Policyholders (and the Courts) Continue to Ignore Section 1123 When Analyzing Insured v. Insured Exclusions

Justin F. Lavella and Kyle P. Brinkman

Last month the United States Court of Appeals for the Sixth Circuit issued its anticipated decision in Indian Harbor Insurance v. Zucker, affirming a 2016 decision from a federal district court in Michigan that an Insured v. Insured (“IVI”) exclusion bars coverage for a claim brought by a post-bankruptcy litigation trustee for the benefit of the insured debtors’ creditors. The district court’s Indian Harbor decision was driven largely by the mistaken conclusion that a post-bankruptcy trustee is an ordinary assignee of the debtor company—an insured—and therefore purportedly stands in the shoes of the insured debtor for purposes of the IVI exclusion. As we described at the time, that decision, however, ignores the fundamentally different nature of transfers pursuant to Bankruptcy Code Section 1123 when compared to ordinary assignments pursuant to state contract law and the fact that a post-bankruptcy trustee assumes special powers as an estate representative. Unfortunately, after appeal, this issue still remains unresolved.

On appeal, neither the parties nor the Sixth Circuit addressed in any meaningful way the interaction of Section 1123 and IVI exclusions. Instead, the Sixth Circuit’s split decision held that the debtor-in-possession “voluntarily transferred” its claim against its former directors and officers to the post-litigation trust, and therefore, that claim “would be filed ‘on behalf of’ or ‘in . . . the right of’” the debtor-in-possession, which the Court held was the same legal entity as the pre-bankruptcy insured. To reach its conclusion, the Sixth Circuit’s majority primarily focuses on whether the pre-bankruptcy insured and the post-bankruptcy debtor-in-possession are legally the same entity. However, in doing so, the majority only makes a passing reference to two equally important issues, namely how the claim against the debtor’s former director and officers was transferred to the litigation trust and the method of the litigation trustee’s appointment.

In dissent, Judge Donald addresses the latter of these issues head on by arguing that there should be no difference between a court-appointed trustee and an assignee trustee: “Although there is case law that states that court-appointed trustees are exempt from the insured-versus-insured exclusion, that does not automatically mean that assignee trustees are not given the same exemption.” Moreover, the dissent highlights the wasting of estate assets and judicial resources that will result from the majority’s opinion:

“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. The cost in terms of professional fees and judicial resources cannot be overstated, especially in light of the fact that there would be no practical difference to the insurance companies as they would still be required to defend the directors’ and officers’ claims.”

With the benefit of hindsight, it is clear that the particular facts of the Indian Harbor case raised a number of concerns for both the district court and the Sixth Circuit, and therefore the proceeding provides a number of lessons for both pre-bankruptcy policyholders buying D&O insurance and post-bankruptcy entities seeking to fashion an acceptable plan of reorganization.

First, the majority was troubled that the applicable IVI exclusion contained no “bankruptcy” exception and the judges were uncomfortable reading such an exception into the policy: “If the parties meant to cover these lawsuits 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.” Therefore, the opinion highlights the importance of reviewing and understanding applicable policy language, both when purchasing a D&O policy and when crafting a plan of reorganization. While the Indian Harbor policy was unusual because it contained no “bankruptcy” exception, many such exceptions are still often insufficient because they do not extend to creditor committees or purported assignees.

Second, the majority was also troubled that the plan at issue in the case “limited any . . . liability to amounts recovered from the [debtor’s] liability insurance policy.” In other words, the plan insulated the debtor’s former directors and officers from any personal liability, effectively shifting all risk of a judgment to the D&O insurers. Although the plan was approved by the bankruptcy court, the Sixth Circuit was concerned that did not provide a full safeguard against collusive suits that IVI exclusions are meant to exclude: “The 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.” Accordingly, parties participating in bankruptcies should avoid any plan provisions that imply a “voluntary” shifting of a claim from an insured to a third party, particularly when it is accompanied by provisions that potentially insulate the targets of a post-bankruptcy claim.

Third, in support of his dissent, Judge Donald notes that the policy in Indian Harbor did not define “Company” to include a “debtor-in-possession,” and therefore, “[t]he plain meaning of the insured-versus-insured exclusion does not include a debtor-in-possession or other estate representative.” While this issue has received less attention, many D&O policies define “Company” or “Named Insured” to include a subsequent “debtor-in-possession.” While such definitions are often seen by insureds as coverage expanding, often the opposite is in fact true. No policy provision is necessary to protect the availability of coverage for a “debtor-in-possession.” That occurs by operation of law under the bankruptcy code. Therefore, such endorsements generally are coverage minimizing because they are used by insurers as further support for an expansive application of their IVI exclusions.

Fourth, any parties involved in a dispute similar to Indian Harbor should remember the critical importance of Section 1123 and the equitable powers it embodies. While it does not appear that Section 1123 was emphasized during the drafting of the plan documents giving rise to the Indian Harbor coverage case, that is often the best time to ensure that a transfer (rather than an assignment) of a claim does not implicate a potentially applicable IVI exclusion. As the authors of this piece have previously noted, Section 1123 expressly applies “[n]otwithstanding any other applicable nonbankruptcy law,” and has been interpreted to permit the transfer of assets, including causes of action, that would otherwise be barred by an “anti-assignment” clause.[1] Explicitly referencing these powers, both before and after a coverage dispute with an insurer, may be the difference in whether millions of dollars of insurance is ultimately accessible.

[1] See, e.g., Citicorp Acceptance Co. v. Robison (In re Sweetwater), 884 F.2d 1323, 1327-30 (10th Cir. 1989); Guttman v. Martin (In re Railworks Corp.), 325 B.R. 709, 719 (Bankr. D. Md. 2005); Metropolitan Creditors’ Trust v. Pricewaterhousecoopers, LLP, 763 F. Supp. 2d 1193 (E.D. Wash. 2006).