Insured v. Insured Exclusion Held Not to Bar Action Brought by Creditor Trust

The New York Supreme Court, Appellate Division, applying New York law, has held that an Insured v. Insured exclusion (IvI Exclusion) in a D&O policy did not bar coverage for an action brought by a creditor trust against former directors and officers (D&Os) of a bankrupt company, because the suit fell within the scope of an exception for claims brought by certain bankruptcy-related entities. Westchester Fire Ins. Co. v. Schorsch, 2020 WL 4905056 (N.Y. App. Div. Aug. 20, 2020).

The insured, an investment banking and advisory firm, filed for Chapter 11 bankruptcy after negotiating a restructuring support agreement (RSA) with its unsecured creditors.  The RSA provided for a Creditor Trust to be governed by a Creditor Trust Agreement (CTA).  The order confirming the bankruptcy plan incorporated the CTA and allowed the Creditor Trust to sue on claims without approval of the Bankruptcy Court.  After confirmation of the bankruptcy plan, the Creditor Trust brought an action against the D&Os alleging breach of fiduciary duty.

The D&Os tendered the action for coverage under the bankrupt insured’s insurance program, which had been eroded significantly through other claims.  The excess insurers, whose policies had not been previously exhausted, denied coverage for the Creditor Trust action, asserting, among other things, that the IvI Exclusion applied because the action was a claim brought “on behalf of” the named insured by its assignee, the Creditor Trust.  One of the insurers brought a declaratory judgment action to determine coverage and ultimately added the other remaining insurers as parties.  The D&Os asserted counterclaims for breach of contract and bad faith and sought a declaration of coverage and attorneys’ fees.

In opposing the insurers’ motions to dismiss, and in support of their own motion for partial summary judgment, the D&Os asserted that the IvI Exclusion did not apply to the Creditor Trust action and, alternatively, that the action fell within an exception for claims brought by certain bankruptcy-related entities.  The trial court denied the insurers’ motion and granted partial summary judgment in favor of the D&Os.  The insurers appealed.

The appellate court first rejected the insureds’ argument that the IvI Exclusion did not apply to the Creditor Trust action, holding that in the absence of the exception for claims by bankruptcy- related entities, the IvI Exclusion would apply to bar coverage.  However, the court also held that the Creditor Trust action fell within the exception to the exclusion for claims “brought by the Bankruptcy Trustee . . . or comparable authority of the Company.”  According to the court, the policy language was unambiguous and “indicates no intent to bar coverage for D & O claims brought by the Creditor Trust, as a post-confirmation litigation trust.”  According to the court, “what makes a Creditor Trust ‘comparable’ to a bankruptcy-related entity, seeking to recover funds for the creditors, is that the Trust is not merely a creditor.  Rather, it is an entity and authority created as part and parcel of the bankruptcy reorganization proceeding, empowered by the bankruptcy court’s order of confirmation to file D & O claims.”  The court also reasoned that a contrary holding would ignore the rationale for the creation of a post-confirmation litigation trust and opined that the insurers’ interpretation of the term “comparable authorities” ignored the economic reality of insolvency.

While the court affirmed the trial court’s determination that the IvI Exclusion did not bar coverage for the Creditor Trust action, it concluded that the trial court should not have granted summary judgment to the insureds on their breach of contract and declaratory judgment counts because material factual disputes remained as to other coverage defenses, including whether the remedy sought in the Creditor Trust action was insurable.  As such, the court held that it was premature for the trial court to have concluded that the insurers were obligated to cover indemnity loss and to award attorneys’ fees.  However, the court did not vacate the trial court’s declaration that the insurers must pay the insureds’ defense costs, holding that the possibility of coverage for the Creditor Trust action required advancement of defense costs as a matter of law.