The “insured vs. insured” exclusion in a directors’ and officers’ liability insurance policy did not absolve the insurer of the obligation to provide defense for a company’s former chief executive when the former CEO was sued by the company after the company filed a chapter 11 petition, under the circumstances presented to Bankruptcy Judge Marvin Isgur of Houston.

The company was the operator of a nonprofit hospital. The CEO left the company just short of two years before the company filed a chapter 11 petition.

After he left the company and before the company’s bankruptcy, the company sent the former CEO a letter demanding $3 million for the former CEO’s fraudulent conduct. When the former CEO tendered the demand letter to the D&O carrier, the insurer took up coverage with a reservations of rights. Five months later, but again before the insured’s bankruptcy, the carrier withdrew defense, citing the so-called insured vs. insured provision in the D&O policy.

After the insurer’s withdrawal, the insured filed a chapter 11 petition and became a debtor in possession. As DIP, the insured sued the former CEO in bankruptcy court. The former CEO tendered the complaint to the insurer.

In the adversary proceeding, the former CEO filed a cross claim against the insurer. One of the claims in the cross complaint sought a declaration that the insurer was obliged to provide defense. The insurer filed a motion to dismiss the cross claim, contending that the insured vs. insured exclusion deprived the former CEO of insurance coverage.

Judge Isgur denied the motion to dismiss in an opinion on October 3.

The Exclusion and the Exception

There was no dispute that the former CEO was an insured person under the policy and that the complaint in bankruptcy court, as well as the prebankruptcy demand letter, were claims under the policy. There was a dispute over the insured vs. insured exclusion.

The exclusion provided that there would be no coverage for a claim “brought by or on behalf of any Insured,” meaning the debtor. However, the exclusion had an exception for “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.”

Before deciding whether the exclusion or the exception applied, Judge Isgur laid out the governing standards under Texas law. Among other things, the Fifth Circuit has held that the insurer must provide coverage “[i]f any allegation in the complaint is even potentially covered by the policy.” Evanston Ins. Co. v. Legacy of Life, Inc., 645 F.3d 739, 745 (5th Cir. 2011), certified question answered, 370 S.W.3d 377 (Tex. 2012). [Emphasis in original.]

Judge Isgur cited other Fifth Circuit authority for holding that an insurer must defend the entire lawsuit if the complaint potentially includes even one covered claim under the policy. The Fifth Circuit also said that “a reviewing court must interpret the complaint liberally and construe the exception narrowly, resolving any ambiguity in favor of the insured.” City of Coll. Station, Tex. v. Star Ins. Co., 735 F.3d 332, 337 (5th Cir. 2013).

A DIP Is Akin to a Trustee

Naturally, the former CEO contended that the DIP was akin to a bankruptcy trustee. A bankruptcy court in Chicago came to that conclusion in In re HA 2003, Inc., 310 B.R. 710 (Bankr. N.D. Ill. 2004). In HA, the court noted that Section 1107(a) gives the DIP all of the rights, powers and duties of a trustee. Similarly, Bankruptcy Rule 6009 allows a DIP to prosecute a suit on behalf of the estate.

Judge Isgur agreed with HA, holding that the “bankruptcy exception thus permits coverage for a Claim brought by or on behalf of a bankruptcy trustee or similar official for a debtor or debtor-in-possession.”

Judge Isgur conceded that the policy had an “ambiguity,” because the DIP was “clearly defined” in the policy to be the insured. On the other hand, he said that a DIP is a “similar official” to a bankruptcy trustee under the exception. When there are ambiguities, he cited the Fifth Circuit for holding “that ambiguities in an insurance policy must be construed against the insurer and in favor of the insured.”

The insurer pointed to decisions where the insured vs. insured exclusion precluded a defendant from having coverage. In those cases, though, Judge Isgur said that the “insured v. insured exclusions in these cases did not contain a bankruptcy exception.”

Judge Isgur denied the insurer’s motion to dismiss, holding that the “insured v. insured exclusion is overridden by the bankruptcy exception” and that the insurer breached contract by denying coverage for the demand letter and the adversary proceeding.