United States: The Insured v. Insured Exclusion And Section 1123: The Primacy Of Bankruptcy Law And The Importance Of Planning Ahead

The Insured v. Insured ("IVI") exclusion is a frequent and important issue for directors & officers ("D&O") liability coverage, particularly where the bankruptcy of an insured entity may blur the lines of who is an insured and who is acting on behalf of an insured. Nevertheless, because the exclusion generally bars coverage for a claim made against an insured individual that is "brought or maintained by or on behalf of" the insured entity, whether the IVI exclusion applies is often the single most important coverage issue for the many claims often asserted against a debtor's former directors and officers in bankruptcy.

Although the applicability of the IVI exclusion to bankruptcy-related claims has been litigated several times and often decided in favor of insurers, none of those cases has addressed the critical question of the primacy of Bankruptcy Code Section 1123, and how this provision may prevent application of the exclusion in such circumstances. Therefore, as insurers become more emboldened by their prior victories, debtors, their former directors and officers, as well as their bankruptcy and coverage counsel should be careful to consider Section 1123 both when drafting the debtor's plan of reorganization and in any subsequent insurance coverage litigation.

Bankruptcy plans often now provide that certain claims will be prosecuted by a litigation trustee for the benefit of a creditor trust post-bankruptcy. A number of cases have applied the IVI exclusion to defeat coverage for such claims. Most recently, in Indian Harbor Insurance v. Zucker, a federal district court in Michigan held that the IVI exclusion applied to bar a claim brought by a trustee appointed to a post-bankruptcy litigation trust. In reaching this conclusion, the Indian Harbor court followed earlier similar decisions in a number of other federal courts, including the Ninth Circuit (Biltmore) and district courts in Virginia (R.J. Reynolds) and Missouri (Weis).[1]

Although each of these decisions was in large part driven by its particular facts, the basic premise of each is that a post-bankruptcy trustee is an ordinary assignee of the debtor company—an insured—and therefore purportedly stands in the shoes of such insured debtor for purposes of the IVI exclusion. This finding of an alleged "ordinary assignment," however, ignores the fundamentally different nature of transfers pursuant to Bankruptcy Code Section 1123 when compared to ordinary assignments pursuant to state contract law and the fact that a post-bankruptcy trustee assumes special powers as an estate representative.

Section 1123 requires that a plan "provide adequate means for [its] implementation," including the final disposition of all estate property.[2] Two expressly sanctioned means for doing so are "transfer of all or any part of the property of the estate to one or more entities, whether organized before or after the confirmation of such plan" and "the retention and enforcement . . . by a representative of the estate appointed for such purpose, of any such claim or interest."[3] Importantly, Section 1123 expressly applies "[n]otwithstanding any otherwise applicable nonbankruptcy law."[4] Case law outside the insurance context already establishes that the transfer of a claim combined with a grant of standing to a representative of the estate to pursue that claim post-confirmation is not necessarily an "assignment" and certainly is not an ordinary assignment under state law.[5]

For example, in Metropolitan Creditors' Trust v. Pricewaterhousecoopers, LLP, 463 F. Supp. 2d 1193 (E.D. Wash. 2006), the issue was whether such an appointment and transfer pursuant to Section 1123 violated a "nonassignment" clause in the defendant's engagement letters.[6] Citing Section 1123, the court held that the transfer of the claim pursuant to the debtor's bankruptcy plan was not an "assignment," suggesting that "courts should follow a case-by-case approach in determining whether an appointed party is serving as an assignee or as a representative of the estate." Id. (citations omitted). In reaching this conclusion, the court set forth a two-prong test for making this determination: (1) "whether recovery by the appointed party would benefit the debtor's estate and its unsecured creditors," and (2) "whether the appointment in question was approved by the bankruptcy court." Id. at 1199. If the answers to both of these questions is yes, the third party is treated as a representative of the estate and the transfer is not an assignment barred by contractual "nonassignment" clauses.

In Metropolitan, this test was easily satisfied: the bankruptcy court had "approved the Joint Reorganization Plan, which incorporate[d] the Trust Agreement," the "aim of establishing the Trusts was to liquidate [the debtors'] assets for the benefit of their creditors," and a "reference to Section 1123 in the trust agreement . . . manifest[ed] a clear intent to appoint the Trusts as representatives, rather than assignees, of the debtors' claims." 463 F. Supp. 2d at 1199-1200. Accordingly, estate claims that are transferred to a post-bankruptcy trust pursuant to the superseding bankruptcy powers of Section 1123 are done so free and clear of any restrictions that would undermine the transfer's purpose.[7]

Insureds and their insurance coverage counsel generally have neglected the importance of these Bankruptcy Code mechanisms in arguing against the application of the IVI exclusion to claims brought or maintained by post-bankruptcy trustees.[8] Insureds should be more careful not to leave such arguments on the table. Likewise, debtors, creditors' committees, other plan proponents, and their respective bankruptcy counsel should be aware of these important issues when drafting the debtor's plan of reorganization and related documents, and should draft such documents to avoid any mention of an alleged "assignment" and specifically state that any transfer of a claim is being executed pursuant to the controlling provisions of Section 1123.

As Metropolitan makes clear, perhaps the best time to ensure that a Section 1123 transfer will not implicate an IVI exclusion is at the time plan documents are completed and submitted to the bankruptcy court for approval. Although often overlooked, even in insurance coverage disputes an ounce of prevention can be worth a pound (or policy limit) of cure.

Footnotes

[1] Indian Harbor Ins. v. Zucker, No. 1:14-CV-1017, 2016 WL 1253040 (W.D. Mich. Mar. 31, 2016); see also Biltmore Associates, LLC v. Twin City Fire Ins. Co., 572 F.3d 663 (9th Cir. 2009); In re R.J. Reynolds, 315 B.R. 674 (Bankr. W.D. Va. 2003); Reliance Ins. Co. of Illinois v. Weis, 148 B.R. 575 (E.D. Mo. 1992), aff'd in part, 5 F.3d 532 (8th Cir. 1993).

[2] 11 U.S.C. § 1123(a)(4).

[3] 11 U.S.C. § 1123(a)(5)(B) (emphasis added); 11 U.S.C. § 1123(b)(3)(B) (emphasis added). See also 11 U.S.C. § 1123(a)(3)(A) (emphasizing that the "debtor" and the "estate" are separate legal entities with separate claims and interests).

[4] 11 U.S.C. § 1123(a).

[5] See, e.g., Citicorp Acceptance Co. v. Robison (In re Sweetwater), 884 F.2d 1323, 1327-30 (10th Cir. 1989); Guttman v. Martin (In re Railworks Corp.), 325 B.R. 709, 719 (Bankr. D. Md. 2005).

[6] Anti-assignment clauses also have been addressed in the context of insurance policy transfers, with courts likewise concluding that Section 1123 and other provisions in the Bankruptcy Code permit such transfers notwithstanding any anti-assignment clauses in the policies or contrary state law. E.g., In re Fed.-Mogul Global Inc., 385 B.R. 560, 566, 571 (Bankr. D. Del. 2008), aff'd, 402 B.R. 625 (D. Del. 2009), aff'd, 684 F.3d 355 (3d Cir. 2012).

[7] See, e.g., Jewel Recovery, L.P. v. Skadden, Arps, Slate, Meagher & Flom (In re Zale Corp.), Adv. No. 395-3599, 1996 Bankr. LEXIS 1933 (Bankr. N.D. Tex. Sept. 5, 1996); Parrett v. Nat'l Century Fin. Enters., Inc., No. 2:04-CV-489, 2006 WL 783361, at *4-5 (S.D. Ohio Mar. 23, 2006); see also Cirka v. Nat'l Union Fire Ins. Co. of Pittsburgh, Pa., No. 20250-NC, 2004 WL 1813283, at *8 (Del. Ch. Aug. 6, 2004).

[8] The only coverage litigation where the issue appears to have been raised is American Casualty Company of Reading, Pa. v. Gelb in the New York Supreme Court and Appellate Division, First Department. In that case, attorneys now at this firm raised the argument but ultimately prevailed on other grounds. Neither the trial nor appellate court addressed the Section 1123 arguments. The insureds' briefing for this case is available here.

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