One way or the other, I have been doing D&O for more than 35 years. One of the reasons I love what I do is that there is always something new and so I am always learning. This week’s new thing is a recent ruling by a federal district court ruling that a debtor’s insurer could not rely on a bankruptcy exclusion in the debtor’s D&O policy to deny coverage for an underlying claim because the exclusion violates the bankruptcy code’s probation against ipso facto provisions in executory contracts. In all my years, I don’t believe I have ever run across the bankruptcy code’s ipso facto provision prohibition, so the district court’s ruling in this case was a learning opportunity for me – and I suspect it will be for most readers as well.
Community Memorial Hospital filed for bankruptcy on March 1, 2012. At the time, CMH had a D&O insurance policy for the policy period March 11, 2011 to March 11, 2012. After filing its bankruptcy petition, CMH renewed its D&O insurance for the policy period March 11, 2012 to March 11, 2013. The renewal policy was identical to the prior policy. CHM began to wind down operations on April 4, 2012. CMH purchased run-off coverage for a three-year period beginning April 4, 2012. The run-off extension was added to the 2011-2012 policy by endorsement.
In February 2014, the CHM Liquidation Trust, to which all of CMH’s rights had been assigned, filed a suit against certain of CMH’s former directors and officers, asserting claims for breach of fiduciary duty and negligence.
The claim was submitted to CMH’s D&O insurer. The insurer denied coverage based on the bankruptcy exclusion (see the relevant exclusionary language below). The Trust initiated an adversary proceeding against the insurer, seeking a judicial determination that the bankruptcy exclusion was enforceable because it was an ipso facto clause prohibited by Section 365(e)(1) of the Bankruptcy Code – that is, that the exclusion was a provision in an executory contract that provides for termination or modification based on the filing of a bankruptcy petition or the financial condition of the debtor.
The bankruptcy court had initially determined that the bankruptcy exclusion was not a prohibited ipso facto provision, because it did not purport to make the entire insurance policy ineffective due to the bankruptcy petition. On appeal, the district court determined that the ipso facto prohibition may be triggered even if the challenged provision invalidates only a part of the contract. The district court remanded the case to determine whether all of the aspects of the ipso facto prohibition had been met, and in particular whether the insurance policy is an “executory contract” to which the prohibition applies.
On remand, the bankruptcy court determined that the insurance policy is an “executory contract” to which the ipso facto prohibition applies. The insurer appealed this determination to the district court.
The Relevant Policy Language
The relevant portion of the bankruptcy exclusion provides 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.” The bankruptcy exclusion was in the 2011-2012 policy, and the 2012-2013 policy for which tail coverage was purchased.
The District Court’s July 23, 2019 Opinion
In a July 23, 2019 Opinion, Eastern District of Michigan Judge Mark A. Goldsmith entered an order overruling the insurer’s objections to the bankruptcy court’s recommendations, adopting the bankruptcy court’s recommendations, and remanding the case for further proceedings on the parties’ pending summary judgment motions. Judge Goldsmith’s Opinion can be found here.
Because the ipso facto provision prohibition applies only to “executory contracts,” Judge Goldsmith began his analysis by considering whether the policy here in an executory contract. The term “executory contract” is not defined in the Bankruptcy Code, but it has been interpreted to mean a contract “under which the obligation of both the bankrupt and the other party to the contract are so far unperformed that failure of either to complete performance would constitute a material breach excusing the performance of the other.”
Judge Goldsmith commented that the issue in this case is not so much whether or not obligations remain unperformed, but with the term “executory contract” should be applied to the tail coverage endorsement. The insurer argued that the tail policy is a distinct contract that did not exist pre-petition. The insurer argued that because the ipso facto prohibition applies only to pre-petition contracts, and because the tail policy is a post-petition contract, the ipso facto prohibition does not apply.
Judge Goldsmith adopted the Bankruptcy Court’s reasoning in rejecting this argument. He agreed with the bankruptcy court’s conclusion that the relevant policies are essentially the same, and that the language of the 2011 and 2012 policies “are identical, except for time frames and the premium amount.” Both policies contained Endorsement 10. Thus, Judge Goldsmith said, “the relationship between the insured and the insurer remained continuous and essentially unchanged.”
Contrary to the insurer’s suggestion that the tail coverage is a separate policy, the coverage, Judge Goldsmith noted, is “nothing more than an endorsement to the 2012 policy. As “an appendage to the 2012 policy,” it had “pre-petition roots that make it part of an executory contract.” He noted further that “in fact, the roots are deep” because the 2011 and 2012 contracts gave the insured the right to purchase tail coverage.
As the bankruptcy court noted, “the insurance contract extant post-petition can be viewed either as a renewal of the pre-petition 2011 contract or as tail coverage purchased under rights guaranteed by the pre-petition contract.” Either way, Judge Goldsmith noted, the insurer’s premise that “the contract did not exist as of the bankruptcy filing is without merit.”
The contractual relationship between the insurer and the insured “was continuous and substantially unchanged as between the pre-petition period and the post-petition period.” 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.”
Both of the key terms involved in this dispute – that is, “executory contracts” and “ipso facto provisions” – were, at least in this context, unknown to me. The district court’s opinion represents, at least for me, an interesting exploration of unfamiliar concepts. The possibility that there are bankruptcy code provisions that might prevent a D&O insurer from enforcing policy provisions is itself a new and interesting concept (although recognizing this concept does reinforce a conclusion I reached very early in my career, that everything is different in the bankruptcy context.)
I suspect that the D&O insurer probably feels hard done by here. It would not surprise me to learn that the only reason the insurer was willing to accept this coverage and to renew the policy was its belief – based on the presence of the bankruptcy exclusion in the various policies — that it was not going to be picking up bankruptcy claim-related loss. The insurer doubtlessly was unaware of the possibility that its exclusion could prove to be unenforceable under the Bankruptcy Code.
I suspect the D&O insurer may also have a hard time with the district court’s analysis rejecting the insurer’s argument that the tail coverage was a post-petition contract to which the ipso facto provision prohibition does not apply. The insurance contracts were indeed a series of contracts with nearly identical terms, but I suspect that the insurer is not persuaded by the court’s logic that because of the continuous and unchanged relationship between the parties, and the “roots” in the later policy from the earlier policy, the Bankruptcy Code’s prohibition on ipso facto provisions in executory contracts nonetheless applies. For its part, the insurer undoubtedly believes that though part of a continuous series, each policy in the series nevertheless is a separate contract.
All of that said, there is a lot of interesting stuff in this opinion. I am still ruminating both on the meaning in this context of this case and in general on the meaning of the term “executory contract” in both the insurance and bankruptcy context, and on what the difference might be between a pre-petition contract and a post-petition contract for purposes of the Bankruptcy Code’s ipso facto provision prohibition.
Like I always say, there’s always something new.
The Kramer Levin law firm’s August 23, 2019 memo about this decision can be found here.