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Companies purchase directors and officers (D&O) insurance to shield management from personal liability related to the business and to attract talent. D&O policies often cover defense costs and fund settlements. Similarly, D&O coverage may provide an avenue of recovery for creditors when the company faces financial distress, including a bankruptcy filing. Potential claims against D&Os may arise from general mismanagement of the business, breaches of fiduciary duties, as well as from intentional harmful acts. It is quite common for third parties to question or second guess management decisions, and such decisions are subject to higher scrutiny once the company files for bankruptcy protection.

Yet, the protections afforded by D&O policies may be inaccessible if devoid of certain nuanced provisions. For example, the benefits of such policies have been curtailed by the breadth of some courts’ broad application of the “insured vs. insured” exclusion, which is common to D&O policies. As its name suggests, this exclusion generally bars claims brought by one or more insureds against other insureds. But some courts have expanded the exclusion’s scope to reach claims brought by or on behalf of the bankruptcy estate against insured directors and officers. Nevertheless, there are certain steps that bankruptcy and insurance practitioners can take to avoid or minimize the pitfalls of the insured vs. insured exclusion.

‘Zucker’

The most recent example where the insured vs. insured exclusion was broadened, thus nullifying the coverage on which the D&Os had relied, comes from the U.S. Court of Appeals for the Sixth Circuit in Indian Harbor Insurance v. Zucker, 860 F.3d 272 (6th Cir. 2017).

In Zucker, Capitol Bancorp (Capitol) filed for relief under Chapter 11 of the U.S. Bankruptcy Code. As a debtor-in-possession, pursuant to a court approved Chapter 11 plan, Capitol assigned all of its causes of action to a liquidating trust to pursue claims for the benefit of Capitol’s unsecured creditors. Thereafter, the liquidating trustee sued Capitol’s executives for mismanagement and breach of fiduciary duties, with the goal of accessing the proceeds of Capitol’s D&O policy in order to pay back (at least in part) Capitol’s obligations to its creditors.

The D&O insurer, Indian Harbor, denied coverage asserting that the trustee’s lawsuit fell within the D&O policy’s insured vs. insured exclusion. That exclusion stated that:

The Insurer shall not be liable to make any payment for Loss in connection with any claim made against an Insured Person [i.e., a director or officer] … by, on behalf of, or in the name or right of the Company. (emphasis added).

After denying coverage, Indian Harbor filed a declaratory judgment lawsuit against the trustee and executives to ratify its denial. The issue before the bankruptcy court was whether the trustee, who was assigned all of Capitol’s (as debtor-in-possession) causes of action, was asserting claims of the “Company,” such that the exclusion would apply.

The Sixth Circuit, in a 2-1 decision, ruled that the liquidating trustee, as an assigned trustee, effectively stood in the shoes of Capitol and had the same rights and defenses that Capitol had. As a result, the court held that the insured vs. insured exclusion barred coverage.

The trustee argued that most courts, in determining the applicability of the insured vs. insured exclusion, distinguish between a pre-bankruptcy and post-bankruptcy entity In short, the “Company,” as that term was used in the policy, referred to Capitol in “its pre-bankruptcy form” and it “underwent a transformation when it filed for bankruptcy.” In rejecting the trustee’s position, the court relied on case law—though not in the insurance context—that did not distinguish between the pre-bankruptcy entity (Capitol) and the post-bankruptcy Capitol as debtor-in-possession. The court also cited case law that generally stated that assignees stand in the shoes and possess the same rights and defenses of the assignor. And while the court conceded that Capitol’s bankruptcy filing created a new legal entity, i.e., the bankruptcy estate, it found that the estate is a nominal entity that cannot act on its own. Rather, the estate needs a debtor-in-possession or trustee to commence suit.

This analysis ultimately led the court to conclude that, based on the exclusionary language of the policy, post-bankruptcy D&O claims pursued by the assigned trustee were brought “‘on behalf of’ or ‘in the right of’ Capitol,” triggering the insured vs. insured exclusion.

Departure From Prior Case Law

As acknowledged by the dissenting judge in Zucker, numerous district and bankruptcy courts hold that “court-appointed trustees are exempt from the insured-versus-insured exclusion because there is no risk of collusion since a court-appointed trustee is a completely independent entity.”

In fact, preventing collusion is the fundamental purpose of the insured vs. insured exclusion:

The primary intent of the development of the “insured vs. insured” exclusion was to prevent collusive lawsuits in which an insured corporation would in essence ‘force’ its insurer to pay for the poor business decisions of its officers and directors by the corporation filing an action against its own officers and directors.

Michael D. Sousa, “Making Sense of the Bramble-Filled Thicket: The “Insured vs. Insured” Exclusion in the Bankruptcy Context,” 23 Emory Bankr. Dev. J. 365, 370 (2007).

Although the majority’s decision was based on the trustee’s status as an assigned trustee, there is arguably no distinction between an “assigned trustee that a bankruptcy court has determined is independent” and a court-appointed trustee who is likewise independent. Critically, in both situations, independence exists and collusion does not.

Courts that have declined to apply the insured vs. insured exclusion to a debtor-in-possession or liquidating trustee also emphasize that they are legally distinct from the pre-bankruptcy debtor and, in the case of the trustee, act for the benefit of creditors and not the company. For that reason, the dissent asserted that the plain language of the insured vs. insured exclusion could not encompass the liquidating trustee’s claim: the claims were not “by, on behalf of, or in the name or right of the Company,” which was defined to include only Capitol and its affiliated entities. Rather, the trustee’s claim was on behalf of a debtor-in-possession, which is not a “Company” and is legally distinct from Capitol.

Best Practices for Practitioners

Despite Zucker, there are proactive steps that bankruptcy and insurance practitioners can (and should) take to secure more expansive D&O coverage for their clients in a bankruptcy setting.

The insured vs. insured exclusion in Zucker was very broad and did not include exceptions that serve to restore coverage. For instance, the Zucker exclusion did not carve out claims brought “in any bankruptcy proceeding by or against a company, to any claim by an examiner, trustee, receiver, liquidator, rehabilitator or creditors committee (or any assignee thereof) of such company.” Indeed, these types of exceptions are common, as an action that is brought by such parties is generally brought for the benefit of the company’s creditors rather than for the company’s benefit. As such, the risk of collusion is eliminated or severely limited.

Therefore, well before any bankruptcy is filed or even considered a possibility, insurance and bankruptcy attorneys should review their clients’ D&O policies to confirm that the insured vs. insured exclusion contains this protection. And, if a client’s policy does not, the company should ask the insurer to add it to the policy at the purchase or renewal stage, a request that is often granted.

Next, if a debtor’s D&O policy does not contain the foregoing protection, bankruptcy practitioners must carefully consider the mechanism for transferring the debtor-in-possession’s causes of action to a liquidating trustee (or other assignee) to avoid triggering the insured vs. insured exclusion. Zucker created a distinction between an assigned or agreed-upon trustee (even one approved by the court) and a court-appointed trustee (like a chapter 7 trustee). To avoid a Zucker denial of coverage, bankruptcy attorneys should consider alternative methods of pursuing D&O claims to not forefeit coverage. And, if a Zucker-type of assignment is possible, bankruptcy attorneys should consider asking the court to make explicit findings that (1) the trustee is independent of the company and (2) no collusion exists between the trustee and the debtor. While it is an open question whether such findings would satisfy the Sixth Circuit’s recent holding, they could serve as a basis for other courts to decline to follow Zucker.