United States: Sixth Circuit's Holding That Debtor In Possession And Liquidating Trustee Are One In The Same For Purposes Of "Insured-Versus-Insured" Exclusion Thwarts Lawsuit Against Corporate Debtor's Directors And Officers

The Sixth Circuit Court of Appeals recently took up the controversial issue of whether a liquidating trustee's lawsuit, alleging breach of fiduciary duty against a corporate debtor's officers, falls within the "insured-versus-insured" exclusion of the debtor's liability policy.  See, Indian Harbor Insurance Company v. Clifford Zucker in his capacity as Liquidating Trustee for the Liquidating Trust of Capitol Bancorp Ltd. and Financial Commerce Corporation, 2017 FED. App. Nos. 16-1695, 16-1697 and 16-1698, (6th Cir.)  The appellate court agreed with the district court's ruling that the policy does not cover the trustee's action.  The decision contributes to a split of circuits regarding the applicability of an insured versus insured exclusion based on the apparent distinctions between a debtor in possession and a claimant.

Capitol Bancorp LTD., ("Capitol") filed for Chapter 11 reorganization and operated thereafter as debtor in possession.  After the debtor in possession created a liquidation trust to pursue the estate's legal claims, the liquidating trustee sued the debtor's officers for $18.8 million alleging that they breached their fiduciary duties to the company.  In response, the debtor's liability carrier filed a declaratory judgment action asserting that, because the lawsuit falls within the "insured-versus-insured" exclusion, the policy does not cover the Trustee's lawsuit.

The relevant policy included an endorsement with an "insured versus-insured" exclusion that, in pertinent part, excluded coverage "any claims made against an Insured Person (as defined under the policy – including the officers) . . . brought by, on behalf of, or in the name or right of the Company (as defined under the policy – including the debtor, Capitol Bancorp) or any Insured Person . . ." except for derivative suits by independent shareholders and employment claims.  Many such insurance contracts include this type of insured versus insured exclusion which limits the coverage to claims by outsiders, and prohibiting coverage for claims by people within the insured company.  Both Courts examined the policy noting that, had Capitol sued its officers for mismanagement, it would be a claim "by" the company (an insured) against its own officers (also insureds) whereby the exclusion would bar the claim.  The Courts went on to examine the facts one-step removed from the above example, observing that while the officers and theory of liability remain the same, the claimant is no longer the company – but instead the trustee of a liquidating trust who received its rights by assignment.  This notwithstanding, the Appellate Court ruled that "as a voluntary assignee, the Trust stands in Capitol's shoes and possesses the same rights subject to the same defenses."  As such, and according to the Appellate Court, "[j]ust as the exclusion covers a lawsuit "by" Capitol, it covers a lawsuit "by" the Trust "in the . . . right" of Capitol.

The Appellate Court rejected opposing arguments that "the Company" referred to Capitol in its pre-bankruptcy form, and that Capitol underwent a transformation when it filed for bankruptcy, becoming a debtor in possession and administering the estate for the benefit of its creditors – making the debtor in possession legally distinct from the pre-bankruptcy company and, thereby, making the insured versus insured exclusion inapplicable to Capitol or its assignee. The Court responded that this new-entity argument would not work before bankruptcy where Capitol could not dodge the exclusion by transferring a mismanagement claim to a new company, and held that the same conclusion applies after bankruptcy where no matter how legally distinct the new-entity might be, the claim would still be "by, on behalf of, or in the name or right of" Capitol.  The Court further refuted arguments that bankruptcy code provisions defining "debtor" and "debtor in possession" support the contention that the debtor in possession and the pre-bankruptcy company are distinct legal entities – at least for purposes of an insurance contract, holding that the exclusion remains applicable by its terms.

The vigorous dissent to the appellate court's opinion argued that an assigned liquidating trustee, like a court-appointed trustee, should have the same right to be exempt from the exclusion.  The dissent pointed to the primary intent of the insured-versus-insured exclusion as to prevent collusive lawsuits wherein an insured corporation would force its insurer to pay for the poor business decisions of its officers and directors, and contended that there is no functional distinction between an assigned trustee and one that is appointed by the bankruptcy court as being independent and thereby posing no risk of collusion.  The dissent further posited that if only court-appointed trustees are exempt from the insured-versus-insured exclusion, creditors will be required to reject any plan where claims against directors and officers have value, and instead seek appointment of a Chapter 11 Trustee to preserve the ability to obtain an insurance recovery.

The Sixth Circuit has weighed in on this issue – but the fact that there exists an increasing Circuit split on the issue of whether a lawsuit against a corporation's directors and officers brought by a debtor in possession, trustee, creditor's committee or post-confirmation liquidation trustee triggers the insured-versus-insured exclusion in a D&O policy, suggests further review of, and opinions on, this issue in the near future.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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