D&O Coverage Applies In Bankruptcy, Despite Exclusions
October, 2011
Introduction
It is not unusual for coverage issues to be litigated in a bankruptcy context after the policyholder has either sought bankruptcy protection or been forced into bankruptcy. In a recent case, the Illinois First District Appellate Court addressed such a situation in holding that a bankruptcy exclusion and an insured-versus-insured exclusion did not bar coverage under a directors and officers liability insurance policy in a suit brought by a bankruptcy court trustee against former directors of the insured debtor. Yessenow v. Executive Risk Indemnity, Inc., No. 1-10-2920, 2011 WL 2623307 (Ill. App. 1st Dist. June 30, 2011).
Facts
The plaintiffs were physicians and former directors of iHealthcare, Inc., an Indiana corporation which was the sole owner of the equity of Heartland Memorial Hospital, LLC. Executive issued D&O coverage to the plaintiffs as directors of iHealthcare.
Heartland was forced into bankruptcy in January of 2007. Shortly thereafter iHealthcare petitioned for Chapter 11 reorganization, and the two cases were consolidated. Heartland's court-appointed trustee, Abrams, then filed lawsuits against plaintiffs for mismanagement and breach of fiduciary duties. Following notice, Executive advised that it was denying coverage, and in January of 2010, plaintiffs brought this coverage action seeking a declaration as to coverage.
In the trial court, Executive asserted that Abrams, as trustee and manager of Heartland, was an "insured" for purposes of the D&O policy, and that coverage was barred by the insured-versus-insured exclusion in the policy. That exclusion excluded coverage for any claim brought by or on behalf of an insured, subject to certain exceptions. Executive also argued in favor of the D&O policy's bankruptcy exclusion, which barred coverage for any claim brought by or on behalf of the bankruptcy estate of the insured or any trustee.
The trial court, however, disagreed with Executive, granted the plaintiffs' motion for partial summary judgment, and found that Executive was obligated to defend the plaintiffs. Executive appealed.
Analysis
Choice of Law
In an opinion by Justice Patrick J. Quinn, the First District affirmed. The appellate court initially determined that Indiana law would apply in interpreting the provisions of the D&O policy, given that the insured entities were Indiana based, but that federal bankruptcy law also would be relevant.
The Bankruptcy Exclusion
The court then took up the bankruptcy exclusion and as a threshold issue addressed whether the plaintiffs, as nondebtors, had standing to challenge the bankruptcy exclusion. The court observed that, under section 541(c)(1) of the Bankruptcy Code, the interest of a debtor in property becomes property of the estate, "notwithstanding any provision in an agreement" to the contrary. Executive argued that because the plaintiffs were not themselves debtors, they should not be afforded the protections of section 541(c)(1).
The appellate court disagreed. The court reasoned that the D&O policy was an asset of the bankruptcy estate. Moreover, although coverage under the policy inured to the benefit of the plaintiffs, the estate's property interest was protected by section 541(c), and because any benefit to the estate could be realized only if the plaintiffs could seek coverage under the policy, they had standing to challenge the exclusion.
As to whether the exclusion precluded coverage for the claim brought by Abrams against the plaintiffs, Executive relied on case law upholding the exclusion where receivers had been appointed under state statutes. The court found that case law inapplicable based in part on the legislative history of section 541(c). The court concluded that because the bankruptcy exclusion is conditioned on the commencement of a bankruptcy case, not a receivership, the trial court did not err in finding that the bankruptcy exclusion was not enforceable under section 541(c).
Insured-Versus-Insured Exclusion
With respect to the insured-versus-insured exclusion, Executive initially argued that the exclusion was not ambiguous and applied to trustee lawsuits as being brought "by or on behalf of" an insured. Alternatively, Executive contended that conflicting judicial opinions regarding the meaning of the exclusion did not equate to ambiguity, and cited Biltmore Associates, LLC v. Twin City Fire Ins. Co., 572 F.3d 663 (9th Cir. 2009), as an example of a court finding the exclusion applicable.
The Illinois Appellate Court, however, distinguished Biltmore on the ground, among others, that that case involved a debtor in possession, not a court-appointed trustee. According to the court, a trustee and the debtor hospital were not the same entity for purposes of the insured-versus-insured exclusion. The appellate court observed that a court-appointed trustee is an instrument of the law and an agent of the court and has rights and powers that are not similarly vested in the debtor or its owners.
Abrams, in other words, according to the court's opinion, was an entity distinct from the pre-petition hospital, and was working on behalf of the hospital's creditors, not on behalf of the hospital. As such, the appellate court concluded that coverage under the policy was not barred by the D&O policy's insured-versus-insured exclusion.
The court therefore affirmed partial summary judgment in favor of the plaintiffs and in favor of coverage.
Learning Points:
(a) Section 541(c) of the Bankruptcy Code precludes application of a bankruptcy exclusion in a D&O policy where the exclusion seeks to negate coverage for directors for claims brought by the bankruptcy estate or a trustee on behalf of the estate.
(b) A court-appointed trustee in bankruptcy has interests distinct from the debtor and is not an insured for purposes of an insured-versus-insured exclusion in a D&O policy.
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