Bankruptcy

D&O Insurance: Debtor-in-Possession Claims and the Insured vs. Insured Exclusion

 The traditional Insured vs. Insured exclusion found in many D&O insurance policies is a frequent source of claims disputes, particularly in the bankruptcy context. As its name suggests, the Insured vs. Insured exclusion precludes coverage for claims brought by one Insured against another Insured. The typical Insured vs. Insured exclusion includes a provision (often referred to as a coverage carve-back) that preserves coverage for claims brought by a trustee in bankruptcy or by other representatives of the bankrupt estate.

While this carve-back provision broadly preserves coverage for many types of bankruptcy-related claims that might arise against the current or former directors or officers of a bankrupt company and that might otherwise be excluded by operation of the Insured vs. Insured exclusion, there is one type of claim that can arise for which the typical policy language does not preserve coverage – that is, a claim against the company’s former directors and officers brought by the bankrupt company as debtor- in- possession.

Along those lines, a June 5, 2015 decision by the Third Circuit, applying New York law, affirmed a district court ruling that a lawsuit initiated by a bankrupt company as debtor-in-possession against certain of its former directors and officers was precluded from coverage by the Insured vs. Insured exclusion in the company’s D&O insurance policy. A copy of the Third Circuit’s opinion can be found here.

Background

Robert Redmond was an officer of Industrial Enterprises of America, Inc. (“IEAM”). In 2009, IEAM filed for bankruptcy protection. In 2011, IEAM, acting as debtor-in-possession, brought an adversary proceeding against Redmond and certain other former IEAM executives and employees alleging that they had engaged in a fraudulent scheme to manipulate IEAM’s share price. In 2013, a Chapter 11 trustee was appointed to pursue IEAM’s claim.

Redmond sought to have IEAM’s D&O insurer fund his defense in the adversary proceeding. The insurer took the position that coverage for the claim was precluded by the policy’s Insured vs. Insured exclusion [strictly speaking, for purposes relevant to this case, the exclusion was actually a Company vs. Insured exclusion], which provides that the insurer is not liable of losses arising from any “Claim brought or maintained by, on behalf of, or in the right of …the Company in any respect.” The term “Company” was defined as IEAM, its subsidiaries, and “any such organization as debtor-in-possession.”

Redmond filed a coverage lawsuit against the insurer. The insurer moved to dismiss Redmond’s complaint, arguing that coverage was precluded by the Insured vs. Insured exclusion. The district court granted the insurer’s motion to dismiss. Redmond appealed.

The June 5 Opinion

In a short June 5, 2015 opinion captioned as “Not Precedential” and written by Judge Patty Shwartz for a three judge panel, the Third Circuit affirmed the district court’s dismissal.

The appellate court said that the phrase “brought … by” as used in the Exclusion unambiguously means “commence” and that under the Exclusion the insurer is not liable for suits commenced or “brought” by the “Company.” The fact that the Chapter 11 trustee has been substituted as the plaintiff and is now pursuing the action on behalf of IEAM “does not mean the trustee initiated the suit or change the fact that IEAM commenced or ‘brought’ the action.” The “plain language of the Exclusion,” the Court said, allows the insurer to deny coverage for Redmond’s defense expenses. The appellate court concluded that the district court had not erred in dismissing Redmond’s complaint.

Discussion

The language of the Insured vs. Insured exclusion has changed over the years. In particular, the provision within the exclusion preserving coverage for claims brought against directors or officers by a bankruptcy trustee or other representative of the bankruptcy estate has evolved. For example, it is now fairly standard for the bankruptcy trustee carve-back provision in the Insured vs. Insured exclusion to preserve coverage for claims brought by a creditors’ committee.

While this bankruptcy trustee carve-back provision of the Insured vs. Insured exclusion has evolved, it is still rare for the carve-back provision to include language preserving coverage for claims brought by the bankrupt company as debtor-in-possession – even though it is now fairly standard, as was the case here, for the policy to include the company as debtor-in-possession within the meaning of Company. As a result, and as was the case here, the Insured vs. Insured exclusion operates to preclude coverage for claims brought against the former directors and officers of a bankrupt company by the company as debtor-in-possession.

This issue could be pretty easily cleaned up by including the company as debtor-in-possession in the list of bankruptcy-related claimants for whose claims coverage is carved back as an exception to the exclusion.  The insurers’ concern with this relatively expedient solution is the possibility of collusive claims. As the Ninth Circuit noted in the Visitalk case (which I discussed here), if there were to be coverage for claims by the company as debtor-in-possession, the policy would

create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D & O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

Not to minimize the collusive possibilities to which the Ninth Circuit referred, but there is a legitimate concern that without policy recognition in some way for debtor-in-possession claims, individuals could be left without insurance for claims of a kind for which D&O policies are intended to provide coverage.

There are, in fact, D&O insurance policies available in the current marketplace that attempt to address the problem of debtor-in-possession claims. For example, one policy’s list of the bankruptcy-related claimants for whose claims coverage is carved back include “a Claim by the Entity as Debtor-in-Possession after such Examiner, Trustee, Receiver has been appointed.” The prerequisite for the availability of coverage under this carve back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.

Whether or not this particular formulation is sufficient to preclude the possibility of collusive claims, it strikes me as a step in the right direction toward protecting against the possibility that individuals could otherwise be left without coverage for claims of a kind for which these policies were intended to provide protection.

One final observation about this particular coverage problem is that whether or not the primary D&O insurer will agree to provide a coverage carve back in the I v I exclusion for debtor in possession claims, an insured company may be able to purchase an excess Side A policy providing “difference in condition” protection and that either does not contain an I v. I exclusion or has one that is very narrowly circumscribed.

 Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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