Debtors, Fiduciaries, and Directors and Officers Beware: The Limits of D&O Liability Policy Coverage

8 Min Read By: Brett Amron, Zakarij Laux

IN BRIEF

  • Bankruptcy fiduciaries who are not court-appointed Chapter 7 or Chapter 11 trustees have been generally successful in pursuing claims against debtors’ D&O policies.
  • However, a recent Sixth Circuit decision may erode this success and have other far-reaching ramifications for fiduciaries who are not court-appointed.

Sometimes, uncontrollable financial circumstances precipitate a company’s decision to seek the protection of the Bankruptcy Code. Other times, a bankruptcy filing results, at least in part, from poor decisions made by the company’s management. A bankruptcy trustee is duty-bound to scrutinize the decisions of management and determine whether certain errors were made that caused harm to the debtor or its creditors and, if appropriate, commence litigation against the relevant decision makers for the benefit of the bankruptcy estate and its creditors. These suits often involve allegations that directors and officers have breached their fiduciary duties.

This type of litigation is all the more likely in cases where the debtor has or had a director and officer liability policy (D&O policy) in place to cover such claims, but most D&O policies contain an “insured vs. insured” exclusion, which excludes claims made by an insured against another insured under the policy.

Although not all courts have agreed, in a majority of jurisdictions, court-appointed trustees (Chapter 7 and Chapter 11) have circumvented insured vs. insured exclusions by arguing that there is no risk of collusion when the suit is brought by an independent, court-appointed fiduciary, and that the debtor company and the debtor’s estate—on whose behalf a trustee is bringing suit—are distinct legal entities.

But what about bankruptcy fiduciaries who are not court-appointed Chapter 7 or Chapter 11 trustees? A debtor-in-possession often will include in its Chapter 11 plan of reorganization the appointment of a litigation trustee, liquidating trustee, or other fiduciary to oversee litigation and make distributions for the benefit of creditors. Just like a court-appointed trustee, these fiduciaries will see a D&O policy as a source of potential recovery.

But a recent decision of the Sixth Circuit Court of Appeals may have far-reaching ramifications for fiduciaries who are not court-appointed, and may even erode at the general success Chapter 7 and Chapter 11 trustees have had in pursuing claims against debtors’ D&O policies.

In Indian Harbor Ins. Co. v. Zucker for Liquidation Tr. of Capitol Bancorp Ltd., 860 F.3d 373 (6th Cir. 2017), the debtor, Capitol Bancorp, confirmed a liquidating plan that created a liquidating trust to pursue litigation claims on behalf of the estate. The liquidation trustee sued Capitol Bancorp’s officers, alleging that they breached their fiduciary duties to the company. Indian Harbor Insurance—the company’s D&O insurer—filed a separate action seeking a declaration that the trustee’s claims fell within the policy’s insured vs. insured exclusion. The district court found the exclusion applied, and the liquidation trustee appealed.

The Sixth Circuit began its analysis with the language of the insured vs. insured exclusions, which excluded coverage for “any claim made against an Insured Person . . . by, on behalf of, or in the name or right of, the Company or any Insured Person.” This is fairly standard language, some variant of which is found in most D&O policies. Notably, there was no mention of the existence in the policy at issue of an exclusion to the insured versus insured exclusion which relates to insolvency and/or bankruptcy proceedings

The court went on to discuss the purpose of insured vs. insured exclusions, analogized well by the Zucker majority:

Not unlike a homeowner’s insurance policy that excludes coverage for a fire that the policyholder intentionally sets, these exclusions limit the management-liability insurance to claims by outsiders, prohibiting coverage for claims by people within the insured company. A company thus cannot hope to push the costs of mismanagement onto an insurance company just by suing (and perhaps collusively settling with) past officers who made bad business decisions.

(citing Biltmore Assocs., LLC v. Twin City Fire Ins. Co., 572 F.3d 663, 670 (9th Cir. 2009)). Although one would generally consider a liquidating trustee to be similarly disinterested as a court-appointed trustee so as to dissuade any fears of collusive behavior, the Zucker majority was not so convinced. It admitted that court approval of the debtor’s plan was a procedural safeguard, but stated that that alone did not “eliminate the practical and legal difference between an assignee [the liquidating trustee who was assigned causes of action under the plan] and a court-appointed trustee that receives the right to sue on the estate’s behalf by statute.” The majority concluded that “[t]he risk of collusion is surely higher when the insured individuals—the management of the debtor in possession—can negotiate and put conditions on a trustee’s right to sue them.” In other words, the mere fact that the debtor’s former managers can propose to name the individual who will serve as trustee and condition his or her authority is enough to raise the red flag of collusion beyond an acceptable threshold.

This is troubling for two reasons. First, if anything, management typically attempts to restrict the ability of a trustee to bring causes of action against them—a negotiating tactic that, if successful, would reduce overall the types of claims the trustee could bring; it would not elevate the risk of the trustee bringing collusive claims to the insurer’s detriment. Second, even if management sought to restrict or steer the trustee’s recovery efforts, those provisions would be subject to objection by creditors and interested parties and, if unacceptable, may result in a failure to garner sufficient votes to confirm the plan. As the dissent points out, “[f]unctionally, however, there is no distinction between an assigned trustee that a bankruptcy court has determined is independent and does not pose a risk of collusion, and one that is appointed by a bankruptcy court and is by nature of that appointment independent.”

With respect to the distinct-legal-entity argument, the liquidation trustee argued that a debtor-in-possession is legally distinct from the prebankruptcy “Company” defined in the insurance policy, making the insured vs. insured exclusion inapplicable to the trustee, who is the debtor-in-possession’s assignee. In response, the Zucker majority provides another analogy:

[T]his new-entity argument surely would not work before bankruptcy. Capitol could not have dodged the exclusion by transferring a mismanagement claim to a new company—call it Capitol II—for the purpose of filing a mismanagement claim against [Capitol’s management]. No matter how legally distinct Capitol II might be, the claim would still be ‘by, on behalf of, or in the name or right of’ Capitol. The same conclusion applies to a claim filed after bankruptcy. Here too the voluntarily transferred claim would be filed “on behalf of” or “in . . . the right of” Capitol. The exclusion remains applicable by its terms.

The majority interpreted its own precedent discussing the legal distinction between a prebankruptcy debtor and a debtor-in-possession narrowly, stating that the two are “one and the same person, although ‘wearing two hats’” (quoting Cle-Ware Indus., Inc. v. Sokolsky, 493 F.2d 863, 871 (6th Cir. 1974)). The majority concluded that Capitol, as a debtor-in-possession, was the same “Company” that entered into the insurance contract; therefore, the liquidation trustee, as assignee of the debtor-in-possession, stand’s in the “Company’s” shoes and is subject to the same defenses. “Just as the exclusion would bar a suit ‘by’ or ‘on behalf of” Capitol, it bars a suit by or on behalf of the Trust” (citing Biltmore, 572 F.3d at 671).

The majority then went a step further, putting even court-appointed trustees on shaky ground. The court stated, “[i]n truth, because the exclusion also applies to claims ‘in the . . . right of’ Capitol, it’s not even clear that a court-appointed trustee or creditor’s committee could collect on the policy.” But the court stopped short of deciding that issue, and held merely that “a voluntary assignee like the Trust, which stands in Capitol’s shoes, brings a breach-of-fiduciary-duty suit ‘by, on behalf of, or in the name or right of’ the debtor in possession” and, therefore, the claim was excluded from coverage under Capitol’s D&O policy.

The Zucker holding could have a dramatic and unintended impact on bankruptcy cases, the assertion of breach of fiduciary duty claims, and the availability of coverage for those claims. As the dissent notes:

If the majority’s decision becomes settled precedent, this Court will send a clear message to creditors in chapter 11 proceedings that if claims against directors and officers are deemed to be of significant value and the plan proposes to put those claims into a trust, the creditors must not agree to a plan proposed or even agreed to by the debtor-in-possession. Instead creditors will be required to seek the appointment of a bankruptcy trustee, where appropriate, or they will have to defeat the debtor-in-possession’s plan and propose their own disclosure statement and plan.

We will have to wait and see the true effect of Zucker, but all debtors, creditors, fiduciaries, and directors and officers are now on notice that the ability to recover against or receive coverage under a D&O policy may, depending upon the terms of the policy and the exact circumstances of the case, be compromised when such claims are pursued by a fiduciary who has not been appointed pursuant to statute or court order.

ABOUT THE AUTHORS

Miami, FL

Brett Amron

Brett has been a litigator his entire career. He advises clients in complex business and bankruptcy litigation matters with an emphasis on director and officer liability, breach of fiduciary duty, partnership…

Miami, FL

Zakarij Laux

Zakarij Laux concentrates his practice in bankruptcy and restructuring, workouts, creditors’ rights, and complex business litigation. Zak has represented national lending institutions and loan servicers,…

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