Business Bankruptcy and Insurance: 5 Policies and What Happens to Each

Insurance is the one set of contracts a failing business should protect before it protects almost anything else, and it is often the first set allowed to lapse. The premiums look discretionary in a cash crisis. They are not. A bankruptcy court treats coverage as part of what keeps the estate intact, the injured customer treats it as the only solvent party left, and the owners, if they served as directors or officers, may discover that a policy they never read is what stands between them and personal liability.

What happens to business insurance in bankruptcy depends on which policy is in question. Five cover most of what an operating company carries.

1. The D&O Policy Belongs to the Estate, and Its Proceeds May Not

Directors and officers liability insurance is the policy owners think about last and need first, because the creditors of an insolvent company, and the trustee or committee that may pursue claims on the company's behalf, sometimes look to the people who ran it.

The policy itself is property of the estate, or, more exactly, the debtor's interest in it is, since section 541(a)(1) sweeps in "all legal or equitable interests of the debtor in property as of the commencement of the case." In In re Minoco Group of Companies, decided in 1986, the Ninth Circuit held that an insurer's attempt to cancel D&O policies after the company filed Chapter 11 was stopped by the automatic stay. The bankruptcy court had found that cancellation would leave the company obliged to indemnify its officers and directors, and would make reorganization harder. The court treated cancellation as an act to exercise control over property of the estate, which section 362(a)(3) stays.

The proceeds are a different matter. In In re Louisiana World Exposition, a year later, the Fifth Circuit held that "the proceeds of the liability coverage afforded the LWE directors and officers are not property of the LWE bankruptcy estate," and it refused to stop the insurers from paying the directors' legal expenses. The court distinguished Minoco as a case about ownership of the policy, not about "ownership of liability proceeds as to which the debtor was not the insured," and it noted that the company-reimbursement coverage was not before it.

The policy and the money it pays out are two pieces of property. Courts have been willing to assign them different owners.

The policies in Louisiana World Exposition covered both the company's indemnification obligations and the individuals themselves under a single total limit, and that shared limit is exactly where the two decisions pull apart and where a committee and the directors may find themselves competing for the same dollars. Neither case settles that contest for a policy written today. Counsel reading the actual policy will.

2. General Liability Claims Stop Against the Company, Not Against the Insurer

A customer injured on the premises before the filing holds a claim against the company, and section 362(a)(1) stays the lawsuit the moment the petition is filed. The claimant's practical interest lies in the insurance, and a claimant may ask the court for relief from the stay for cause under section 362(d)(1) so the case can proceed against the policy. The court decides.

The discharge does not end the insurer's obligation. Section 524(e) provides that the discharge of a debt of the debtor "does not affect the liability of any other entity on" that debt. A policy is a promise made to the company about other people's losses, and bankruptcy changes the company without changing the promise.

The company's own duty runs forward. Among the grounds on which a court shall convert or dismiss a Chapter 11 case, section 1112(b)(4)(C) lists "failure to maintain appropriate insurance that poses a risk to the estate or to the public," and in a small business case section 1116(5) requires the debtor in possession to "maintain insurance customary and appropriate to the industry."

3. Property Insurance Protects the Lender Named on It

Buildings, equipment, and inventory are usually insured under policies naming the secured lender as loss payee or mortgagee. The Louisiana World Exposition opinion collected earlier cases treating fire insurance proceeds made payable to mortgagees "to the extent of their interest" as outside the debtor's estate. A fire during the case pays the lender to the extent the policy directs. The coverage must remain in force, and a lapse is one of the first things a secured creditor and the United States Trustee will notice in the operating reports.

4. Trade Credit Insurance Belongs to the Vendor

A supplier that insured its receivables against a customer's insolvency holds a policy the debtor never signed. The automatic stay protects the debtor and its estate; a vendor's claim against its own insurer is a claim against neither.

The insurer that pays may take over the vendor's claim in the bankruptcy. If the transfer happens after a proof of claim is filed, Bankruptcy Rule 3001(e) requires the buyer to file evidence of it, and the vendor has 21 days after the clerk's notice to object.

The vendor keeps doing business with a customer that is now in Chapter 11, and it usually does so on shorter terms.

5. A Premium-Financed Policy Can Be Cancelled for Nonpayment

Many businesses finance their annual premiums, signing an agreement under which a finance company pays the insurer and the business repays in installments, with the unearned premium as the lender's security and a right to have the policy cancelled if an installment is missed.

Section 365(e)(1) forbids terminating an executory contract "solely because of" a clause keyed to the debtor's insolvency or its bankruptcy filing. It says nothing about installments missed after the filing. A premium finance company that is not paid after the petition will claim its contractual remedies (whether it must first ask the bankruptcy court's permission before cancelling, and whether the policy is an executory contract at all, are questions that turn on the agreement, the policy, and the law of the circuit, and they are precisely the questions that should be answered before the first postpetition installment comes due rather than after the cancellation notice arrives). New premium financing during the case is its own issue: section 364 permits unsecured ordinary-course credit without an order, but credit secured by the unearned premium requires notice and a hearing.

A business that allows a financed policy to lapse in the middle of a case has handed a creditor an argument under section 1112(b)(4)(C) that no one else could have given it.

Before Coverage Becomes a Question for the Court

Most owners who read about insurance in bankruptcy are not yet in a case. They are deciding which bills to pay this month, and the premium installment is competing with a merchant cash advance debit that arrives every morning. Keeping coverage in force is not optional in either path. For businesses whose cash is being drained by funder debits, Delancey Street reviews the positions in a free, confidential first consultation and negotiates with funders. The company does not sell insurance, file bankruptcy cases, or give legal advice; not a law firm itself, it coordinates with independently licensed counsel on legal matters. A business facing claims that only a stay can hold back needs bankruptcy counsel, and should call one before the policy that would have answered those claims is cancelled.