Sixth Circuit Court of Appeals Limits Assignees’ Ability to Recover from Insurance Company on Claims of Mismanagement

July 5, 2017Legal Alerts

In many corporate Chapter 11 cases, unsecured creditors of the debtor have few, if any, assets they may use to satisfy their claims. A debtor’s hard assets, cash and cash equivalents are almost always subject to liens in favor of secured creditors, leaving no tangible assets for unsecured creditors. If unsecured creditors are to receive any value in return for their claims, this value usually must be realized from the debtor’s causes of action. 

When a Chapter 11 debtor cannot feasibly reorganize, it is standard practice for that debtor’s plan of liquidation to assign the debtor’s causes of action to a liquidating trustee, who pursues the claims for the benefit of unsecured creditors. The most valuable claims belonging to a debtor are usually claims against the debtor’s directors and officers. A debtor’s managers often have significant exposure in the wake of a debtor’s collapse, and debtors usually obtain directors & officers insurance policies (D&O Policies) to cover the defense and satisfaction of those claims. Thus, D&O claims offer the best chance for a debtor’s unsecured creditors to obtain some distribution in return for their claims against the debtor. 

But following the Sixth Circuit’s June 20, 2017 decision in Indian Harbor Ins. Co. v. Zucker, __ F.3d __, 2017 U.S. App. LEXIS 10821 (6th Cir. 2017), the value of D&O claims is in jeopardy due to a provision found in nearly every D&O Policy: the “insured v. insured” exclusion. Zucker arose out of the bankruptcy of a company called Capitol Bancorp. Capitol filed for Chapter 11 bankruptcy protection in 2012 and was unable to successfully reorganize, leading to negotiations with its creditors committee over a plan of liquidation. 

The parties ultimately agreed to, and the bankruptcy court approved, a plan of liquidation wherein all of Capitol’s causes of action, including its D&O claims, were assigned to a liquidating trust. Clifford Zucker, the liquidating trustee, sued Capitol’s officers for breach of fiduciary duty, alleging $18.8 million in damages. The D&O insurer, Indian Harbor, filed a declaratory judgment action asserting it had no obligation to cover the officers’ damages because those damages fell within the insured v. insured exclusion contained in Capitol’s policy. This provision excluded from coverage “any claim made against an Insured Person . . . by, on behalf of, or in the name or right of, the Company,” except for derivative suits and employment claims. The District Court held that the exclusion applied to bar coverage, and Zucker appealed. 

In a 2-1 decision, the Court of Appeals for the Sixth Circuit affirmed. Applying the language in the exclusion, the majority reasoned that, because the defendant-officers were “Insured Persons” and Zucker was bringing claims as an assignee of Capitol, the claims were “in the ... right of” Capitol and therefore excluded from coverage. The court further rejected any argument the pre-bankruptcy debtor and Chapter 11 debtor-in-possession should be treated as separate entities, which would remove any issue with the exclusion. The majority also dismissed the assertion that the existence of the liquidating trust should remove the exclusion, since, as an assignee, it was still pursuing claims “in the right of” Capitol. Most ominously for unsecured creditors, the court implied this result might hold even if a court-appointed trustee or committee brought the D&O claims. While the majority expressly stated it was not ruling on that question, a holding that no representative of a bankruptcy debtor could overcome the insured v. insured exclusion would seriously hinder, if not eliminate, the value of D&O claims. 

Judge Bernice Donald dissented. Judge Donald, herself a former bankruptcy judge, noted the point of the insured v. insured exclusion was to prevent collusive suits and settlements between insured parties, which would force insurers to pay for bad management decisions. In this case, Judge Donald pointed out the liquidating trustee was independent and had been approved by the bankruptcy court as part of plan confirmation. Thus, the liquidating trustee should be exempt from the insured v. insured exclusion, as many other courts had concluded. 

Under the majority’s logic, Judge Donald predicted creditors who believe a debtor possesses substantial D&O claims will be forced to oppose any plan that proposes the assignment of those claims and instead seek the appointment of a court-appointed trustee. This result would likely be costly and a waste of judicial resources. However, Judge Donald did not weigh in on the majority’s hypothetical suggestion that even a court-appointed trustee might not be able to obtain coverage for D&O claims where an insured v. insured exclusion is in place. 

Zucker has potentially significant repercussions for the ability of unsecured creditors to obtain any distribution on account of their claims in bankruptcy. As indicated above, causes of action are often all unsecured creditors in a Chapter 11 case can use to satisfy their claims. D&O claims are usually valuable, but because a debtor’s officers and directors rarely can afford to pay a judgment themselves, a D&O insurer is the place to which creditors turn for payment. 

Because of the ubiquity of insured v. insured clauses, however, the logic of Zuckerwould impose transaction costs on the pursuit of such claims at best, or make them infeasible to pursue at worst. More dramatically, if Zucker remains settled law and is expanded to apply to even court-appointed trustees and committees, a D&O claim would be valueless where an insured v. insured exclusion is involved. Zuckerthus presents a problem for unsecured creditors and potentially other constituencies involved in Chapter 11 cases. At this time, no petition for rehearing en banc or for Supreme Court review has been filed, but hopefully the Sixth Circuit or Supreme Court will have the opportunity to consider the ramifications of the majority’s holding.