The Insured vs. Insured exclusion is a standard provision found in most D&O insurance policies. As its name implies, the exclusion precludes coverage for claims brought by one insured against another insured. The exclusion is a frequent source of coverage disputes, particularly in the bankruptcy context, due to frequent disagreements over the exclusion’s application to claims brought against company management by representatives of the creditors or of the bankrupt estate. One recurring dispute of this type is the question of the exclusion’s applicability to claims brought against company management by the company as debtor-in-possession. A recent appellate question considered a variation of this question – that is, whether the exclusion precluded coverage for claims brought against company management by the trustee of a liquidation trust as an assignee of the company as debtor in possession. In a June 20, 2017 opinion (here), the Sixth Circuit (applying Michigan law) held that the exclusion precluded coverage for the liquidation trustee’s claim. The appellate ruling raises some interesting issues, discussed below.
John Reid founded and was Chairman and CEO of Capitol Bancorp, which owned community banks in seventeen states. His daughter Cristin Reid served as Capitol’s president. In 2012, Capitol filed a voluntary bankruptcy petition under Chapter 11 of the bankruptcy code. Capitol became custodian of the bankrupt estate as a debtor in possession. In 2014, Capitol and its creditors agreed to a liquidation plan that required Capitol to assign all of the company’s causes of action to a Liquidating Trust. Among other things, the plan limited the Reids’ liability for any post-petition conduct and restricted the Reids pre-petition liability to amounts recovered from Capitol’s liability insurance policy.
In August 2014, the Liquidation Trustee sued the Reids, alleging they had breached their fiduciary duties to Capitol through a number of improper actions. The Liquidation Trustee also notified Capitol’s D&O insurer of the lawsuit. The insurer responded by filing an action seeking a judicial declaration that coverage for the lawsuit was precluded by the D&O insurance policy’s insured vs. insured exclusion. The district court agreed that the policy does not cover the Liquidation Trustee’s action. The Liquidation Trustee and the Reids appealed.
The policy’s insured vs. insured exclusion excludes from coverage “any claim made against an Insured Person … by, on behalf of, or in the name or right of, the Company or any Insured Person.”
The June 20, 2017 Opinion
On June 20, 2017, in an opinion by Judge Jeffrey Sutton for a 2-1 majority (Judge Bernice Donald dissenting), the Sixth Circuit affirmed the district court’s ruling that the policy’s insured vs. insured opinion precluded coverage for the Liquidation Trustee’s claims against the Reids.
Judge Sutton began by noting that if Capitol itself had sued the Reids, that would be a claim “by” an insured person (the company) against its officers (also insured persons), and the insured vs. insured exclusion would preclude coverage. This case, the judge said, is “one step removed from that example,” but the “outcome remains the same even so.” As a voluntary assignee of Capitol’s claims, “the Trust stands in Capitol’s shoes and possesses the same rights subject to the same defenses.” Just as the exclusion precludes coverage for a lawsuit “by” Capital, it also precludes coverage “by” the Trust “in the … right of” Capitol.
In reaching this conclusion, the appellate court rejected the Liquidation Trustee’s argument that the “Company” referred to in the exclusion was Capitol in its pre-bankruptcy form, not the company as debtor in possession. When it filed for bankruptcy, the Liquidation Trustee argued, Capitol “underwent a transformation” and became legally distinct from the pre-bankruptcy company, making the insured vs. insured exclusion inapplicable. In rejecting this argument, Judge Sutton noted that Capitol could not have dodged the exclusion by transferring the mismanagement claim to a different company, because the claim still would be “by, on behalf of, or in the name or right of” Capitol. The same conclusion, Judge Sutton said, applies to a voluntarily transferred claim after bankruptcy.
The appellate court found that legal principles regarding the debtor in possession status confirm the court’s conclusion. Among other things, the court noted that the U.S. Supreme Court has rejected the argument that a debtor in possession is a wholly new entity unbound by the pre-bankruptcy company’s contracts. The appellate court noted further that if Capitol had successfully emerged from Chapter 11 bankruptcy, it would once again be the same “Company” covered by the contract, which contradicts the notion that as debtor in possession is an entirely distinct entity for purposes of the insurance contract.
The court also said that it makes no difference that the bankruptcy court had approved the plan that transferred the bankruptcy estate’s causes of action from Capitol to the Liquidation Trust. While, the appellate court acknowledged, the court’s approval “offers a safeguard against the collusive suits that the insured-versus-insured exclusions seek to prevent, the fact that the plan was designed to avoid collusion does not avoid the effect of the contract’s exclusion.” The court said the policy’s provision “does not mean that collusion must be found before the provision applied.” Because, the appellate court said, the term “Company” includes Capitol as debtor in possession, the exclusion precludes coverage.
In a dissenting opinion, Judge Bernice Donald stated her view that the majority’s opinion was contrary to some fundamental bankruptcy law principles. In particular, she said, one of the reasons company’s seek protection under the bankruptcy laws is precisely because a company as debtor in possession take on a different status from the pre-petition entity. Companies in debtor in possession status have important rights that the pre-petition companies do not.
In a general sense, the Sixth Circuit’s holding here is consistent with the rulings of other courts, which have held that D&O insurance policies insured vs. insured exclusion precludes coverage for claims brought against a company’s management by the company as debtor in possession. For example, as discussed here, in June 2015, the Third Circuit, applying New York law, held that a D&O insurance policy’s insured vs. insured exclusion precluded coverage for a claim brought by a company as debtor in possession against company management.
The twist on the recurring question this case presents is whether the assignment of Capitol’s causes of action to the liquidation trustee changes the analysis. The Sixth Circuit rejected both ends of the trustee’s argument; the appellate court ruled that the fact that the company was a debtor in possession did not alter the exclusion’s preclusive effect, and that the assignment by the company as debtor in possession of the causes of action to the trustee did not eliminate the preclusion.
One curious thing about the exclusion at issue in this case is that it did not seem to have a standard coverage carve-back typically found in D&O insurance policies that preserves coverage for claims asserted by bankruptcy court trustees, receivers, liquidators and creditors’ committees. The absence of this standard coverage carve-back in the exclusion at issue here fueled discussion both by the majority and by the dissent, as both opinions sought to analyze whether the exclusion’s preclusive effect would operate differently where causes of action are involuntarily transferred (to a bankruptcy trustee, for example) than a situation such as the one here where the causes of action were voluntarily transferred. While the policy at issue here apparently lacked this standard coverage carve-back, it seems unlikely that even if the exclusion at issue here had included the standard coverage carve-back that the outcome here would have changed.
The insured vs. insured exclusion at issue in the recent Third Circuit case cited above included the standard coverage carve back for claims brought by a bankruptcy trustee, yet the court nevertheless concluded that the insured vs insured exclusion precluded coverage for claims brought against company management by the company as debtor in possession. The bankruptcy claim coverage carve-back found in the insured vs. insured exclusion in most D&O insurance policies (including the policy at issue in the Third Circuit case) typically does not include claims by the company as debtor in possession within the list of the types of claims for which coverage is preserved.
The policy at issue here also omitted another term that increasingly is standard in D&O insurance policies – that is, many policies these days include a specific provision expressly providing that the term “Company” in the policy includes the company as debtor in possession. This case shows why this provision has become standard. It eliminates the issue that was at the core of the questions surrounding the applicability of the insured vs. insured exclusion here, which is whether the term “Company” in the policy included the company as debtor in possession.
The coverage problem that is created when the company as debtor in possession is included within the term “Company” (whether – as in the Third Circuit case — as a result of an express policy provision or –as was the case here — as a result of an interpretation of the legal principles surrounding debtor in possession status) is that as a result the policy’s insured vs. insured exclusion thereby operates to preclude coverage for claims brought against company management by the company as debtor in possession. The problem with this is that it leaves company management exposed to claims without insurance for claims of a kind for which D&O policies are intended to provide coverage.
The solution I have advocated for this problem is for the standard bankruptcy claim coverage carve back found in most D&O insurance policies to be modified to expressly preserve coverage for claims brought against company management by the company as debtor in possession.
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 frequently recurring kinds of claims of the very type for which D&O policies are intended to provide coverage.
There are 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 note about the Sixth Circuit’s opinion has to do with the appellate court’s reference to collusive claims. It is often said that the purpose of the insured vs. insured exclusion is to prevent collusive claims. On the basis of this theory, attempts are frequently made to argue that the exclusion doesn’t apply if an otherwise precluded claim is not collusive. The defect with this argument is that the exclusion doesn’t say anything about collusive claims, as the Sixth Circuit noted here. The contractual provision, the appellate court said, “does not mean that collusion must be found before the provision applies.” In other words, the exclusion’s preclusive effect is not limited just to collusive claims, and if the exclusion otherwise applies to a particular set of circumstances, the exclusion operates to preclude coverage, whether or not the claim is collusive.
More About the Insured vs. Insured Exclusion: In yet another recent judicial decision addressing an insurance coverage dispute concerning the insured vs. insured exclusion, on June 21, 2017, the Superior Court of New Jersey Appellate Division, applying New Jersey law, affirmed a lower court’s holding that the insured vs. insured exclusion precluded coverage for a counterclaim filed against a manager of a medical equipment leasing company. A copy of the New Jersey decision can be found here.
The manager (Abboud) had initiated the underlying litigation by suing the company and several of its members and managers. The defendants filed counterclaims against Abboud. He sought defense and indemnity for the counterclaim from the company’s management liability insurer. The insurer denied coverage in reliance on the insured vs. insured exclusion. Abboud filed an action for a seeking a judicial declaration that the policy covered the counterclaims. The trial court entered summary judgment in the insurer’s favor. Abboud appealed.
The appellate court affirmed. Contrary to Abboud’s arguments, the appellate court found no ambiguity in the exclusion. The appellate court also found “no basis” for Abboud’s argument that a showing of collusion between the insureds is required to invoke the exclusion. Finally the appellate court said that it found “no merit” in Abboud’s argument that the insurer should be barred from denying coverage because it would violate his reasonable expectations. In rejecting Abboud’s reasonable expectations argument, the court said that the exclusion’s language is “straightforward” and not so confusing that the average policyholder cannot make out the boundaries of the coverage.
In holding that a showing of collusion is not required in order for the exclusion to apply, the court reviewed the history and purpose of the exclusion in D&O insurance policies. Readers may find this portion of the court’s opinion particularly interesting.