Bankruptcy and the "insured vs. Insured" Exclusion in Directors and Officers Liability Insurance Policies

• Publication year: 2017
• Author: Feliciano M. Ferrer and Kavita Gupta

Bankruptcy and the "Insured vs. Insured" Exclusion in Directors and Officers Liability Insurance Policies

Feliciano M. Ferrer and Kavita Gupta¹

Feliciano M. Ferrer is a partner in Gupta Ferrer LLP. Mr. Ferrer specializes in civil and commercial litigation in the bankruptcy, federal, and state courts. He also has significant experience representing clients in all aspects of restructuring matters, including debtors, trustees, and individual commercial creditors.

Kavita Gupta is a partner is Gupta Ferrer LLP. Ms. Gupta's practice focuses on representing a variety of debtors and creditors in all phases of complex distressed financial situations, including out-of-court workouts and Chapter 11 cases. Ms. Gupta has served as a trustee in numerous corporate and individual cases.

In 2016, 26% of private companies reported that claims had been filed against their directors and officers within the last three years and that the average and maximum reported resulting losses for such claims were $387,000 and $17 million, respectively.² Therefore, given the potential of such claims, an attorney advising a company experiencing financial difficulties may wish to review its D&O liability insurance policy ("D&O Policy") and understand the issues that may arise under that policy if the company files a bankruptcy case.

A D&O Policy generally provides coverage for third party lawsuits, including shareholder derivative actions, filed against a company's directors and officers. A common exclusion in the policy, however, is the "insured vs. insured" exclusion (the "IVI Exclusion"), which generally precludes coverage for lawsuits filed by the company itself. Without an IVI Exclusion, a company facing financial difficulties might be tempted to sue its own directors and officers and look to its D&O Policy to recoup ordinary operational business losses—a risk against which the insurer never intended to insure.

Bankruptcy, however, can sometimes add a level of complexity to ordinary business litigation, resulting in unexpected outcomes. For example, as discussed above, if a company filed suit against its own directors and officers, it would likely discover that the IVI Exclusion in its D&O Policy precludes coverage and, therefore, the funds necessary to defend, settle, or pay a judgment resulting from the suit would likely have to come from the directors and officers themselves. On the other hand, if the company filed a bankruptcy petition before it filed suit, it is not entirely clear that the IVI Exclusion would still preclude coverage.

The two cases discussed below illustrate the uncertainty in the law, as interpreted by the U.S. Ninth Circuit Court of Appeals (the "Ninth Circuit") and a California bankruptcy court, when a company first files a bankruptcy case and then initiates a lawsuit against its own directors and officers.

Biltmore Associates, LLC v. Twin City Fire Ins. Co.3

In Biltmore Associates, LLC v. Twin City Fire Ins. Co., Visitalk.com, Inc. ("Visitalk") filed a voluntary petition under Chapter 11 of the United States Bankruptcy Code. Subsequently, as a debtor in possession,⁴ Visitalk filed a lawsuit against its directors and officers for breaches of their fiduciary duties.⁵ It alleged, among other things, that they had "charged grossly excessive amounts as expenses for inappropriate things such as 'personal expenses, strippers, lavish trips, and gifts'..., failed to institute financial controls..., [and] purchased unnecessary software and usurped corporate opportunities."⁶

Visitalk's liability insurers, Reliance Insurance Company and Twin City Insurance Company, declined to cover Visitalk's claims, citing the IVI Exclusion in their respective D&O Policies, which precluded coverage for:

[Page 13]

any Claim made against the Directors and Officers ... brought or maintained by or behalf of an Insured in any capacity ... except ... a Claim, including, but not limited to ... a derivative action that is instigated and continued totally independent of, and totally without the solicitation of, or assistance of, or active participation of, or intervention of an Insured.⁷

In other words, the policies did not cover claims brought by Visitalk itself against its own directors and officers.

Visitalk then filed and confirmed a Chapter 11 plan that assigned the claims against its directors and officers (which, at this point, only Visitalk's bankruptcy estate could pursue)⁸ to a trust established for Visitalk's creditors.⁹ The trust, in turn, named Biltmore Associates, LLC ("Biltmore") as the trustee. Biltmore, as trustee, settled the claims against Visitalk's directors and officers for $175 million in return for an assignment of their respective rights against the insurers. Biltmore, as assignee, then sued the insurers. The Arizona federal district court dismissed Biltmore's lawsuit, and Biltmore appealed.

At the outset, the Ninth Circuit framed the matter of Visitalk's initial lawsuit, which ultimately resulted in Biltmore's lawsuit against Visitalk's insurers, as a variation of the "confession of judgment, assignment of rights, covenant not to execute technique."¹⁰ It explained:

[s]ometimes when a liability insurer denies coverage and declines to defend, the injured party sues the insured tortfeasor, and they agree on a confession of judgment, assignment of rights, and covenant not to execute. That way the insured party obtains protection from having to pay anything, and the injured party steps into the insured's shoes in order to sue the liability insurer. The injured party may be able to get more than the policy limits from the insurer, if he prevails on coverage, because damages for bad faith denial of coverage and punitive damages are in the nature of tort damages, not limited by the insurance contract.¹¹

Under this framework, the Ninth Circuit proceeded to discuss the purpose of the IVI Exclusion in a D&O Policy: that is, as the liability insurers' reaction to prior lawsuits in which insured corporations sued their own directors to recoup operations losses caused by improvident or unauthorized actions.¹² It explained that "[s]uch lawsuits created problems of moral hazard, collusion, and unintended expansion of coverage. The reasonable expectation of the parties was that they were protecting against claims by outsiders, not intracompany claims."¹³

The Ninth Circuit then rejected Biltmore's assertion that its claim against the insurers was not brought on behalf of Visitalk, but instead on behalf of Visitalk's creditors. First, it...