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In Brief: Ninth Circuit Weighs In on Insured-versus-Insured Exclusion in Chapter 11

Once a debtor files for bankruptcy protection, its bankruptcy estate succeeds to all of the debtor’s pre-bankruptcy assets, including any causes of action that existed as of the petition date. The bankruptcy trustee (or chapter 11 debtor in possession) has the exclusive right to prosecute such claims on behalf of the estate. The trustee, in keeping with his mandate to maximize the value of the estate, is statutorily conferred with a broad range of powers, including the ability to avoid fraudulent or preferential transfers and to prime unperfected liens. However, the trustee’s powers are not unfettered. In most cases, his ability to prosecute estate claims is subject to the same limitations that governed the pre-bankruptcy debtor. One limitation recognized by some courts concerns claims made against the debtor’s directors’ and officers’ (“D&O”) insurance policies.

In general, D&O policies provide coverage for certain claims based on alleged wrongful acts committed by a company’s directors and officers. Typically included in these policies is what is commonly called an “insured versus insured” exclusion, which excludes coverage for any claim made against an insured that is brought by another insured, the company, or any of the company’s security holders. The exclusion was devised as a reaction to a wave of litigation in the 1980s in which insured corporations sued their own directors to recoup operational losses caused by improvident or unauthorized actions. Because the purpose of the exclusion is to prevent collusive suits between insureds to collect on the policy’s proceeds, D&O policies often contain an exception to the insured-versus-insured exclusion for claims brought by security holders against an insured where the claim is initiated and maintained independently and without the assistance or active participation of the company. Thus, this exception will provide coverage for situations where collusion is not suspected.

If a company files suit against its directors and officers, such a suit clearly falls within the insured-versus-insured exclusion, allowing the insurance company to deny coverage for the suit. If, however, the suit is brought after the company files for bankruptcy, so that the plaintiff is either a bankruptcy trustee or a chapter 11 debtor in possession, may the insurance company use the insured-versus-insured exclusion to deny coverage for the claim? Some courts treat a post-bankruptcy entity as different from the debtor before it filed for bankruptcy for purposes of the exclusion. Others hold that they are the same entity for this purpose.

The Ninth Circuit Court of Appeals recently had an opportunity to address this question in Biltmore Associates, LLC v. Twin City Fire Ins. Co., concluding that “for purposes of the insured versus insured exclusion, the prefiling company and the company as debtor in possession are the same entity.” As such, the court ruled that claims against a chapter 11 debtor’s officers and directors for breach of statutory and fiduciary duties were excluded from coverage under the debtor’s D&O policy, even though such claims had been assigned under the debtor’s chapter 11 plan to a creditor litigation trust. According to the Ninth Circuit, because the claims could have been asserted derivatively outside bankruptcy only on behalf of the corporation and belonged to the debtor corporation’s estate, assignment of the claims to a trust did not alter the fact that the same entity—the insured company, albeit as a chapter 11 debtor in possession—“instigated and continued” such claims against its officers and directors. To hold otherwise, the court emphasized, would only invite abuse:

We therefore affirm the dismissal of the complaint. The alternative position would create a perverse incentive for the principals of a failing business to bet the dwindling treasury on a lawsuit against themselves and a coverage action against their insurers, bailing the company out with the money from the D&O policy if they win and giving themselves covenants not to execute if they lose. That is among the kinds of moral hazard that the insured versus insured exclusion is intended to avoid.

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Biltmore Associates, LLC v. Twin City Fire Ins. Co., 572 F.3d 663 (9th Cir. 2009).

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