September 6, 2022
Reprinted with permission from Law360
By Kristine Christ, Scott Schechter and Joshua DiLena
For years, directors and officers underwriters have had to factor in the potential for an insured’s bankruptcy or insolvency when assessing a risk and determining the appropriate coverages and premiums.
Although we would have expected to see an increase in corporate bankruptcy filings throughout the global pandemic, the federal government provided assistance in order to help sustain businesses.
According to S&P Global Ratings, U.S. corporate bankruptcy rates were down in 2021, with 418 bankruptcy filings compared to 641 in 2020. Analysts are expecting corporate bankruptcies to remain low, at least through the first half of this year.
However, there is always an inherent insolvency risk to D&O carriers, especially during challenging economic periods. In addition to the global pandemic, businesses are also faced with market volatility, rising inflation and interest rate hikes, as well as political challenges and supply chain
disruptions.
The industries most recently affected include energy, retail, hospitality, restaurants, healthcare, travel and entertainment.
D&O underwriters need to understand the risks presented by these challenging economic conditions and be able to evaluate the impact on their insureds.
Underwriters have used bankruptcy and insolvency exclusions to help protect against these and other financial challenges to businesses across various industry sections. However, there have been challenges to the enforceability of these exclusions.
The increasing use of these exclusions should raise some questions with the marketplace. The following research provides some clarification on when and why some of these exclusions have been challenged and, in some instances, found invalid and unenforceable.
Two provisions of the Bankruptcy Code, found respectively in Section 541(c)[1] and Section 365(e),[2] prevent the enforcement of ipso facto clauses — which, generally, are contractual provisions that modify the rights of a debtor due to the commencement of a bankruptcy proceeding.
Some courts have relied on the foregoing provisions to hold that bankruptcy and insolvency exclusions in insurance policies are unenforceable. While the number of decisions on this topic is extremely limited, the decisions naturally raise a question as to whether bankruptcy and insolvency exclusions run afoul of the Bankruptcy Code’s restrictions on ipso facto clauses.
The following provides a summary of the decisions issued to date and an assessment of each. As noted above, there are two provisions of the Bankruptcy Code that Courts have relied upon to invalidate bankruptcy and insolvency exclusions.
The provisions have slightly different language and thus application. Accordingly, we address each in turn.
Enforceability of a Bankruptcy and Insolvency Exclusion Under Section 541(c) of the Code
Initially, Section 541(c) of the code provides that “an interest of the debtor in property becomes property of the estate … notwithstanding any provision in an agreement” that “is conditioned on the insolvency or financial condition of the debtor” or the commencement of a bankruptcy proceeding, and “that effects or gives an option to effect a forfeiture, modification, or termination of the debtor’s interest in property.”[3]
In In re: Forth Worth Osteopathic Hospital Inc. in the U.S. Bankruptcy Court for the Northern District of Texas in 2008,[4] the trustee of a bankrupt insured entity challenged the insurer’s reliance on a bankruptcy exclusion, which excluded coverage for a claim brought by the bankruptcy estate or the insured entity as debtor-in-possession, or by a trustee, liquidator or similar official appointed to manage or liquidate the insured.
The court initially found that the bankruptcy exclusion was an ipso facto clause — reasoning that pre-bankruptcy, coverage would have been available for a derivative claim, but postbankruptcy, coverage would not be available for the same claim pursued on behalf of the estate or by a trustee — but found that the exclusion was not unenforceable under Section 541(c).
The court found that the estate did not have a property interest in the proceeds of the policy “that might one day be paid to satisfy potential recoveries on that derivative claim.”[5]
The First District Appellate Court of Illinois in Yessenow v. Executive Risk Indemnity Inc.[6] came to a similar conclusion in 2011 by a different path, holding that a similarly worded bankruptcy exclusion was unenforceable under Section 541(c). In this case, former directors of a bankrupt entity asserted that they were entitled to coverage for claims brought by the bankruptcy trustee.
The D&O carrier argued that coverage was barred by the policy’s bankruptcy exclusion.
After finding that plaintiffs had standing to challenge the bankruptcy exclusion — reasoning that the policy was property of the estate and the benefit of that interest would be realized only if plaintiffs could seek coverage under the policy — the appellate court agreed that the bankruptcy exclusion was unenforceable under Section 541(c).
The court found that this section invalidates contractual provisions conditioned on the debtor’s insolvency or the commencement of a bankruptcy case; and because the bankruptcy exclusion applied if the company went bankrupt, it was precluded by the Bankruptcy Code.[7]
In summary, the court in Yessenow essentially found that since the policy was property of the estate, any provision therein conditioned on the bankruptcy or insolvency of the debtor was prohibited by Section 541(c), whereas the bankruptcy court’s decision in Fort Worth Osteopathic turned on whether the proceeds of the policy, which may be used to resolve aclaim brought by the trustee, not the policy itself, was property of the estate.
Generally, the reasoning in Fort Worth Osteopathic appears to be more persuasive — courts routinely draw a distinction between ownership of the policy itself and the proceeds that may be paid under the policy — and the estate has no cognizable, present right to collect any amounts under the policy in its capacity as a claimant, as opposed to an insured, at the commencement of the bankruptcy proceeding.
Given the limited decisions on this topic, however, there is certainly a risk that future courts
could follow the reasoning in Yessenow.
Enforceability of a Bankruptcy and Insolvency Exclusion Under Section 365(e) of the Code
Section 365(e)(1)[8] of the code applies to executory contracts, and provides that such a contract or any right or obligation thereunder may not be terminated or modified based by the debtor’s insolvency, financial condition or commencement of a bankruptcy proceeding.
In Fort Worth Osteopathic, the bankruptcy court explained that Section 365(e)(1) is markedly different from Section 541(c), noting that the latter refers to property becoming property of the estate notwithstanding an ipso facto clause, [and] the former bars operation of such a clause to terminate or modify a contract or to terminate or modify “any right or obligation under such a contract.”[9]
In other words, Section 365(e)(1) applies more broadly than Section 541(c).
The threshold question with respect to the applicability of this provision, however, is whether a D&O policy constitutes an executory contract, which was the focus of the U.S. District Court for the Eastern District of Michigan’s 2019 decision in In re: Community Memorial Hospital,[10] where the court held that an insurance policy that was renewed post-petition was still an executory contract.
Thus, a provision denying coverage for acts leading to bankruptcy was a prohibited ipso facto clause.
In that case, the federal district court began by analyzing whether the insurance policy should be deemed an executory contract. The National Union Fire Insurance argued that “because the tail coverage did not exist pre-petition, it could not possibly constitute an executory contract against which ipso facto provisions are unenforceable.”[11]
The trust argued that the court should focus on the contractual relationship between the parties in order to determine whether the tail coverage 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.[12]
The court agreed with the trust, explaining that, except for the time frames and the premium amounts, the policies in effect pre- and post-petition were “functionally the same.”[13] Further, the court found that the tail coverage was not a separate policy but an endorsement on an existing, pre-petition contract.
[14]Therefore, the court held that National Union’s declination of coverage impeded an executory contract and violated the Bankruptcy Code’s prohibition on enforcement of ipso facto provisions.[15]
One potential issue with the court’s decision in Community Memorial is that the parties did not seem to dispute that the policy that existed pre-petition was an executory contract.
Community Memorial appears to be the only decision to address the applicability of Section 365(e)(1) to a D&O policy, but other decisions regarding the interpretation of executory contract may indicate that the section does not apply, since such a policy may not be an executory contract.
The Bankruptcy Code does not define executory contracts, but most courts follow the so-called Countryman rule for determining whether a contract is executory or nonexecutory.
Under the Countryman rule, an executory contract is defined as a contract under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that the failure of either to complete performance would constitute a material breach excusing performance of the other.[16]
With respect to a D&O policy, the issue may turn on whether the policy premium has been paid in full — which is often the case.
In In re: Vanderveer Estates Holding LLC in the U.S. Bankruptcy Court for the Eastern District of New York in 2005,[17] an insurer sought a declaratory judgment that it had no obligation to defend or indemnify the debtor because it had breached its obligations under the insurance policy by failing to pay the self-insured retention of $25,000 per claim.
The insurer contended that the failure of the debtor to pay the self-insured retention amount was a breach of the policy that relieved the insurer from any obligation under the policy.[18] The bankruptcy court disagreed.
The court’s decision ultimately turned on whether the policy for which the premium had been paid in full prior to the petition date is an executory contract.
Specifically, the court held that where an insured debtor has paid the policy premium in full, the insurance policy is not an executory contract for purposes of [Section] 365 of the Bankruptcy Code, even where the debtor has continuing obligations, such as the payment of a self-insured retention, a deductible, or a premium [since failure to] perform these continuing obligations does not excuse the insurer from performance under the contract.[19]
By contrast, in Fort Worth Osteopathic, the court provided, in a footnote, that the cooperation and subrogation requirements imposed continuing obligations on the debtor, the nonperformance of which could result in the breach of the policy excusing the performance of the insurer.
The court recognized that it was arguable that the foregoing could result in the policy at issue there — e.g., where the premiums had been paid in full prior to the petition date — being deemed an executory contract.
To summarize, if a policy is determined to be an executory contract, Section 365(e)(1) might prevent the enforcement of a bankruptcy and insolvency exclusion. There is a strong argument that a policy for which the premium has been paid in full is not executory.
The purpose of Section 365, as a whole, is to permit the representative of the debtor’s estate to determine whether to assume or reject contracts that may impose additional responsibilities or obligations on the estate.
It is highly doubtful that a trustee would ever consider rejecting a policy that has already been acquired and paid in full, such that Section 365 should ultimately not come into play.
However, there are risks that a court may focus on the debtor’s ancillary ongoing obligations under the policy to determine that the policy is executory.
Options for Insurers and Brokers
Given the recent court cases analyzed above, D&O underwriters may not be able to rely on bankruptcy exclusions to protect them from the risk of their insured filing for bankruptcy. That does not, however, mean they are without options.
Sound underwriting fundamentals continue to be critical. One of the biggest risk factors that brokers and D&O underwriters consider is the financial condition and stability of the insured.
Whether it be a lack of revenue and income generation, large amounts of debt and being able to service that debt or the ability to raise additional capital in order to fund operations, all are factors that are considered in the underwriting process.
As noted above, underwriters also consider the industry class and how they are affected by current economic and political challenges, putting them at a higher risk for bankruptcy.
When there is higher risk of an insured filing for bankruptcy, bankruptcy exclusions should be considered, but should not be relied on exclusively given that recent rulings establish a precedent for finding these exclusions to be unenforceable. D&O underwriters may also want to consider addressing their concerns about potential bankruptcy through creditor exclusions.
These policy restrictions can be added if it is determined that the amount of debt and the ability to service that debt is the major issue.
Another underwriting option is to use bankruptcy sublimits to protection against loss. These sublimits do not exclude coverage outright, but applying a smaller sublimit can help reduce the insurer’s overall exposure in cases where the insured does file for bankruptcy.
Conclusion
As evidenced above, there are a limited number of decisions addressing the enforceability of bankruptcy and insolvency exclusions under the code. However, those that have addressed the topic create a risk that these exclusions may be deemed unenforceable.
Underwriters should be aware that these exclusions may not provide the protection the underwriters were seeking when the policy was written.
As we continue to monitor the current economic landscape and the increased risk factors corporations are facing or if bankruptcies filings begin to rise, we will need to consider alternatives to protecting against these exposures.
Underwriters may limit their exposure to these potential risks in different ways, such as by adding creditor exclusions or sublimiting coverage for bankruptcy.
Kristine Christ is vice president at Crum & Forster Specialty Insurance Co.
Scott A. Schechter is a partner at Kaufman Borgeest & Ryan LLP.
Joshua DiLena is a partner at Kaufman Borgeest.
The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.
[1] 11 U.S.C. § 541(c).
[2] 11 U.S.C. § 365(e).
[3] 11 U.S.C. § 541(c).
[4] In re Forth Worth Osteopathic Hospital, Inc. , 387 B.R. 706 (N.D. Tex. Bankr. 2008).
[5] Id.
[6] Yessenow v. Executive Risk Indemnity, Inc. , 953 N.E.2d 433 (Ill. Ct. App. 2011).
[7] Id. at 441.
[8] 11 U.S.C. § 365(e)(1).
[9] Fort Worth Osteopathic, 387 B.R. at 713-14.
[10] In re Community Memorial Hospital , No. 16-cv-14434, 2019 WL 3296994 (E.D. Mich.
Jul. 23, 2019).
[11] Id. at *3.
[12] Id.
[13] Id. at *4.
[14] Id.
[15] Id. at *5.
[16] Vern Countryman, Executory Contracts in Bankruptcy: Part 1, 57, Minn. L. Rev. 439,
460 (1973).[17] In re Vanderveer Ests. Holding, LLC , 328 B.R. 18 (Bankr. E.D.N.Y. 2005).
[18] Id.
[19] Id. at 25