Wasn’t Me: The Insured vs. Insured Exclusion (“Side A”)

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In the novel A Frolic of His Own, by William Gaddis1, the protagonist, Oscar Crease, is run over by his own driverless car when it slips from park into neutral while Oscar is standing in front of the car trying to hot-wire it. With Oscar being both the owner of the car as well as the victim of an accident in which there is no driver, a novel question arises: What will his insurance company cover, and who will Oscar and his insurance company sue for damages? While this may not sound like such a novel concept now, bear in mind that the novel was published in 1994, and Tesla was founded in 2003.

To answer the question (without spoiling the novel), certain insurance policies contain a provision excluding from coverage claims brought by a person insured under a policy against a person also insured under the same policy. This is called the insured-versus-insured exclusion. If Oscar Crease’s car insurance policy had simply contained such an exclusion, the novel might not have won the U.S. National Book Award for Fiction.

A similar question – albeit without the self-driving cars – was addressed in the bankruptcy context in Indian Harbor Ins. Co. v. Zucker.2 The United States Court of Appeals for the Sixth Circuit in this case grappled with the question of whether an insured-versus-insured exclusion that applied to claims “by, on behalf of, or in the name or right of, the Company or any Insured Person” against an Insured Person properly excluded from coverage – that is, insured-versus-insured – could instead be brought by a company’s Liquidating Trust against an Insured Person properly excluded from coverage, specifically against former officers and directors of the company. Permitting such claims would seemingly be an end-run around the very concept of the insured-versus-insured exclusion.

The Sixth Circuit agreed, ultimately finding that the exclusion applied and precluding the Liquidation Trust from prosecuting such claims.

This decision was recently examined in Palmaz Scientific, Inc. v. Admiral Insurance Co.3 by the United States Bankruptcy Court for the Western District of Texas, which found it unpersuasive, reaching the opposite conclusion.

This post is part one of a two-part series examining these two opinions and the intricacies of the insured-versus-insured exclusion. However, before delving into the Indian Harbor v. Zucker opinion, it’ll be helpful to first spend some time discussing the role of management liability insurance in the context of chapter 11 bankruptcy proceedings.

Management Liability Insurance

State law generally permits companies to maintain “management liability insurance” to protect a company and/or its directors and officers from loss in connection with claims made against them for acts or omissions by the company or its directors and officers in their official corporate capacities. Management liability insurance can include, in a single or multiple policies, directors and officers liability insurance (“D&O” insurance), employment practices liability insurance, and fiduciary duty liability insurance, among other things.

For companies facing or undergoing a restructuring or liquidation, D&O insurance is typically the most important component of the company’s management liability coverage. D&O insurance, while bespoke, is usually comprised of three different components:

  1. “Side A” coverage, which typically insures past, present, and future directors and officers in their respective capacities as individual insureds against insured losses arising from claims for their actual or alleged wrongful acts;
  2. “Side B” coverage, which insures the company for amounts it pays out to indemnify its directors and officers; and
  3. “Side C” coverage, which insures the company against losses arising from claims for its actual or alleged wrongful acts. Exactly what wrongful acts or omissions are covered by D&O insurance varies from policy to policy, but generally, intentionally illegal acts are not insurable.

In the context of a bankruptcy proceeding, disputes often arise as to whether the proceeds of a D&O insurance policy are property of the debtor’s estate (and thus available for distribution to creditors) or are property of the officers and directors personally. Such disputes are usually quite fact intensive and courts have not decided the issue uniformly. However, amid this uncertainty, deals are frequently struck in which causes of action covered by insurance are assigned to or otherwise held for the benefit of creditors in exchange for their support of a proposed plan of reorganization. Such an arrangement usually limits the creditors’ recovery to the amounts paid by the insurer, thereby increasing the potential recovery received by creditors while also cutting off recourse to the debtors or their officers and directors for payment — a win-win for all parties involved, with the notable exception of the insurance company responsible for paying out the claim.

Indian Harbor Ins. Co. v. Zucker

In Indian Harbor v. Zucker the debtor failed to gain support from the official committee of unsecured creditors (“the Committee”) for any of three potential chapter 11 plans of liquidation it had proposed. Each of these liquidating plans included provisions releasing the debtor’s executives from both pre- and postpetition liability.

The debtor ultimately reached an agreement with the Committee in which executives would only be released from liability for conduct that occurred after the debtor filed for chapter 11. As part of this agreement, liability for executives’ prepetition conduct would remain intact but would be limited to amounts recovered from the debtor’s insurance policy.

To give effect to this agreement, the debtor assigned all of its causes of action to a Liquidation Trust, so that these actions could be pursued on behalf of creditors.

With the requisite support in hand, the debtor’s liquidating plan was confirmed in January 2014, and in August 2014, the Liquidation Trustee for the Liquidation Trust sued certain of the debtor’s executives for breach of their fiduciary duties to the Company. In response, the insurance company underwriting the D&O policy sued the Liquidation Trustee for a declaratory judgment that “the [Liquidation] Trustee’s lawsuit falls within the ‘insured-versus-insured’ exclusion in [the Company’s] liability insurance policy.”

The Liquidation Trustee’s suit was not a derivative suit on behalf of creditors. Standing for the Committee to bring such a suit was denied by the bankruptcy court, and that was one of the contributing factors that led the Committee to negotiate the plan ultimately confirmed with the debtor. Rather, the Liquidation Trustee initiated a direct suit based on a cause of action that originally belonged to the debtor’s estate, and which was transferred to the Liquidation Trust. Moreover, it is unclear from the record whether the debtor’s specific insurance policy would have covered a derivative suit brought by creditors, or a suit brought by a court-appointed trustee since the two enumerated exceptions to the insured versus insured clause were for “derivative suits by independent shareholders and employment claims.”

Although the court expressly declined to opine on this issue, it noted that “[i]f the parties meant to cover these lawsuits after bankruptcy, they could have included an exception for suits brought by bankruptcy trustees or creditor’s committee, just as they included an exception for derivative shareholder suits.”

The district court held that the insured-versus-insured exclusion applied. The Liquidation Trustee and the affected officers appealed the decision to the court of appeals for the Sixth Circuit, which upheld the District Court decision by a split 2-1 margin.

Majority Opinion

In upholding the District Court’s determination that the Liquidation Trust’s lawsuit fell within the insured-versus-insured exclusion, the Court of Appeals rejected the Liquidation Trustee’s argument that pursuant to section 541(1)(a) of the Bankruptcy Code, the Company, as a debtor in possession, was legally distinct from the prepetition company and thus outside the scope of the insured-versus-insured exclusion. The court found this argument untenable for three main reasons:

First, even if the postpetition company was legally distinct from the prepetition company, it still received its claim from the prepetition company and thus, “the transferred claim would be filed on behalf of or in the right of” the Company.

Second, by its own terms, the insurance contract continued to be in effect and continued to cover the Company after it filed for chapter 11 protection, and the Company twice extended the policy postpetition.

Third, such reasoning was rejected by the Supreme Court in NLRB v. Bildisco & Bildisco4, which stated that “if the [debtor in possession] were a wholly ‘new entity,’ it would be unnecessary for the Bankruptcy Code to allow it to reject executory contracts, since it would not be bound by such contracts in the first place.”

While the court specifically declined to hold that the insured-versus-insured exclusion would not have applied to a suit brought by “a court-appointed trustee that receiv[ed] the right to sue on the estate’s behalf by statute,”5 it nevertheless went to great lengths to distinguish such a trustee from “a voluntary assignee” like the Liquidation Trust in the instant case. According to the court, “[a]s an assignee, the Trust stands in [the Company’s] shoes and is subject to the same defenses” and thus “brings a breach-of-fiduciary-duty suit by, on behalf of, or in the name or right of the debtor in possession.”

Dissenting Opinion

By contrast, the dissent reached the opposite conclusion based on two main lines of reasoning:

First, the dissent reasoned that case law supports the proposition that a suit brought by a court-appointed trustee does not fall within the insured-versus-insured exclusion.6 Thus, if a court-appointed trustee could bring this suit without tripping the exclusion, why wouldn’t an assigned trustee have the right to the same exemption given that, functionally, “there is no distinction between an assigned trustee that a bankruptcy court has determined is independent and does not pose a risk of collusion, and one that is appointed by a bankruptcy court and is by nature of that appointment independent”?

Second, the dissent reasoned that because the terms of the insurance contract did not extend the insured-versus-insured exclusion to the Company’s successors or assigns, the Trustee’s suit was not brought “in the name or right of the Company,” as it was brought in the name or right of the Company’s successor — the debtor in possession — by such successor’s assignee, the Liquidation Trust.

The dissent also raised significant concern with the result reached in this case — “it makes it harder for companies to emerge from bankruptcy with a consensual plan of reorganization” — cautioning that “[i]f the majority’s decision becomes settled precedent, this Court will send a clear message to creditors in chapter 11 proceedings that if claims against directors and officers are deemed to be of significant value and the plan proposes to put those claims into a trust, the creditors must not agree to a plan proposed or even agreed to by the debtor-in-possession. Instead creditors will be required to seek the appointment of a bankruptcy trustee, where appropriate, or they will have to defeat the debtor-in-possession’s plan and propose their own disclosure statement and plan. The cost in terms of professional fees and judicial resources cannot be overstated, especially in light of the fact that there would be no practical difference to the insurance companies as they would still be required to defend the directors’ and officers’ claims.”

In Part II of this post, we will look at a decision on “Side B” of the insured-versus-insured exclusion argument: Palmaz Scientific, Inc. v. Admiral Insurance Co.7 by the United States Bankruptcy Court for the Western District of Texas, which reached the opposite conclusion to Indian Harbor Ins. Co.