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ONE OF THE PURPOSES of directors and officers liability insurance is to protect corporate decision-makers from personal liability for claims arising out of the good-faith performance of their duties. Since the mid-1980s, the coverage afforded by D&O insurance has become uncertain, especially in the bankruptcy context, because of conflicting case law interpreting the so-called "insured vs. insured" exclusion clause.

Generally, the insured vs. insured exclusion bars coverage of claims against directors and officers brought "by the company or on behalf of the company."

A typical exclusion clause reads as follows:

"The insurer shall not be liable to make any payment for loss that is based upon or attributable to any claim made against any director or officer by any director or officer or by the institution defined in the policy except for a shareholder derivative action brought by a shareholder of the institution other than the insured."

The underlying rationale of this exclusion is to prevent collusive suits between a corporation and its directors and officers that would effectively compel the insurer to underwrite the company's losses.

This exclusion was created only after a number of corporations successfully litigated and recovered against their own directors and officers under broad D&O policies. As a result, insurers have sought to limit coverage in those circumstances and designed policies denying coverage to directors and officers who were being sued by the corporations that they served.

The language of the typical exclusion, however, has generated uncertainty as to whether claims against directors and officers brought by third parties -- such as trustees; statutory receivers, such as the Federal Deposit Insurance Corp.; and debtors-in-possession -- are excluded from coverage because the claims are considered to be brought by an "insured," i.e., the company, against another insured. The issue comes into sharp focus in the case of failed companies, where a third-party trustee or a litigation trustee attempts to hold former directors and officers liable for their wrongs to the corporation.

A litigation trustee is usually appointed after a plan of reorganization has been confirmed by the bankruptcy court to pursue various claims against third parties, including former directors and officers. Generally, the appointment occurs in a large Chapter 11 bankruptcy by recommendation of the creditors' committee. Litigation trustees have been appointed in a handful of recent bankruptcy cases, including In re County of Orange (Bankr. C.D. Cal.), In re Resorts International, Inc. (Bankr. D.N.J.), and In re Gulf USA Corp. (Bankr. D. Idaho).

Several courts have considered whether the exclusion applies in an action where a statutory receiver, such as the FDIC, brings suit against former officers and directors. Most courts have held that the exclusion is not applicable, reasoning that the receiver, in essence, represents third-party creditors and, therefore, the purpose of the exclusion -- to prevent collusive suits -- is not furthered by excluding coverage.

However, reported cases are few and in sharp conflict as to whether the exclusion applies to claims where the plaintiff is a bankruptcy trustee or other third party in a bankruptcy situation. In Reliance Insurance Co. vs. Weis, 148 B.R. 575 (E.D. Mo. 1992), aff'd, 5 F.3d 532 (8th Cir. 1993), cert. denied, 510 U.S. 1117 (1994), where a creditors' committee in a Chapter 11 bankruptcy sued former directors and officers, the court held that the exclusion applied and denied coverage. The court reasoned that the claims were necessarily brought on behalf of the company because they originally belonged to the company. According to the court, the committee was simply an assignee of the company's claims by reason of the Chapter 11 reorganization plan; since the company itself could not obtain the benefit of the D&O coverage, its assignee stood in no better position.

By contrast, in Pintlar Corp. vs. Fidelity & Casualty Co. of N.Y., 205 B.R. 945 (Bankr. D. Idaho 1997), aff'd, Case No. CV 97-250-N-EJL (D. Idaho Sept. 11, 1997), appeal docketed, No. 98-35007 (9th Cir. Dec. 31, 1997), the court reached a different result where the plaintiff was a litigation trustee. The court ruled that the exclusion did not apply -- thereby upholding coverage -- for a litigation trustee's claims against former directors and officers. The court reasoned that the litigation trustee, in pursuing such claims, was acting on behalf of the creditors, not the company. Accordingly, there was no possibility of the suit being collusive. Such reasoning, in the authors' view, was correct and may represent a trend toward finding the exclusion inapplicable in similar circumstances.

The reasons that claims brought by litigation trustees should fall outside of the exclusion are similar to those in cases involving receivers. First, recoveries are generally distributed to the company's creditors, not to the company -- which may be an "insured" under a policy. Second, collusive suits between a corporation and its officers and directors are not a threat if, as is the case where a litigation trustee is involved, creditors are the ultimate beneficiaries of the recovery.

The exclusion typically precludes coverage for claims brought "on behalf of the company." This language does not specifically address the nature of claims asserted in bankruptcy or insolvency contexts, where claims that belonged to the company prior to its bankruptcy now exist for the benefit of other members of the bankruptcy "estate" -- the creditors. For example, a litigation trustee appointed by a bankruptcy court is typically the assignee of the claims of the bankrupt corporation and, therefore, does not pursue the assigned claims "on behalf of" the insured company. Rather, such a trustee asserts claims on behalf of the trust and its respective beneficiaries. Those beneficiaries are usually creditors and/or shareholders of the debtor. Because creditors of a corporation are not the corporation itself -- i.e., the insured -- the exclusion is inapplicable. Indeed, the recognition that creditors are the real parties in interest may underlie the trend toward finding coverage.

Another factor that may prompt the courts to find coverage is the legitimate expectations of corporate directors and officers. After all, D&O insurance typically is bought to protect directors and officers against lawsuits arising from their good-faith mistakes. Such lawsuits are likely to be most numerous -- and the need for coverage most acute -- in an insolvency or bankruptcy meltdown.

Any uncertainties as to coverage can be resolved by the marketplace. A modification in the policy's language, such as a specific exclusion of all claims "brought by the company, receiver, litigation trustee,. . ." would eliminate the confusion and create certainty in litigation. Of course, such a product might have limited appeal even if it were priced lower to reflect its decreased coverage.

Some insurance companies, recognizing the need for a product providing better-defined coverage, have begun offering a D&O liability policy that explicitly provides coverage for claims brought by trustees or examiners against directors and officers in bankruptcy situations. Presumably, the pricing of the policy reflects the greater certainty of coverage for directors and officers.

Policy language should be carefully reviewed by both insurers and potential insureds. For example, even expanded coverage for claims of "trustees" or "examiners" might not cover claims brought by litigation trustees, debtors-in-possession, or creditors' committees.

Tightening up the draftsmanship on new policies should have a positive effect in the marketplace. The legitimate expectations of directors and officers can be more effectively met, and all sides should be relieved of unnecessary legal costs when the parties' rights and obligations are more clearly defined.

Martin R. Pollner is a senior litigation partner in the New York office of Loeb & Loeb L.L.P. Brian R. Socolow is a senior associate at Loeb & Loeb. The views expressed herein are those of the authors only.