Michael D. Sousa, Making Sense of the Bramble-filled Thicket: the "insured vs. Insured" Exclusion in the Bankruptcy Context

• Publication year: 2011

ARTICLES

MAKING SENSE OF THE BRAMBLE-FILLED THICKET: THE "INSURED VS. INSURED" EXCLUSION IN THE

BANKRUPTCY CONTEXT†

Michael D. Sousa^*

ABSTRACT

This Article addresses the application in bankruptcy of an exclusion contained in many directors and officers liability insurance policies, namely, the "insured vs. insured" exclusion. Part I of this Article provides an overview of the development of directors and officers liability insurance policies. Part II of the Article identifies the legal principles governing the interpretation of insurance policies. Part III discusses the development of the "insured vs. insured" exclusion in directors and officers liability insurance policies. Part IV provides an overview of the sometimes inconsistent judicial decisions addressing the "insured vs. insured" exclusion in the bankruptcy context. Part V presents the author's proposed test for applying the "insured vs. insured" exclusion in bankruptcy, namely: 1) whether "true adversity" exists between the litigating parties; 2) the status of the plaintiff at the time the claim is made; 3) the identity of the beneficiaries of the claim, or stated differently, on whose behalf are the claims being pursued; and 4) the reasonable expectations of the parties. Part VI applies the proposed multifactor test to the various constituents in the bankruptcy process. The Article concludes that an "insured vs. insured" exclusion should ordinarily apply to a debtor in possession, a Chief Restructuring Officer under the employ of a debtor in possession, and a plan trustee; however, an "insured vs. insured" exclusion should ordinarily not apply to suits brought by a bankruptcy trustee or creditors' committee.

"The Large Print Giveth and the Small Print Taketh Away."

Little v. MGIC Indemnity Corp., 649 F. Supp. 1460, 1465 (W.D. Pa. 1986).

INTRODUCTION

Over the course of the past several decades, directors and officers liability insurance has become a fixture in the modern corporate environment. Presently, as many as ninety-five percent of Fortune 500 companies maintain directors and officers liability insurance. The "fundamental purpose" behind directors and officers liability insurance "is to shift by contract to an independent third party-the insurance carrier-a portion of the risk arising out of actions taken both by the corporation's officers and directors in their official capacity and by the corporation itself in connection with securities law matters."¹Fairly recently, the disgruntled shareholders and creditors of failed corporate enterprises have been willing to look increasingly towards the directors and officers of these corporations to recompense their losses. In general, directors and officers of corporations ordinarily face two types of claimants: disgruntled shareholders who sue on behalf of the corporation in a derivative action²or sue in their own right; and third parties, such as the corporation's creditors, employees, suppliers, customers, or government agencies.³Shareholder claims, which include both derivative suits and third- party class actions, traditionally have been the largest source of directors and officers litigation.⁴The types of claims generally brought by a corporation's shareholders against either the corporation or its directors and officers, or most commonly both, can be characterized as follows: 1) inadequate or inaccurate disclosures; 2) dishonesty or fraud; 3) problems with financial reporting; 4) disappointing financial performance; 5) breach of fiduciary duties;⁵6) problems with public offerings; and 7) merger activity with another company.

Lawsuits against a corporation's directors and officers will implicate the directors and officers liability insurance policy possessed by the corporation. As a result, the importance of having adequate directors and officers liability insurance coverage is undeniable. Directors and officers liability insurance is similar to other forms of professional liability insurance insofar as it is designed to protect corporate officials from loss in the event of a claim made against them in their official capacities.⁶Nonetheless, the standard directors and officers liability insurance policy "bristles with provisions governing which claim will and will not be covered, in what amounts, and under what circumstances."⁷

A common provision, or more appropriately, "exclusion," contained in a directors and officers liability insurance policy is the so-called "insured vs. insured" exclusion.⁸Today, "insured vs. insured" exclusions are standard in directors and officers liability insurance policies.⁹Simply stated, an "insured vs. insured" exclusion bars coverage for claims made by one insured under the policy, for example, the corporation, against another insured under the same policy, for example, the corporation's directors and officers.¹⁰Although the wording from policy to policy may vary slightly, a representative example of an "insured vs. insured" exclusion provides as follows:

It is understood and agreed that the Insurer shall not be liable to make any payment for Loss in connection with any claim made against the Directors and Officers by any other Director or Officer of the Corporation or by the Corporation, except for a shareholders' derivative action by a shareholder of the Corporation, when such shareholder is not a Director or Officer of the Corporation.¹¹

To determine whether an "insured vs. insured" exclusion applies in a particular lawsuit, a court will not focus upon a specific count in the lawsuit, but rather the court will look at the civil proceeding itself, and if an insured sues another insured in the proceeding, the exclusion applies.¹²

Questions regarding the applicability of the "insured vs. insured" exclusion have usually arisen in the context of derivative lawsuits and receiverships in the banking industry.¹³During the past decade, however, the "insured vs. insured" exclusion has been frequently implicated within the contours of a corporate bankruptcy. Indeed, a corporate bankruptcy is an event that is likely to precipitate lawsuits against the corporation's directors and officers in their individual capacities as all interested parties scramble to find avenues to augment the bankruptcy estate.¹⁴In such instances, the lawsuit might implicate the "insured vs. insured" exclusion in the directors and officers liability insurance policy and leave the directors and officers uninsured, with their personal assets easily in reach.

A split of authority currently exists among the federal courts on the issue of whether a lawsuit against a corporation's former directors and officers brought by a debtor in possession, trustee, creditors' committee, or postconfirmation liquidating trustee triggers the "insured vs. insured" exclusion in a directors and officers liability insurance policy. For example, courts in the First, Eighth, and Eleventh Circuits have concluded that the "insured vs. insured" exclusion bars coverage for lawsuits against a company's former directors and officers brought by a plan committee or a trustee.¹⁵To the contrary, courts in the

Second, Third, Sixth, and Ninth Circuits have concluded that the "insured vs. insured" exclusion was not triggered in suits by a trustee or other entity against the former directors and officers for breach of fiduciary duty.¹⁶

The primary intent of the development of the "insured vs. insured" exclusion was to prevent collusive lawsuits in which an insured corporation would in essence "force" its insurer to pay for the poor business decisions of its officers and directors by the corporation filing an action against its own officers and directors.¹⁷While the absence or presence of collusion is certainly a significant factor in determining the applicability of the "insured vs. insured" exclusion, there has been no reported case that has specifically found evidence of collusion between insureds. Moreover, even if the insured corporation and directors and officers had in fact conspired or agreed to the institution of a "friendly" lawsuit so as to have the corporation access the directors and officers liability insurance proceeds, evidence of collusion, absent the proverbial "smoking gun" memorandum, would be difficult, if not impossible, to prove as a matter of law. Consequently, the notion of collusion, in and of itself, is not a sufficient guidepost for determining the applicability of an "insured vs. insured" exclusion, particularly in the realm of bankruptcy and due to the various constituents interested in the reorganization process.

Certainly, the ultimate determination of the applicability of the "insured vs. insured" exclusion in the bankruptcy context depends upon a careful examination of the facts of each case and the specific language of the directors and officers liability policy under consideration. Nevertheless, given the divergent treatment by the courts on the application of the "insured vs. insured" exclusion in the bankruptcy context and its importance both to substantive bankruptcy law and insurance law, the purpose of this Article is to propose a multifactor test for courts to utilize when faced with this issue. Thus, in assessing the application of a particular "insured vs. insured" provision to a particular set of facts, courts should consider the following: 1) whether "true adversity" exists between the litigating parties; 2) the status of the plaintiff at the time the claim is made; 3) the identity of the beneficiaries of the claim, or stated differently, on whose behalf are the claims being pursued; and 4) the reasonable expectations of the parties. Admittedly, the handful of courts that have already addressed this issue have usually relied upon one or two of the factors in reaching their conclusions. However, as will be examined later, these decisions omit a great deal of important analysis.¹⁸The constituents in the bankruptcy process, namely, the debtor in possession, Chief Restructuring Officer, plan trustee...