The Intersection of Insurance and Bankruptcy

The issue of D&O coverage and exclusions during bankruptcy proceedings is far from cut and dried.
By: | January 22, 2014

When a company goes bankrupt, D&O policies become a battle arena for debtors and creditors trying to reclaim losses.

Are directors and officers protected from claims made from within their own organization asserting that their mismanagement, negligence, or breach of fiduciary duty directly led to the business’ demise? Is the claimant included under the D&O coverage as an insured, and does that inclusion bar them from making such a claim in the first place?

“There are often skirmishes in the early stage of bankruptcy over what to do with the litigation covered by the D&O policy: how to manage it, and to what extent they’re going to let the directors and officers access the defense costs under Side A coverage,” said Jonathan Young, a partner with the law firm Edwards Wildman Palmer LLP.

“I’ve seen efforts to marshal the whole dispute into an early mediation process,” he said during a discussion at the Anderson Kill 17th Annual Policyholder Advisor Conference last fall.

At the heart of D&O disputes are often “insured vs. insured” exclusions, according to Dennis Nolan, an Anderson Kill attorney specializing in insurance recovery and bankruptcy and restructuring.

Those exclusions preclude coverage for a D&O claim brought on behalf of another insured (in the case of bankruptcy, the insolvent debtor-company), he said. The purpose is to prevent collusive claims and remove the incentive for bankrupt companies to “use insurance companies to cover operating losses disguised as corporate malfeasance.”

But the issue is far from cut and dried.

Take, for example, the 1992 case of Reliance Ins. Co. of Illinois vs. Weis. The debtor company filed a plan of liquidation providing that all causes of action of the estate would form a plan committee. The committee then brought an action against the company’s former directors and officers for poor management.

Reliance claimed the insured vs. insured exclusion precluded coverage, while the committee claimed that, as the bankruptcy estate, it was a different entity than the pre-petition company and did not qualify as an insured under the exclusion.

Ultimately, the court sided with Reliance. It decided that the bankruptcy estate takes on the role of the pre-petition debtor and is not a distinct entity. Because its actions were brought “on behalf of the company,” the estate’s interests were the same as the pre-petition debtor; thus, it was subject to the limitations imposed by the insured vs. insured exclusion and not entitled to policy proceeds.

This and similar cases revealed the need for a distinction between a debtor-company and a bankruptcy trustee, wherein the latter is not defined as an insured. Subsequently, later cases ruled that the insured vs. insured exclusion does not apply when a trustee brings a D&O claim. A trustee is appointed to manage an estate after the bankruptcy petition is filed and therefore has no collusive interests with the insolvent company, making it an entity distinct from the debtor.

In the end, however, disputes are largely settled on a case-by-case matter, depending on policy language.

“Cases are inconsistent on where they come out on this,” said Darlene Alt, a partner with Edwards Wildman Palmer. “Most courts really analyze whether or not the party or the creditors committee or the bankruptcy trustee is really stepping into the shoes of the insured organization that is serving the claim, or whether they have independent grounds to bring this claim.”

Katie Dwyer is a freelance editor and writer based out of Philadelphia. She can be reached at [email protected].

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