Ninth Circuit Rules on the Application of the Insured-vs.-Insured Exclusion

Companies routinely purchase directors’ and officers’ liability insurance (D&O insurance) to shield directors and officers from personal liability based on the actions they take in their official capacities. Since the mid-1980s, these D&O insurance policies have included standard “insured versus insured” exclusions, which bar D&O insurance coverage for claims brought by or on behalf of a company against its own directors and officers absent certain specific circumstances. Citing insured vs. insured clauses, insurers argue that when a debtor or representative of the bankruptcy estate files a lawsuit against the company’s directors and officers, there should be no D&O insurance coverage and the plaintiff should be limited to recovering from the directors and officers personally. This issue has arisen whenever a lawsuit is brought against a bankrupt company’s directors and officers by a debtor in possession (DIP), official committee, bankruptcy trustee or a liquidating trustee appointed pursuant to a confirmed chapter 11 plan.

Some bankruptcy courts have rejected insurers’ arguments finding, inter alia, that the entities created after the bankruptcy filing are distinct from the pre-bankrupt companies and are not subject to the insured vs. insured exclusion. The U.S. Court of Appeals for the Ninth Circuit, however,declined to follow this line of cases in Biltmore Assocs. LLC v. Twin City Fire Ins. Co., holding that a DIP and its assignee (a litigation trust for the benefit of creditors) had no right of recovery against the proceeds of a D&O insurance policy containing an insured vs. insured exclusion.

Early Courts Reject Insurers’ Arguments
In Rieser v. Baudendistel (In re Buckeye Countrymark Inc.),[1] a chapter 7 trustee filed a complaint alleging breaches of fiduciary duty against nine of the debtor’s former directors and a former officer. The defendants filed third-party complaints against the insurers, asserting entitlement to coverage under a D&O insurance policy. The insurers moved for summary judgment, alleging that the insured versus insured provision within the policy barred coverage.[2] The insurers asserted that the trustee’s claims were only extensions of claims that could be brought by the debtor outside of bankruptcy.[3]

The bankruptcy court denied the insurers’ summary-judgment motion for three reasons. First, under Ohio law, if an exclusionary clause will reasonably allow an interpretation that would preserve coverage for the insured, then a court is bound to adopt the construction that favors coverage.[4] Second, the insurers’ argument ignored what the bankruptcy court considered to be a very real difference between the trustee and the debtor: The trustee is a separate legal entity that neither represents the debtor nor owes the debtor a fiduciary obligation. The trustee’s responsibility is to the estate and its creditors.[5] Third, the bankruptcy court reasoned that the purpose of the insured-vs.-insured exclusion does not apply to adversarial claims brought by the trustee against the former directors and officers. The exclusionary provision’s intent was to protect the insurers against collusive suits between the insured corporation and its officers and directors. When the plaintiff is not the corporation, but a trustee acting as a “genuinely adverse” party to the defendant officers and directors, there is no threat of collusion. Accordingly, the court concluded that the insurance contract provision excluding coverage for claims “brought by” or “on behalf” of the company did not apply to those brought by a bankruptcy trustee.[6]

Ninth Circuit Rejects Argument that Claims Brought by a Litigation Trustee are Not on Corporation’s Behalf 
The debtor in Biltmore Assocs. LLC v. Twin City Fire Ins. Co.,[7]Visitalk.com Inc., had D&O insurance policies that contained insured vs. insured exclusions with exceptions for shareholder derivative actions and claims by former directors and officers for wrongful termination, discrimination or sexual harassment. These exceptions only applied if the claims were “instigated and continued totally independent of the corporation.”[8]

Visitalk, as a debtor and DIP, sued some of its recently discharged officers and directors for breach of their fiduciary duties. The insurers refused coverage under the insured-vs.-insured exclusion and the claims against the former directors and officers were then assigned by the debtor to a trust established for the benefit of Visitalk’s creditors, pursuant to a confirmed chapter 11 plan. The trustee settled with four of the former directors and officers for a confession of judgment in the amount of $175 million with a covenant not to execute and an assignment of whatever rights the former directors and officers had against the insurers for failure to cover and bad faith.[9] The trustee then sued the insurance companies on the basis of these claims.

On appeal, the Ninth Circuit held that that the insured-vs.-insured exclusion applied and affirmed a lower court’s dismissal of the complaint.[10] This exclusion “provided [that] the Insurer shall not be liable to make any payment for Loss in connection with any Claim made against the Directors and Officers…brought or maintained by or on behalf of an Insured in any capacity.”[11] In the Ninth Circuit’s view, the “only question…on the language of the exclusion is whether the underlying suit was ‘brought or maintained on behalf of an insured in any capacity.’”[12]The trustee answered that the claim was brought on behalf of creditors and not on behalf of the pre-bankruptcy corporation.

The Ninth Circuit squarely rejected the trustee’s argument for four reasons. First, the underlying lawsuit against the former directors and officers for breach of statutory and fiduciary duties asserted a cause of action for mismanagement that belongs to a corporation and can only be brought derivatively on behalf of the corporation. Second, since none of the insurance companies issued any policies to the trustee or the creditors, the creditors and the trustee had no contractual claim against the insurance companies. Third, the Ninth Circuit found that the outcome of the application of the insured-vs.-insured exclusion was unaffected by the assignment of the claims by the DIP to the trust that was formed for the creditors’ benefit. In doing so, the court of appeals stated that “Biltmore cannot jump into the insureds’ shoes to bring the lawsuit, out of their shoes to claim not to be suing as though it were the insureds, and then back into their shoes to get compensatory and punitive damages for the insurers’ failure to cover their liabilities.”[13] Fourth, the court of appeals rejected the reasoning of “[s]everal bankruptcy decisions around the country, including one in [its] circuit, [that] treat a post-bankruptcy entity as different from the debtor before it went into chapter 11 for purposes of the insured [vs.] insured exclusion.”[14] Indeed, the Ninth Circuit found that the differences in fiduciary responsibilities of Visitalk’s management on account of bankruptcy did not make Visitalk a different entity for purposes of the insured versus insured exclusion.[15]

In affirming the dismissal of the trustee’s complaint, the Ninth Circuit noted that to rule otherwise would result in the moral hazard that the insured-vs.-insured exclusion is intended to avoid. It would create incentive, the court reasoned, for principals of a failing business to bet on a lawsuit that would bail them out with money from the D&O insurance policy if they won and protect them from personal liability if they lost.

The impact in other circuits of Biltmore Assocs., LLC v. Twin City Fire Ins. Co. is yet to be seen, since it is the first decision by a court of appeals to treat the post-bankruptcy DIP and the pre-bankruptcy entity as the same for the purpose of applying the insured vs. insured exclusion. Some circuits, including the Third Circuit, have held that the post-bankruptcy DIP is a distinct legal entity from the pre-bankruptcy company in other contexts.[16] Therefore, it is possible that parties will seek a more favorable forum by filing a declaratory judgment action against its insurers outside the Ninth Circuit. However, if other courts find Biltmore Assocs. persuasive, there may be a significant decrease in the volume of litigation brought by or on behalf of a debtor against its former and/or current officers and directors because the application of the insured-vs.-insured exclusion removes the most likely source of recovery, the proceeds of D&O insurance policies.