of the policy, because it was added after the debtor had filed for bankruptcy, the insurer argued that the endorsement was a distinct policy and, as such, it could not constitute an unenforceable executory contract because only pre-petition contracts are subject to the ipso facto prohibition.
The assignee argued that the proper focus was not when the run-off endorsement came into existence, but “whether the contractual relationship was continuous and essentially unchanged from the pre-petition period through the post-petition period, such that the same contractual relationship and the same contract can and should be deemed to have been extant pre-petition.” Id. The district court agreed with the assignee and adopted the bankruptcy court’s reasoning that the D&O policies in effect pre- and post- petition were essentially the same. Id. at *4. Both had the same policy language, except for policy periods and premium amounts, and both contained the run-off endorsement. Id.
The district court further reasoned that “the relationship between insured and insurer remained continuous and essentially unchanged.” Id. at *4. Thus, given this “business reality,” the insurer’s declination of coverage “impeded an executory contract, in violation of the Bankruptcy Code’s prohibition on enforcement of ipso facto provisions.” Id. at *5.
As the expected wave of bankruptcy filings hit, policyholders and trustees alike should carefully scrutinize their D&O policies and view bankruptcy exclusions with a critical eye.
This article originally appeared in the New York Law Journal on June 4, 2020 and can be found here.