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It is an unfortunate, yet predictable situation in an insolvency proceeding: officers and/or directors of a financially distressed company are sued by a liquidating trustee or Chapter 7 trustee for alleged mismanagement, resulting in a claim against the directors and officers insurance policy. The plaintiff has the opportunity to pursue a deep pocket while the alleged perpetrators of the malfeasance are covered. But then the entire process is derailed when insurance company denies coverage for this claim on the basis of the “insured versus insured” exception set forth in the policy. The directors and officers are left questioning when and how they could possibly pay for such a large claim, and the parties are caught in an expensive fight about insurance coverage.

Traditionally, the “insured versus insured” exception limits the application of management liability insurance to claims by outsiders, “[n]ot unlike a homeowners’ insurance policy that excludes coverage for a fire that the policyholder intentionally sets.” Indian Harbor Insurance Company v. Zucker, 860 F.3d 373 (6th Cir. June 20, 2017). However, the application of this exception in the context of bankruptcy, liquidating trustees, and assignees of insurance policies has been varied, resulting in split circuit court opinions. The Sixth Circuit Court of Appeals has finally contributed to the morass in the Indian Harbor Insurance Company v. Zucker decision from late June of this year.

The Sixth Circuit considered the question of whether a liquidating trustee appointed pursuant to a confirmed chapter 11 plan of reorganization is the “same entity” as the debtor company that existed before and during the chapter 11 bankruptcy case. In Indian Harbor, the liquidating trustee sued the former debtor’s officers for alleged breaches of fiduciary duty after the debtor’s assets (including causes of action) were transferred to a liquidating trust. The debtor’s insurance company, Indian Harbor, denied insurance coverage for the action, seeking a declaratory judgment that was not obligated to provide any coverage for the action due to the insured versus insured exception. The Sixth Circuit affirmed the district court’s decision to deny coverage, noting that the liquidating trustee stood in the shoes of the debtor when bringing the suit against the debtor’s officers and directors.

The Sixth Circuit did not focus on the nature of the underlying cause of action itself – instead, the Court focused on the relationship and similarities between the debtor and the liquidating trustee. The Court noted that the “objects of the claim are the same (the officers) and so is the theory of liability (mismanagement).” The only difference between this action and the former action was that the liquidating trust “stands in [the debtor’s] shoes,” but “possesses the same rights subject to the same defenses.” Therefore, the Court concluded that the company covered by the directors’ and officers’ insurance policy was the same entity – prepetition, postpetition, and after the liquidating trust was established. Citing Supreme Court precedent on the issue, the Court held that the debtor company did not undergo “a transformation when it filed for bankruptcy” or become a “‘wholly new entity’ unbound by the prebankruptcy company’s contracts.” The Court also referenced the distinct characteristics of chapter 11 cases in support of its “continuing entity” interpretation; chapter 11 bankruptcy allows companies to continue to operate as going concerns, and some companies may emerge from bankruptcy as reorganized, solvent entities. Because the Court saw no legal distinction between the company’s prepetition assets, postpetition assets, or assets in the liquidating trust, it found the liquidating trustee was the “same entity” as the debtor, and the insurance company did not have to provide coverage for an action against the former company’s directors and officers.

The majority decision stands in stark contrast with the dissenting opinion and other circuit decisions. In her dissent, Judge Donald expressed concern that the Sixth Circuit’s decision 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.” Such a strict interpretation of the “insured versus insured” exception may significantly lessen recovery for creditors, strain judicial resources, increase professional fees, and expose directors and officers to potentially significant liability.

With the Indian Harbor decision, the “insured versus insured” exception is not going away in the bankruptcy/liquidating trustee context anytime soon. This holding may also serve as an impetus for creditors’ committees and significant creditors who think malfeasance has occurred to more proactively consider and commence D&O actions.  But the Sixth Circuit even suggested an alternative for directors officers looking for coverage for fiduciary lawsuits brought by liquidating trustees: “[i]f the parties meant to cover these lawsuits [such as breach fiduciary duty actions] after bankruptcy, they could have included an exception for suits brought by bankruptcy trustees or creditor’s committees, just as they included an exception for derivative shareholder suits.”

After the Indian Harbor decision, negotiating such an exception when purchasing directors and officers liability coverage may be the only way for directors and officers to remain covered in potential breach fiduciary duty suits brought by a liquidating trustee after a bankruptcy case. Therefore, it is critical that directors and officers and professionals advising potentially distressed companies review and carefully consider the implications of directors and officers insurance policies – if such an exception does not exist, it may be time to renegotiate the policy. 

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