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Sixth Circuit Finds No Insurance Coverage Available for D&O Claims Assigned in Bankruptcy

A recent decision from the United States Court of Appeals for the Sixth Circuit is an important read for insurers and other key constituencies in Chapter 11 bankruptcy proceedings. The opinion highlights a continuing split among federal courts as to whether a bankrupt insured can successfully assign D&O claims to third parties. At issue in Indian Harbor Insurance Company v. Clifford Zucker,  860 F.3d 373 (6th Cir. 2017), was whether the insured vs. insured exclusion in a Chapter 11 debtor’s management liability policy barred coverage for D&O claims that were assigned by the debtor to a liquidating trust. The Sixth Circuit concluded that the debtor and the liquidating trust were effectively the same entity and, as such, the exclusion applied. The practical result of this decision was that the intended beneficiaries of the D&O claims — the creditors of the debtor — will not recover on account of the D&O claims valued in excess of $18 million.

Facts

In Indian Harbor, Capitol Bancorp, Ltd. (“Capitol” or the “Debtor”) was a holding company that owned community banks in seventeen states. The Debtor sustained significant losses following the global economic meltdown in 2008. Unable to withstand those continuing losses, the Debtor sought to reorganize under Chapter 11 of the United States Bankruptcy Code (the “Bankruptcy Code”).

Prior to the bankruptcy filing, the Debtor obtained a management liability insurance policy (the “Policy”) from Indian Harbor Insurance Company (the “Insurer”). The Policy indemnified the Debtor for losses resulting from claims made against its directors, officers and employees. Importantly, the Policy included an insured vs. insured provision that excluded from coverage any claim against an insured person (such as officers, directors and employees) that was made “by, on behalf of, or in the name or right of the [C]ompany or any [I]nsured [P]erson.”[1]

The Debtor’s efforts to reorganize in the Chapter 11 proceeding were unsuccessful. As a result, the Debtor and a committee comprised of unsecured creditors agreed to a consensual plan (the “Plan”) to liquidate its assets, including litigation claims against the officers of the Debtor (the “Officers”). Significantly, a liquidation trust (the “Trust”) was established under the Plan for the purpose of pursuing the litigation claims for the benefit of the creditors. The Plan provided for the assignment of D&O claims to the Trust and limited the Officers' liability on such claims to any proceeds available under the Policy.

After the Plan was confirmed by the bankruptcy court, the Trust commenced an action against the Officers alleging that they breached their fiduciary duties to the Debtor. The lawsuit was tendered to the Insurer for defense and indemnity. The Insurer responded by filing a declaratory judgment action in federal court. In that lawsuit, the Insurer requested a legal determination that it was not obligated to provide coverage for the claims on the grounds that they fell within the insured v. insured exclusion. The District Court held that the action against the Officers was excluded from coverage under the insured v. insured provision. That decision was upheld by the Sixth Circuit.

Sixth Circuit’s Analysis

On appeal, the Officers argued that the exclusion did not apply because, at the time Capitol filed for bankruptcy protection: (i) all of its assets, including the causes of action, became property of the bankruptcy estate; (ii) after the bankruptcy filing, Capitol transitioned into a debtor in possession, a separate legal entity; and (iii) as debtor in possession, it was charged with administering the bankruptcy estate’s assets for the benefit of creditors. The thrust of the Officer’s argument was that because Capitol became a debtor in possession as of the bankruptcy filing, Capitol and the debtor in possession were legally distinct entities and, as a result, the insured vs. insured exclusion did not apply.

The Indian Harbor Court rejected that argument noting that coverage would not have been available had the Debtor assigned the D&O claims outside the context of the bankruptcy. Nor could the Debtor have sued its Officers directly without vitiating coverage under the insured vs. insured provision. The Court concluded that the D&O claims asserted by the Trust were likewise subject to the exclusion reasoning that, as a voluntary assignee of those claims, the Trust stood in the shoes of the Debtor and was subject to the same coverage defenses that could have been raised against the Debtor.

The Sixth Circuit also relied on the terms of the Policy and provisions of the Bankruptcy Code in further support of its holding. The Policy included a “Change in Control” provision providing that any available coverage would continue regardless of whether Capitol filed for bankruptcy protection. The fact that coverage would remain in effect post-bankruptcy undermined the Officers’ argument that the debtor in possession was a completely different legal entity. The Indian Harbor Court also relied upon Supreme Court precedent for the proposition that a debtor in possession was not a “wholly new entity.”

Lastly, it was apparent that the Court was troubled by the manner in which the assignment of D&O claims was structured. The Court cautioned that the risk of collusion was higher when the management of a debtor in possession — in this case the Officers — could negotiate and put conditions on a trustee’s right to sue them. While it was not expressly stated, one can logically conclude that the Court was troubled by the fact that the assignment of the D&O claims was conditioned upon a release of the Officers of any personal liability and limited recovery on the D&O claims to any available insurance proceeds.

Conclusion

As evidenced by the vigorous dissent, Indian Harbor’s reasoning is not without its critics. The Sixth Circuit’s opinion adds further uncertainty to a complex legal landscape as other circuit and lower courts have adopted divergent views on the application of the insured v. insured exclusion to claims assigned in bankruptcy proceedings. Absent Supreme Court review of this issue, this divergence will continue for the foreseeable future. What is crystal clear; however, is that debtors and creditor constituencies will continue to look to D&O policies as a funding vehicle for plans of reorganization. Their ability to successfully recover under such policies — whether through a debtor in possession, litigation trust, creditors’ committee or some other capacity — will depend in large part on the jurisdiction in which the bankruptcy case is pending. In those jurisdictions that follow Indian Harbor’s reasoning, an assignment of D&O claims may very well be met with a challenge by the insurer. Insurers are undoubtedly paying close attention to Indian Harbor and the continuing evolution of this doctrine as a potential basis for coverage defenses to significant D&O claims. Finally, it remains to be seen whether insurers and insureds will attempt to eliminate any uncertainty by including language in policies expressly addressing the assignment of D&O claims and making appropriate adjustments to premiums to account for any increased exposure. Those who are considering service as an officer or director may insist on such language to ensure any assigned claims are covered.

If you have any questions regarding this Client Alert, please contact John C. Kilgannon at 215.751.1943 or the Stevens & Lee attorney with whom you normally consult.

Related Attorney:
John C. Kilgannon

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.

[1] The purpose of insured vs. insured exclusions is to prohibit a company from engaging in collusive lawsuits against its own officers and directors or otherwise attempting to pass along the costs of mismanagement to its insurer.