Among the looming economic consequences of the pandemic is the likelihood of a huge surge in bankruptcy filings. A rise in bankruptcies will in turn likely lead to an increase in the number of bankruptcy-related litigation claims against directors and officers of the bankrupt companies, which in turn could lead to insurance coverage issues under the companies’ D&O insurance policies. In the following guest post, Alicia Garcia and Kate Hausmann, Complex Claim Specialists with Hiscox USA, and James Talbert and Elan Kandel of the Bailey Cavalieri law firm take a look at the issues that could arise in the bankruptcy context with respect to the policies’ Insured vs. Insured Exclusion. I would like to thank the authors for allowing me to publish their article as a guest post on this site. I welcome guest post submissions from responsible authors on topics of interest to this blog’s readers. Please contact me directly if you would like to submit a guest post. Here is the authors’ article.
In recent weeks, The New York Times and the Wall Street Journal have each reported that the Coronavirus crisis may cause already teetering debt laden companies to seek bankruptcy protection in record numbers. [i] Indeed, this prediction appears to have been partially borne out already. According to the American Bankruptcy Institute, Chapter 11 bankruptcy filings have risen from 1,380 in 2019 to 1,812 in 2020, with a 48% year-over-year increase in the month of May.[ii] Further, some commentators have opined that the rise in commercial bankruptcies closely tracks the pattern seen in the 2008 financial crisis.[iii]
As more companies seek relief via the Bankruptcy Code, it is not unreasonable to expect a commensurate uptick in bankruptcy related litigation claims made against directors and officers and, in turn, an uptick in claims made under directors and officers policies. Accordingly, insurers and policyholders alike would be well-served to review their policies, and in particular, the applicability of the “insured vs. insured” exclusion.
As the name suggests, the insured vs. insured exclusion generally bars coverage for claims prosecuted by or on behalf of an insured against any other insured. The exclusion reflects the principle that D&O policies are intended to cover external threats, rather than infighting among the insureds. Another often-cited rationale for insured vs. insured exclusion is that it serves to eliminate coverage for collusive lawsuits.
In the context of coverage litigation involving underlying bankruptcy related claims, an often litigated issue focuses on the identity of the persons or entities on whose behalf the underlying claim is being prosecuted—a question that can become somewhat abstract in the bankruptcy context, where the rights and interests of the debtor may be prosecuted by one of several possible stand-ins or proxies (e.g., a receiver, trustee, litigation trust, liquidator, examiner, conservator, etc.).
Several cases demonstrate that, to understand an insured vs. insured exclusion’s applicability in the context of a bankruptcy, one must carefully consider the nature and purpose of the proxy pursuing the bankruptcy claim(s). Several cases illustrate this point.
Most recently, in Westchester, et al. v Schorsch, et al.,[iv] a creditor trust sued the debtor’s directors and officers, alleging that they had breached their fiduciary duties. The insurer denied coverage based on the policy’s insured vs. insured exclusion, which barred coverage for “any Claim made against an Insured Person . . . by, on behalf of, or at the direction of the Company or Insured Person.”[v] The court did not sustain the declination noting that the policy’s insured vs. insured exclusion contained an exception that restored coverage for claims “brought by the Bankruptcy Trustee or Examiner of the Company or any assignee of such Trustee or Examiner, or any Receiver, Conservator, Rehabilitator, or Liquidator or comparable authority of the Company.” (emphasis added). According to the court, the creditor trust fit within the “comparable authority” clause of the exclusion’s bankruptcy exception.[vi] In reaching this decision, the court relied on the fact that the post-confirmation creditor trust was an entity and authority in its own right, with its own agency, distinct from the debtor corporation. The court also noted a divergence of interest between the creditor trust and the remaining insureds, pointing out that the creditor trust was created in order to pursue claims that the existing management might be reluctant to pursue (including claims against former officers and directors).
In another recent case, styled Phila. Indem. Ins. Co. v. Providence Cmty. Action Program, Inc., the court concluded that an insured vs. insured exclusion was inapplicable to claims brought by a bankruptcy receiver. However, unlike the Westchester court, the Philadelphia Indemnity court reached this conclusion solely based on the insured vs. insured exclusion’s requirement that a lawsuit be brought “by or on behalf of” an insured. According to the court, a court-appointed receiver could not accurately be viewed as working “on behalf” of the insured debtor, since the receiver was appointed by the court and served as the court’s agent, worked for the benefit of various parties, and had the ability to distribute assets to parties other than the debtor corporation.[vii] Accordingly, the court found that the receiver was not operating on behalf of the insured debtor and its claims were therefore not precluded by the applicable policy’s insured vs. insured exclusion.
Lastly, in Indian Harbor Ins. Co. v. Zucker, the Sixth Circuit Court of Appeals found an insured vs. insured exclusion applicable to claims brought by a debtor in possession. There, the court acknowledged that a debtor in possession is legally distinct from the insured company, accepting the insureds’ argument that the insured entity “underwent a transformation when it filed bankruptcy . . . . [in which a]ll of its assets, including all causes of action, became property of the bankruptcy estate and [it] became a debtor in possession administering the estate for the benefit of the creditors.”[viii] However, the court rejected the argument that a debtor in possession was not acting “by or on behalf of” the insured for purposes of the insured vs. insured exclusion. Specifically, the court observed that, outside of the bankruptcy context, an insured could never escape the application of an insured vs. insured exclusion merely by transferring its claims to another entity. As such, the court found the “legal distinction” argument insufficient, holding that “no matter how legally distinct [the debtor in possession] might be, its claim would still be ‘by, on behalf of, or in the name or right of’” the insured debtor.
If the past is prologue, we would expect the perennial coverage issues involving the insured-v-insured exclusion to remain a “hot button” issue for D&O insurers and policyholders. Accordingly, we would recommend that insurers and policyholders alike review their policy wording during the underwriting process to ensure that the exclusion is tailored to obviate such issues, particularly assuming record numbers of bankruptcies ensue.
[i] Mary Williams Walsh, A Tidal Wave of Bankruptcies is Coming, The New York Times (June 18, 2020), https://www.nytimes.com/2020/06/18/business/corporate-bankruptcy-coronavirus.html; Cezary Podkul & Ana Rivas, How Coronavirus Upended a Trillion-Dollar Corporate Borrowing Binge and Kicked Off a Wave of Bankruptcies, The Wall Street Journal (June 24, 2020), https://www.wsj.com/articles/how-coronavirus-upended-a-trillion-dollar-corporate-borrowing-binge-and-kicked-off-a-wave-of-bankruptcies-11592991001.
[ii] See April 2020 Bankruptcy Statistics – Commercial Filings, American Bankruptcy Institute (last visited July 1, 2020), https://www.abi.org/newsroom/bankruptcy-statistics; May Commercial Chapter 11s Increase 48 Percent over Last Year, Total Filings Down 42 Percent, American Bankruptcy Institute (June 4, 2020), https://www.abi.org/newsroom/press-releases/may-commercial-chapter-11s-increase-48-percent-over-last-year-total-filings.
[iii] See Vince Sullivan, Rise in Ch.11 Echoes 2008 Financial Crisis, Law 360 https://www.law360.com/articles/1289289/rise-in-ch-11-cases-echoes-2008-financial-crisis (last visited July 21, 2020)
[iv] 2020 N.Y. App. Div. LEXIS 2979, at *2–3 (N.Y. App. Div. 1st May 14, 2020).
[v] Id. at *7, 9.
[vi] Id. at *14.
[vii] 2017 U.S. Dist. LEXIS 9345, at *8–10 (D.R.I. Jan. 24, 2017).
[viii] 860 F.3d 373, 376 (6th Cir. 2017).