Standard D&O insurance policies typically include an exclusion precluding coverage for claims brought by one insured against another insured. This exclusion also typically has a carve-back to the exclusion preserving coverage claims brought by bankruptcy officials, such as a trustee or received. One recurring question is whether or not a claim brought against an insured person by the company acting as debtor-in-possession is precluded by the exclusion, or whether the bankruptcy carve-back preserves coverage for the claim.
In an interesting October 3, 2024, decision, a bankruptcy court judge presiding over the Chapter 11 bankruptcy of Walker County Hospital Corporation, and applying Texas law, held that a claim by the Hospital acting as debtor-in-possession against the Hospital’s former CEO fell within the bankruptcy carve-back, and therefore that the insured vs. insured exclusion did not preclude coverage. The court’s analysis of this recurring question is interesting, as discussed below. A copy of the bankruptcy court’s October 3, 2024, opinion can be found here.
Background
Shannon Brown was the Hospital’s CEO from 2013 to February 2018. In November 2021, the Hospital filed a voluntary bankruptcy petition under Chapter 11 of the Bankruptcy Code. The filing of the petition automatically created a bankruptcy estate. Under the provisions of the Bankruptcy Code, the Hospital Corporation is the debtor-in-possession of the bankruptcy estate.
The Hospital sent Brown two demand letters, accusing Brown of having breached his duties to the Hospital while he served as the Hospital’s CEO. The Hospital demanded that Brown reimburse the Hospital for certain losses that the Hospital contended were the result of the CEO’s breaches of his duties. In March 2022, the Estate, acting through the debtor-in-possession, filed an adversary action in the bankruptcy proceeding against Brown.
Brown tendered the demand letters and the complaint to the Hospital’s D&O insurer, seeking to have the insurer provide him with a defense in the adversary proceeding. The insurer denied coverage for the claims based on its assertion that coverage for the claims was precluded by the policy’s insured vs. insured exclusion. Brown filed a cross-claim in the adversary proceeding against the insurer, alleging that the insurer had breached its duties under the D&O insurance policy and seeking a judicial declaration that the insurer was obliged to defend him in the adversary proceeding.
The insurer filed a motion to dismiss Brown’s cross-claim, arguing that coverage for the claims was precluded by the insured vs. insured exclusion. Brown filed a motion for judgment on the pleadings, arguing that the Hospital’s claims as debtor-in-possession fall within the bankruptcy exception to the insured vs. insured exclusion, and therefore that coverage was not precluded.
The Relevant Policy Language
The policy defines “Company” as the “Named Insured,” “any Subsidiary of the Named Insured,” and “the Named Insured or Subsidiary as a debtor, a debtor-in-possession, or equivalent status.”
The policy provides in pertinent part that “This Coverage Section shall not cover any Loss in connection with any Claim … H. Brought by or on behalf of any Insured, provided however, that this Exclusion shall not apply to: … (6) any Claim brought or maintained by or on behalf of a bankruptcy or insolvency trustee, examiner, receiver or similar official for the Company or any assignee of such trustee, examiner, receiver or similar official.”
The Court’s Opinion
On October 3, 2024, Southern District of Texas Bankruptcy Judge Marvin Isgur issued an opinion granting Brown’s motion for judgment and denying the insurer’s motion to dismiss.
Judge Isgur started his analysis by observing that if the Hospital had brought its claim against Brown in the Hospital’s original status, the claim would be precluded by the Insured vs. Insured exclusion. The question is whether the Hospital’s status as debtor-in-possession necessitates a different result.
In arguing that the bankruptcy carve-back to the exclusion preserved coverage for the Hospital’s claim against Brown, Brown argued that a debtor-in-possession is “akin to a bankruptcy trustee,” the debtor-in-possession is a “similar official” to the bankruptcy court offices for whose claims, and therefore the bankruptcy carve-back preserved coverage.
In concluding that the Hospital’s claim as debtor-in-possession against Brown came within the bankruptcy exception, Judge Isgur followed a 2004 opinion of the Northern District of Illinois Bankruptcy Court, which had reached this conclusion in reliance upon the provisions of the Bankruptcy Code and the Bankruptcy Rules which, the court said, and Judge Isgur agreed, provides the debtor-in-possession with all of the rights, powers, functions, and duties of a bankruptcy trustee. The court expressly cited Section 1107(a) of the Bankruptcy Code, which provides, with certain exceptions not relevant here, that “A debtor-in-possession shall have all of the rights … of a trustee serving in a case under this chapter.”
Judge Isgur did identify an “ambiguity,” which is that on the one hand, the Policy defines the debtor-in-possession to be the company, which would imply by itself that coverage for a claim by a company as debtor-in-possession against an insured person is precluded by the insured vs. insured exclusion, while on the other hand a debtor in possession is a “similar official to a bankruptcy trustee” and therefor authorized to bring a claim in the same way as a trustee. Judge Isgur said “By using these terms without precision, the Policy never considers what happens when a claim is brought by an entity acting for the Estate, the legal owner of the claim.”
To resolve this ambiguity, Judge Isgur cited the principle of insurance contract interpretation under Texas law that ambiguities in an insurance policy must be construed against the insurer, observing that the more reasonable interpretation is that the insured vs. insured exclusion’s bankruptcy exception “acts to permit coverage for suits in bankruptcy by fiduciaries acting on behalf of a debtor’s estate.”
This interpretation, Judge Isgur said, is “better supported” by the Bankruptcy Code, “where bankruptcy trustees and debtors-in-possession are authorized to perform nearly identical functions on behalf of the estate.” He added that “An exception that permits coverage for a trustee to take an action while excluding coverage for a debtor-in-possession taking the exact same action would ignore Section 1107 of the Bankruptcy Code.”
Discussion
The question of whether the insured vs. insured exclusion applies to preclude coverage for an action brought against an insured person by a company acting as a debtor-in-possession is not new. It is an issue that recurs with fairly regular frequency. Indeed, I have had occasion to consider this issue multiple times in the past on this site (for example, here). From Judge Isgur’s opinion, it is apparent that both sides of this dispute were able to cite multiple judicial decisions to the court in which the court cited had decided the issue in a way consistent with each of their respective arguments.
There is a puzzle at the center of this frequently disputed issue, and that is why many D&O insurance policies (like the one at issue here) very expressly and deliberately define the term “Company” to include the company acting as debtor-in-possession, but when it comes to the bankruptcy carve-back to the insured vs. insured exclusion, most policies are silent.
The logical explanation for this apparent conundrum is that the insurers want it to be clear that the company acting as debtor-in-possession is still the company, and also that claims by the company acting as debtor-in-possession does not fall within the bankruptcy carve back to the exclusion. However, as was the case here, even though the bankruptcy carve-back does not expressly refer to the debtor-in-possession, a court could well conclude that the bankruptcy carve-back applies.
The crux of the issue here is what the word “similar” means in the phrase “similar official” in the bankruptcy carve-back. Judge Isgur had no problem saying that, because a debtor-in-possession and a trustee have similar powers and duties, a debtor-in-possession and a trustee are sufficiently “similar” for a debtor-in-possession to qualify as a “similar official” within the meaning of the bankruptcy carve-back to the insured vs. insured exclusion.
In the sense that Judge Isgur meant, a debtor-in-possession and a trustee are “similar.” But it does not necessarily follow that a debtor-in-possession is a “similar official” to a “trustee, examiner, [or] receiver” within the meaning of the bankruptcy carve-back. In important ways, a debtor-in-possession is in fact a “dissimilar official” from a “trustee, examiner, or receiver.” Those other officials are all third parties, not previously affiliated or connected with the company, and appointed by the bankruptcy court. The debtor-in-possession is of course the company (which in fact the policy itself says) and its status as debtor-in-possession is the result of self-appointment; the bankruptcy company becomes debtor-in-possession by filing the bankruptcy petition.
There is an obvious reason that an insurer might be okay insuring claims brought by third-party appointed bankruptcy officials (i.e., trustees, receivers, etc.) but not okay with insuring claims brought by the debtor-in-possession, and that is the possibility of collusive claims. As the Ninth Circuit concluded in the July 2009 Visitalk case, which I discussed here, if there were to be coverage for claims by the company as a 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 the 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.
The collusion issue did, in fact, come up in the Walker County Hospital case. Judge Isgur, in explaining his conclusion that the bankruptcy carve-back preserved coverage for the debtor-in-possession’s claim, observed that this outcome was consistent with the purposes of the insured vs. insured exclusion; the exclusion, he noted, was there to prevent against collusive claims and corporate in-fighting. He said that these considerations were not present here, which apparently is true. But I think it is important to note that the insured vs. insured exclusion is there not just to preclude coverage for collusive claims; it is also there to ensure that the policy does not create perverse incentives for collusive claims, as the Ninth Circuit observed in the Visitalk case.
I have long thought that insurers could clean up this recurring coverage issue by the relatively simple expedient of making it clear that claims by a company acting as debtor-in-possession fall within the bankruptcy carve-back to the insured vs. insured exclusion. But this simple expedient has never really caught on, and I think the reason is that the insures actively don’t want the carve-back to include claims brought by a company as a debtor-in-possession.
There are ways around the problem here. At least 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, or Receiver has been appointed.” The prerequisite for the availability of coverage under this care back for the appointment of an examiner or trustee does represent some check against the collusive possibilities about which the Ninth Circuit was concerned.
Another 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 insured vs. insured exclusion for debtor-in-possession claims, a company may be able to purchase an excess Side A policy providing “difference in condition” (DIC) protection and that does not contain an insured vs. insured exclusion or has one that is very narrowly circumscribed.
In the end, and in the absence of a revision to the bankruptcy carve back to expressly state that the carve back applies to preserve coverage for claims brought by a debtor-in-possession, insured persons seeking coverage for claims brought against them by a debtor-in-possession is a “similar official” to a trustee, because under the bankruptcy code the debtor in possession has the same powers and duties as a trustee, as Judge Isgur said.