Bank Holding Company Execs Not Entitled to Insurance Coverage

by Manatt, Phelps & Phillips, LLP

Manatt, Phelps & Phillips, LLP

Is a bank holding company that owns and operates banks the same entity both pre- and postbankruptcy filing for the purposes of pursuing directors and officers (D&O) insurance coverage? Yes, the U.S. Court of Appeals, Sixth Circuit, has ruled, finding that because the liquidating trustee of a bank holding company held essentially the same legal status, it was unable to tap into D&O insurance coverage for former executives facing liability for its financial problems.

What happened

A holding company incorporated in Michigan, Capitol Bancorp owned community banks in 17 states. Joseph Reid founded Capitol and served as its chairman and chief executive officer, his daughter Cristin Reid served as president, and her husband, Brian English, served as general counsel.

Hit hard by the financial crisis, Capitol accepted oversight by the Federal Reserve in 2009 and entered Chapter 11 bankruptcy proceedings in 2012. With the filing, Capitol’s assets (including its ownership interests in the subsidiary banks) became the property of the bankruptcy estate, with Capitol the debtor in possession under the direction of the Reids. Reorganization efforts failed and Capitol was subject to a liquidating plan in 2013.

Capitol reached an agreement with the creditor’s committee that required Capitol to assign all of the company’s causes of action to a liquidating trust, which could pursue those claims on behalf of creditors. Another provision stated that the executives had no liability for any conduct after they filed the bankruptcy petition and limited any prepetition liability to amounts recovered from Capitol’s liability insurance policy.

Capitol took out a one-year management liability insurance policy from Indian Harbor Insurance Co. in 2011, twice extending the policy after the bankruptcy proceedings began. Pursuant to the policy, Indian Harbor agreed to pay for any “Loss resulting from a Claim first made against the Insured Persons”—a group that included Capitol’s directors, officers and employees—“during the Policy Period … for a Wrongful Act.” A policy exclusion covered “any claim made against an Insured Person … by, on behalf of, or in the name or right of, the Company or any Insured Person.”

In 2014, Capitol’s liquidating trustee sued English and the Reids for $18.8 million, alleging they breached their fiduciary duties to Capitol through a number of improper actions. The liquidating trustee notified Indian Harbor of the lawsuit, and the insurer responded with a declaratory judgment action that it owed no obligation to cover any damages from the lawsuit because the trust’s claim fell within the insured v. insured exclusion.

A district court judge agreed, and the Sixth Circuit affirmed.

The appellate panel was not persuaded by the argument that when Capitol and Indian Harbor formed the insurance contract, “the Company” referred to the financial institution in its prebankruptcy form and that, as a result of the bankruptcy filing, it underwent a transformation, with Capitol as debtor in possession administering the estate for the benefit of the creditors. Because a debtor in possession is legally distinct from the prebankruptcy “Company,” the insured v. insured exclusion was inapplicable, the executives told the court.

“But this new-entity argument surely would not work before bankruptcy,” the appellate panel said. “Capitol could not have dodged the exclusion by transferring a mismanagement claim to a new company—call it Capitol II—for the purpose of filing a mismanagement claim against the Reids. No matter how legally distinct Capitol II might be, the claim would still be ‘by, on behalf of, or in the name or right of’ Capitol.”

The same conclusion applied to a claim filed after bankruptcy, the court said. “Here too the voluntarily transferred claim would be filed ‘on behalf of’ or ‘in … the right of’ Capitol,” the panel said. “The exclusion remains applicable by its terms.”

Other terms of the contract similarly resisted the reading proposed by the executives, the court added, such as a “Change in Control” clause contemplating that coverage would continue uninterrupted during bankruptcy, even after the company became a debtor in possession. And the parties’ actions were consistent with this reading of the contract, as Capitol paid more than $3 million in total premiums to extend the policy—twice—after filing for bankruptcy.

Further, the Supreme Court has rejected the argument that a debtor in possession is a “wholly new entity” unbound by the prebankruptcy company’s contracts, the Sixth Circuit noted, writing that it was “sensible to view the debtor-in-possession as the same ‘entity’ which existed before the filing of the bankruptcy petition.”

The Bankruptcy Code itself supported this understanding, the court said, as the animating purpose of a Chapter 11 filing is to keep the prebankruptcy company up and running, giving the debtor in possession all the statutory powers and duties of a trustee.

“If Capitol had successfully emerged from Chapter 11 bankruptcy … it would once again be the same ‘Company’ covered by the contract,” the panel wrote. “How strange then to treat the debtor in possession as an entirely distinct entity for purposes of this insurance contract.”

Although the court recognized that the debtor in possession and the prebankruptcy debtor are legally distinct, it characterized the situation as one and the same person, wearing two hats. The panel left open the question of whether a court-appointed trustee or creditor’s committee could collect on the policy.

One member of the panel dissented, writing that the majority ignored the fundamental principles of bankruptcy law, as “a new entity is in fact formed” upon the filing of a bankruptcy case.

To read the opinion in Indian Harbor Insurance Company v. Zucker, click here.

Why it matters

The decision provides an important reminder for the management and boards of financial institutions and, where applicable, their holding companies to consider the scope of insurance coverage, particularly with regard to the impact of a bankruptcy filing. It also left open the question of whether a court-appointed trustee, liquidating trustee or creditor’s committee could collect on the policy, potentially signaling that creditors will be required to seek the appointment of a trustee in order to pursue insurance proceeds.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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