This article is the first in a series discussing COVID-19 bankruptcies and insurance coverage.

As the expected wave of bankruptcies crashes upon the business world, directors and officers (D&O) insurance will play a critical role and serve as a key asset in any related disputes.

Per the Brookings Institute:

The current crisis could bring a much greater surge in business bankruptcy filings than either of the two most recent recessions. Prior to the current crisis, businesses took on an extraordinary amount of debt—$15.5 trillion, according to one estimate, a 52% increase since its high point during the 2008 crisis. This debt, coupled with the nearly complete shutdown of the economy and the fact that the revenues of many businesses will be slow to recover, even after economic activity resumes, suggests there will be a surge of business bankruptcies.

David Skeel, "Bankruptcy and the coronavirus," Economic Studies at Brookings (April 2020); see also Hank Tucker, "Coronavirus Bankruptcy Tracker: These Major Companies Are Failing Amid the Shutdown," Forbes (May 3, 2020).

The anticipated surge in bankruptcies will likely result in a wave of D&O claims filed by creditors or bankruptcy trustees. Kevin M. LaCroix, "Coronavirus and D&O Insurance: The Latest Interim Update," D&O Diary (May 10, 2020); Pasich LLP, "Legal Alert: Insurance Coverage for Losses and Claims Associated with the Coronavirus," (May 18, 2020). These claims will likely arise out of a combination of suits regarding allegations of misstatements in company reporting on the impact of COVID-19, allegations of mismanagement, or alleged breaches by a Board of the duty of care or breach of the duty of oversight. Id.

Insureds and trustees seeking to utilize D&O insurance should bear in mind that D&O policies generally contain so-called Insured versus Insured exclusions purporting to limit or eliminate coverage. The language of these exclusions and the rationale for such exclusions should be closely evaluated as there is case law, discussed below, which supports the notion that the lack of collusion between insureds in the underlying lawsuits should limit the applicability of the exclusion. (Some D&O policies even specifically exempt from the insured versus insured exclusion claims brought by a bankruptcy trustee, receiver, or creditors committee. Even if such exemption is not present in a D&O policy, however, the analysis which follows can be brought to bear on recalcitrant insurers.)

'Yessenow'

In Yessenow v. Executive Risk Indemnity, 953 N.E.2d 433 (Ill. App. Ct. 2011), former directors of two Chapter 11 bankrupt Indiana corporations sought a declaration that their insurer was obligated to defend them in underlying bankruptcy actions brought by a trustee. In trying to avoid its obligations under the operative D&O policy, the insurer asserted the insured versus insured exclusion. The former directors filed a motion for partial summary judgment, arguing that the exclusion was ambiguous and should be construed in favor of coverage.

The policy's insured versus insured exclusion purported to preclude coverage for

any Claim by or on behalf of, or in the name or right of, the Company or any Insured Person, except that this exclusion [] will not apply to:

(1) Any derivative action by a security holder of the Company on behalf of, or in the name or right of, the Company, if such action is brought and maintained independently of, and without the solicitation of, the Company or any Insured Person.

(2) Any Claim in the form of a crossclaim, third party claim or other claim for contribution or indemnity by an Insured Person which is party of or results directly from a Claim which is not otherwise excluded by the terms of this Policy; or

(3) Any Claim for an Employment Practices Wrongful Act.

Id. at 437 (emphasis added).

The trial court, citing Biltmore Associates v. Twin City Fire Insurance Co., 572 F.3d 663 (9th Cir. 2009), found that "the issue of whether a trustee or debtor in possession is an insured for the purposes of an insured versus insured exclusion is unsettled law and that 'ambiguities and doubts in insurance policies are resolved in favor of the insured, especially those that appear in exclusionary clauses.'" Yessenow, 953 N.E.2d at 436-37. The court further reasoned that the insurer could have "sidestepped any ambiguity by including trustees and debtors-in-possession in either the definition of the 'insured' or the language of the insured versus insured exclusion." Id. at 437. Because the insurer did not draft the policy with such specificity, the trial court interpreted the D&O policy in favor of coverage and held that neither a trustee nor debtor-in-possession is an "insured" under the policy.

On appeal, the appellate court addressed the insurer's arguments that (1) "the unsettled nature of the law alone, without consideration of the arguments on both sides, is not grounds for finding the provision is ambiguous," and (2) the "case law supports a finding that the insured versus insured exclusion bars coverage for claims against an insured by either a bankruptcy trustee or a debtor-in-possession." Id. at 442. The insurer primarily relied on Biltmore Associates v. Twin City Fire Insurance Co., 572 F.3d 663, 671 (9th Cir. 2009). In Biltmore, the court found that the insured versus insured exclusion precluded coverage for a lawsuit brought by a debtor-in-possession against its officers and directors. The court stated that "[t]he 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." Id. at 674.

Relying on Biltmore, the insurer argued that the suit brought by a trustee "unambiguously falls within the scope of the insured versus insured exclusion." Yessenow, 953 N.E.2d at 443. The court found that Biltmore did not support the insurer's argument because it was distinguishable in two key respects. First, the underlying lawsuit in Yessenow was filed by a court-appointed trustee, not a debtor-in-possession. "A court-appointed trustee, unlike a debtor-in-possession, is acting with the imprimatur of the court, reducing the fear of collusion …" Id. Second, there was actual evidence of collusion in Biltmore, as the debtor-in-possession initially filed the lawsuit against the corporation's officers and directors and then consented to a judgment against itself before assigning the claims to the trustee. No such evidence of collusion was present in Yessenow. Therefore, the court in Yessenow held that the trustee was "a distinct entity from the prefiling hospital who is working on behalf of the hospital's creditors, not on behalf of the hospital," id. at 446, and that, ultimately, coverage under the D&O policy was not barred by the insured versus insured exclusion.

This conclusion finds further support in the policy underlying the insured versus insured exclusion. "The primary focus of the exclusion is to prevent collusive suits in which an insured company might seek to force its insurer to pay for the poor business decisions of its officers or managers." Township of Center, Butler County, Pa. v. First Mercury Syndicate, 117 F.3d 115, 119 (3d Cir. 1997). "These exclusionary clauses became prominent after a wave of litigation in the 1980s in which corporations attempted to recoup operational losses by filing claims against the director & officer policies." Bodewes v. Ulico Cas. Co., 336 F. Supp. 2d 263, 272-73 (W.D.N.Y. 2004) citing to Catherine E. Vance & Geoffrey L. Berman, Last in Line: Do "Insured vs. Insured" Exclusions Apply to Assignees in Assignments for the Benefit of Creditors?, 23 American Bankruptcy Institute Journal 12 (February 2004).

Like the court in Yessenow, courts have looked beyond the exclusion's text to its rationale, and do not apply the exclusionary clause when the underlying lawsuit is not collusive. See, e.g., MegAvail v. Illinois Union Ins. Co., No. 05-1374 AS, 2006 WL 3063487 (D. Or. Oct. 26, 2006) (lawsuit filed by minority shareholders against an insured company was not "collusive," despite some of the minority shareholders being former directors and officers); Fidelity & Deposit Co. of Maryland v. Zandstra, 756 F. Supp. 429, 431-32 (N.D. Cal. 1990) (in the context of a receivership, the court found that the insurer had "come forward with neither evidence nor plausible argument to demonstrate that there was any other justification or purpose behind the exclusion"); American Cas. Co. of Reading, Pennsylvania v. Baker, 758 F. Supp. 1340, 1350 (C.D. Cal. 1991) (observing that "the obvious intent behind the insured v. insured exclusion is to protect the insurer against collusive suits among the failed institution and its directors and officers," the court did not apply the exclusion because the receiver was a "genuinely adverse party"); but see Sphinx Intern. v. National Union Fire Ins. Co. of Pittsburgh, Pa., 412 F.2d 1124 (11th Cir. 2005).

Looking Ahead

With a view towards the expected surge of bankruptcies, policyholders and trustees alike should scrutinize their D&O policies and review insured versus insured exclusions with a critical eye.

Peter A. Halprin and Pamela Woods are partners and Vincent Xu is an associate at Pasich LLP.