Insurance Policy Excluding Coverage for Causing Bankruptcy Is Unenforceable

A provision in an insurance policy that voids coverage for acts leading to bankruptcy or insolvency is an unenforceable ipso facto clause, according to District Judge Mark A. Goldsmith of Detroit. Judge Goldsmith was adopting a report and recommendation by Bankruptcy Judge Daniel S. Opperman of Bay City, Mich.

The debtor was a hospital attempting to reorganize in chapter 11. After bankruptcy, the hospital purchased a one-year renewal of its existing directors and officers’ liability insurance policy, known as a D&O policy. When the hospital decided to halt operations, the debtor exercised its right to purchase so-called tail or runoff coverage and extend the D&O policy for three years. 

The trust created under a confirmed chapter 11 plan mounted a lawsuit against former officers and directors, alleging negligence and breach of fiduciary duties. The insurance company denied coverage based on an endorsement found in both the expired policy and the tail policy.

The endorsement provided that the insurance company would not be liable for any “wrongful acts” that allegedly “led to or caused . . . the bankruptcy or insolvency” of the insured. The endorsement also said there would be no liability on the part of the insurance company for any losses the hospital sustained “due . . . to a Wrongful Act [if the] Claim is made after [the hospital] . . . has filed a petition for bankruptcy.”

The trustee contended that the endorsement was an ipso facto clause that is not enforceable under Section 365(e)(1). The section provides that an “executory contract . . . may not be terminated or modified . . . after the commencement of the case solely because of a provision in such contract that is conditioned on — (A) the insolvency . . . of the debtor . . . ; [or] (B) the commencement of a [bankruptcy] case . . . .”

Bankruptcy Judge Opperman issued a report concluding that the endorsement was an unenforceable ipso facto clause. Judge Goldsmith agreed in his July 23 opinion.

The insurance company argued primarily that the tail coverage was a distinct policy that did not exist before bankruptcy. As a post-petition contract, the insurer contended that the endorsement was enforceable because Section 365(e)(1) did not apply.

Like Judge Opperman, Judge Goldsmith concluded that the pre- and post-petition policies “were essentially the same,” given that the language was “identical,” aside from “the timeframes and the premium amounts.” “Notably,” he said, the endorsements were contained in the policies both before and after bankruptcy.

Judge Goldsmith rejected the idea that the tail policy was a “separate policy.” He said the tail was “nothing more than an endorsement on [the first post-bankruptcy policy that] had pre-petition roots that make it part of an executory contract.”

“In fact,” Judge Goldsmith said, the roots were “deep” because the policy purchased after bankruptcy gave the hospital “the right to purchase tail coverage.” Consequently, he rejected the “premise that the contract did not exist as part of the bankruptcy filing.”

Because the insurance contract was “essentially unchanged” before and after bankruptcy, Judge Goldsmith held that the endorsement was an unenforceable ipso facto clause. In the process, he distinguished cases enforcing ipso facto clauses when the debtor had purchased new coverage after bankruptcy.