Bankruptcy and the Insured versus Insured Exclusion

The Financial Institution Cases

In response to the financial institution crisis of the 1980s and early 1990s, the Federal Deposit Insurance Corporation (FDIC), Federal Savings and Loan Insurance Corporation (FSLIC), and RTC made zealous efforts to hold former management of hundreds of failed institutions financially responsible for those failures. D&O insurers took the position that suits by regulators as receivers, successors, or assigns of a failed financial institution against its former directors or officers were barred from coverage by the insured versus insured exclusion.

Several courts agreed with the insurers' position. These courts reasoned that claims of an institution to which a regulator had succeeded, as receiver or otherwise, fell squarely within the insured versus insured exclusion because the regulator "stands in the shoes" of the institution with respect to those claims: that is, the regulator has all the rights of, and is subject to the same defenses as, the insured institution, had it brought the suit before it failed.

The court in Gary v American Casualty Co., 753 F Supp 1547, 1555 (WD Okla 1990), affirmed on other grounds, 975 F2d 677 (10th Cir 1992), rejected the FDIC's argument that the exclusion did not apply to its claims because "the FDIC performs many functions and represents not only a failed bank and its shareholders, but also its depositors, creditors, the deposit insurance fund, and the public at large," and criticized the judicial decisions that had accepted that argument:

The problem with those courts' premise is that regardless of to whom the benefits of any recovery on a D&O policy by the FDIC or FSLIC might indirectly or immediately inure, their claims are claims of the financial institution which they acquired after failure of such financial institution by succession or purchase and are thus asserted in the capacity of assignee of the failed financial institution. . . . In any event, regardless of whom the FDIC may represent and to whom the benefits of any claim asserted by it may inure, it is clear that in this case the FDIC is seeking a determination of coverage for claims previously owned by the bank....

Other courts, however, held that the insured versus insured exclusion did not unambiguously exclude regulators' suits, relying on two principal arguments. First, these courts interpreted the language of the exclusion narrowly, noting that the exclusion bars coverage for claims "by" an insured, not "of" it, and contains no "language which would indicate an intent to include insureds' successors...." Finci v American Casualty Co., 593 A2d 1069, 1082 (Md 1991). But see Hyde v Fidelity & Deposit Co. of Maryland, 23 F Supp 630, 634 (distinguishing Finci and holding applicable to receiver's action an insured versus insured exclusion that barred coverage for claims "by or on behalf of" an insured).

Second, courts found that a regulator did not merely "stand in the shoes" of a failed institution because the regulator is authorized to sue not only on behalf of the failed institution, but also on behalf of the institution's shareholders and creditors, as subrogee to the rights of depositors, and as a creditor itself on behalf of the deposit insurance funds. For example, see Fidelity and Deposit Co. of Maryland v Zandstra, 756 F Supp 429, 433 (ND Cal 1990). Some courts in accepting this argument relied on the regulators' special governmental function and indicated that they would not reach the same result with respect to an ordinary trustee in bankruptcy. See FDIC v Zaborac, 773 F Supp 137, 143 (CD Ill 1991).

The Purpose of the Exclusion

Several of the decisions holding that claims of a receiver are not the same as claims by the failed institution were based on a mistaken understanding of the purpose of the insured versus insured exclusion. For example, in Zandstra the court found that a shareholder derivative suit exception to an insured versus insured exclusion demonstrated that the insurer intended to provide coverage for losses suffered by the institution as a result of breaches of fiduciary duty by directors or officers. The court concluded that the "obvious intent behind the insured versus insured exclusion is to protect the insurer against collusive suits among the institution and its directors and officers," and that it was "clear beyond doubt" that the FDIC was genuinely adverse to the directors and officers and that its suit was not collusive. [756 F Supp at 431-32.]

However, that reasoning does not appear sound. The presence of a specific exception for shareholder derivative actions from a broad insured versus insured exclusion indicates both (1) that, in the absence of such a specific exception, derivative suits would fall within the scope of the exclusion; and (2) that claims of the institution asserted derivatively by a successor to the institution, other than a shareholder derivative claim, fall within the scope of the exclusion.

Moreover, Zandstra was mistaken in its assumption that the sole purpose of the insured versus insured exclusion is to prevent "collusive" suits. Suits such as the Bank of America case, however, certainly did not involve any "collusion" between the plaintiffs and defendants. The true purpose of the insured versus insured exclusion was to

prevent [insurers] being put in the position of underwriting the daily business risks of the insured companies… J. Olson & J. Hatch, Director and Officer Liability: Indemnification and Insurance § 10.06 [6] [b] [iii], at 10-33 (1990), precisely the risk presented by suits by receivers or trustees in bankruptcy.

Recent Cases

The smaller body of case law involving application of the insured versus insured exclusion to suits by nongovernmental trustees or receivers in bankruptcy, like the financial institutions case law, has been split. Compare In re Buckeye Counrymark, 251 B.R. 835 (SD Ohio 2000) (exclusion held inapplicable), with Reliance Insurance Co. v Weis, 148 B.R. 575 (ED Mo 1992), aff'd, 5 F3d 532 (8th Cir 1993) (table) (exclusion held applicable).

A number of cases decided in the last year, however, indicate that the trend may be against application of the exclusion, at least based on the language involved in those cases. See Alstrin v St. Paul Mercury Insurance Co., 179 F Supp 2d 376 (D Del 2002); In re Molten Metal Technology, 271 B.R. 711 (Bankr. D Mass 2002); Zurich American Insurance Co. v Boyes, 2001 U.S. Dist. LEXIS 15123 (ND Tex 2001).

The courts in each of these three recent cases held that the plain language of the insured versus insured exclusion did not apply to claims by a trustee in bankruptcy or estate representative, emphasizing that such claims "are not the same as claims brought 'by' the Debtor under the exclusionary provision." [Alstrin, 179 F Supp 2d at 404.]

The courts emphasized that a bankruptcy estate is a separate entity created by federal bankruptcy law, and that the estate has different functions from and serves different constituencies than the corporation prior to bankruptcy. In Molten Metal (as well as in Alstrin) the insured versus insured exclusion barred coverage for claims "brought by any Insured or by the Company." The court noted that "Company" was "expressly defined to mean MMT [the insured corporation] and its subsidiaries. The definition includes no reference to successors or assigns of any nature." [271 B.R. at 725.]

The court also found support for its holding in the term "brought by." The court stated that:

in order [for the exclusion] to encompass the Trustee's claims it would not be enough for "claim brought by" to include "claim belonging to" or "claim brought on behalf of." In order to encompass the Trustee's claims, "claim brought by" would have to include "claim that originated in favor of but that no longer belongs to and that is brought neither by nor on behalf of." No objectively reasonable insured could construe "claim brought by" to have that reach. [Id. at 726.]

The courts in Alstrin and Molten Metal also noted that their holdings were consistent with the purpose of the insured versus insured exclusion to prevent collusive suits, although they found it unnecessary to examine intent in light of their finding that the language of the exclusion was plain and unambiguous. [179 F Supp 2d at 404; 271 B.R. at 728.]

All three courts also stated that, if the language of the exclusion had been found to be ambiguous, they would have construed it against the insurer and reached the same result. See Alstrin, 179 F Supp 2d at 404; Molten Metal, 271 B.R. at 725, 726. In Boyes—where the exclusion barred coverage not only for claims "by" but also "on behalf of" an insured—the court stated:

The ambiguity appears when the court applies the clause to a suit by a Trustee in bankruptcy, who has responsibilities and obligations defined by the bankruptcy code that do not fit squarely with the phrase "on behalf of." . . . The Trustee's and [insureds'] interpretation of that phrase, read in light of the policies of the bankruptcy code and job of the Trustee, is a reasonable one and supplies an alternate basis for the declaratory judgment. [2001 U.S. Dist. LEXIS 15123, at *6.]

Conclusion

In light of these recent cases, both insurers and insured corporations and directors and officers will wish to consider precisely what risks they wish to insure, particularly in times of financial uncertainty. New policy language likely will be introduced defining in greater detail the scope of coverage for claims by bankruptcy trustees or receivers or by other successors or assigns of the corporation.