Suing a corporate officer following bankruptcy discharge to tap a D&O insurance pot-o-gold

by Christopher Graham and Joseph Kelly

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Overview: We recently covered a case here where a bankruptcy trustee claimed a D&O policy and proceeds belonged to the bankrupt company’s estate and shouldn’t be used to pay director and officer defense fees. Today’s story, also from bankruptcy land, is about another common issue following a major financial disaster. Those who caused the harm are inundated with claims or otherwise have serious financial problems. So they seek a bankruptcy “fresh start” and get a discharge, including an order preventing suit for discharged claims. What then is the injured party’s remedy? What about the liability insurance for the claims against the discharged “wrongdoer”? What if, as here, insurer argues its policy doesn’t cover the claims, because of an insured versus insured exclusion? What if, as here, the insured is a failed bank’s officer and claimant is FDIC as the bank’s receiver? Read on, as the story is about to begin!

The Story: You underwrite management liability insurance. You bind coverage for a company. Policy is issued. And, though you’re usually much better picking winners, . . . eventually this company goes bust. There are many unhappy folks. Lots of money has been lost. And they say, “Who can we make pay?” You say, “Not good.”

Investors, creditors, a bankruptcy trustee or receiver, government agencies, and the like target the company’s directors and officers. And some of them also target a perceived pot-o-gold: the management liability insurance policy underwritten by you. Yikes!

The company’s Big Chief Muckety-muck is wiped out. He was heavily invested in the failed company. That’s all lost. Lost job. Lost salary. Lost benefits. Claims galore. Solution? Bankruptcy! Discharge! No more liability.

You say, “Great. At least we don’t have to pay for that guy’s defense. And at least we’re off the hook for his potential liability to others.”

Then, much to your surprise and despite the bankruptcy discharge, unhappy camper asks the bankruptcy court to allow a suit versus Mr. Chief. Unhappy camper plans to sue the rest of the company’s board and upper management too. You say, “Bad enough that camper is suing the others. Why does camper need Mr. Chief? He has no dough. What’s the point? And doesn’t Chief’s bankruptcy discharge mean camper can’t sue him?”

Silly you. Have you heard of the “empty chair”? That’s what the defense lawyers point to when they say their clients aren’t to blame for an unhappy camper’s financial disaster. They’ll say Mr. Chief is solely responsible. He hasn’t been sued; he’s not in the court room; his chair is the “empty chair”; and the others in the court room chairs aren’t responsible.

By going to bankruptcy court, camper aims to put Mr. Chief in the chair. Keeping it warm for the trial duration. To avoid the “empty chair” tactic. And . . . to tap your management liability policy. “Chief,” camper will say, “is a ‘necessary party’ under the law.”

Now for some legal mumbo-jumbo:

As a technical matter, camper seeks to (1) reopen, if necessary, Chief’s bankruptcy case under Bankruptcy Code section 350(b) and (2) modify the discharge injunction under Bankruptcy Code section 524(a) to permit camper to proceed against an available limit of liability insurance policy under Bankruptcy Code section 524(e).

Specifically, camper asks the court to modify the discharge injunction so camper can name Chief as a nominal defendant in a suit for establishing and seeking payment from the management liability insurer. The policy you underwrote is in the crosshairs!

What to do? What to do? Well, your company tries to stop camper. And Mr. Chief does too.

Your company and Chief tell the bankruptcy court: “Isn’t bankruptcy meant to provide Chief an economic ‘fresh start’?”

“That won’t happen if camper gets to sue Chief,” says your company. “The management liability policy places the duty to defend on Chief. And while our company must “advance” fees ‘incurred’ by Chief, Chief must agree to repay us if it is later established there is no coverage for those fees.” “That’s unfair to Chief,” your company says. “An unfair burden!” “Defeats the ‘fresh start’ purpose of Chief’s bankruptcy discharge.”

Of course, none of what your company argues has anything to do with your company’s additional financial hit if camper gets to sue Chief, right? It’s just about the poor Chief. . . .

The decision: So what sayeth the bankruptcy court? Well, in In the Matter of: William H. Gafford, Jr., Case No. 11-13490-WHD (N.D. Ga. Feb. 4, 2014), a case generally along those lines, the winner is “camper” aka the FDIC!

Why?

Well, first more bankruptcy law education; as explained by the court:

The filing of a bankruptcy petition prevents temporarily the litigation of prepetition claims against a debtor [(like camper’s claim)]. . . . The entry of a discharge acts as a permanent injunction against litigation for the purpose of collecting a debt from the debtor [(here. Chief)] or the debtor’s property.

Further:

“A discharge in bankruptcy does not extinguish the debt itself, but merely releases the debtor [(Chief)] from personal liability for the debt.” . . . Following the discharge, section 524(a)(2) [of the Bankruptcy Code] enjoins “actions against a debtor,” . . . , but section 524(e) “specifies that the debt still exists and can be collected from any other entity that might be liable.” . . . Therefore, a creditor may establish the debtor’s nominal liability for a claim solely for the purpose of collecting the debt from a third party, such as an insurer or guarantor

Got that: under the Bankruptcy Code, “a creditor may establish the debtor’s nominal liability for a claim solely for the purpose of collecting the debt from a third party, such as an insurer or guarantor.” So camper aka FDIC may establish Mr. Chief’s aka Mr. Gafford’s nominal liability solely for the purpose of collecting the debt from an insurer. Here, that means the management liability insurer.

Was Mr. Chief, the failed bank’s CEO, really a “necessary party” as argued by camper aka FDIC? Yes, says the court; for the same reasons given in In re Grove, 100 B.R. 417, 418 (Bankr. C.D. Ill. 1989), also involving FDIC claims against a failed bank’s directors and officers. As the Gafford court explained:

The In re Grove court held that the relief sought by the FDIC did not adversely affect the debtors’ fresh start, and that a failure to modify the [Bankruptcy Code section] 524(a) injunction to allow the FDIC to proceed against the debtors nominally would allow other defendants to point to an “empty chair” at trial for the purposes of attributing liability, thus placing the FDIC at a “tactical disadvantage” and creating the possibility that the FDIC would “lose the potential benefit of $1,000,000.00 of insurance coverage.”

Further:

In the context of the Debtor’s being a necessary party, the Court finds In re Grove both factually similar and persuasive. If the FDIC pursues this action without nominally naming Mr. Gafford, who was the Chief Executive Officer of [failed bank], as a defendant, the FDIC would be placed in the same “tactical disadvantage” as in In re Grove.

The “empty chair” defense thus was a real concern, said the Gafford court.

But if FDIC were allowed to sue Chief now, wouldn’t that jeopardize Chief’s “fresh start” from his bankruptcy discharge, as insurer argued? What about Chief’s obligation to reimburse insurer for defense costs advances under the management liability policy? Chief, would be stuck with that, right? We can’t have that, right? Defeats the purpose of the discharge in bankruptcy.

Well, this court, while being a bit more diplomatic, essentially concluded those arguments were “hooey”! According to the court, relying on In re Grove once again:

[Chief’s] fresh start will not be adversely affected by allowing the FDIC to pursue an action naming him as a nominal defendant, solely for the purposes of pursuing liability against [management liability insurer] on the Policy, because any claims against [Chief] for defense costs were discharged in bankruptcy pursuant to section 524 of the Bankruptcy Code.

Further, per the Gafford court, “The real parties in interest, from a financial perspective, would be the FDIC and the insurance company.” Quoting from In re Grove:

“While it is apparent the FDIC will benefit from a successful pursuit of the [liability] action, it must also be recognized that [the D&O insurer] stands to benefit from the defense of the [liability] action. A successful defense equates to $1,000,000.00 not having to be paid on the claim. The true and ultimate adversaries, those who have something to win or lose, are the FDIC and [the D&O insurer].”

Per the Gafford court: “The economic interests in the present case are the same as in In re Grove. In particular, [the management liability insurer] stands to gain if it is ultimately held that there is no liability in the underlying action.”

The Gafford court also found the appeals court’s reasoning in In re Jet Florida Systems, Inc., 883 F.2d 970 (11th Cir. 1989) required allowing FDIC to sue Chief. As in In re Grove, it made no difference to the Jet Florida panel that the discharged debtor company might incur defense costs if the bankruptcy court injunction prohibiting suit against debtor was lifted to allow suit against debtor solely to tap into debtor’s liability insurance. The Jet Florida panel explained:

“We can determine no effective means of determining at this stage whether the bankrupt or the insurance company will pay the cost of the litigation. To have our ruling premised on that determination would provide an incentive for the debtor to claim to assume the burden. If that simple fact barred the plaintiff from going forward on his claim, there would exist no adversarial relationship between the bankrupt and the insurer so that we could actually resolve this crucial question, because both of those parties would have an obvious interest in demonstrating that the debtor was liable for litigation costs.”

Collusion!

Also as in In re Grove, the Jet Florida panel didn’t believe that permitting suit against the discharged debtor would thwart debtor’s “fresh start.” As the panel explained:

“[T]he practical and economic realities compel the insurance company to defend the underlying action. The insurance company may be responsible pursuant to a contract with the bankrupt, in which case it is in their direct interest to defend the action.”

The management liability insurer in Gafford argued Jet Florida shouldn’t control because, unlike the policy in Jet Florida, it’s policy required the Chief to defend and included an insured-versus-insured or IVI exclusion supposedly barring coverage. On the IVI, insurer cited FDIC v Miller, No. 2:12-CV-0225-RWS (N.D.Ga. August 19, 2013), applying the exclusion to FDIC claims.

Insurer argued further “that because the underlying contract that makes up the [management liability] Policy included specific language excluding ‘Insured v. Insured’ from [insurer’s] liability in defending lawsuits, the bargained for Policy should control, which would create financial liability on [Chief], contrary to the fresh start policy of [Bankruptcy Code] section 524.”

But the Gafford court wasn’t buying any of this, explaining that insurer’s “argument relies upon the presumption that any litigation between [insurer] and [Chief] would result in the same outcome as the Miller decision [holding the IVI exclusion applied].” (Emphasis added).

Further:

[Insurer] fails to distinguish the present case from In re Jet Florida because this Court, just as the In re Jet Florida court, has no “effective means” in determining whether [Chief] or [insurer] will pay the cost of litigation. While the Miller decision [about the IVI] appears to be similar to the issue here, the underlying coverage issue is not before the Court, and the Court cannot “predict” the potential outcome of future litigation.

As a matter of fact, the Miller court’s decision applying the insured versus insured exclusion to the FDIC’s claims in that case conflicts with other court decisions about similar wording, such as Progressive Casualty Insurance Company v. FDIC, 1:12-CV-1103-RLV (N.D. Ga. Jan. 4, 2013), and has been criticized in the blogosphere here.

Additionally:

[T]his Court agrees with the reasoning in In re Jet Florida, in that the practical and economic realities compel the “insurance company” to defend the underlying action. . . . The Eleventh Circuit further reasoned in In re Jet Florida that “if there is a dispute between the bankrupt and the insurer as to the applicability of coverage, it remains in the interest of the insurer to defend the suit.” (Emphasis added).

Finally, insurer argued “that if the Court were to allow [Chief] to breach his duty to defend under the Policy, it would do so knowing that [insurer] is essentially without process or remedy.” But according to the court, insurer “had the opportunity to object to [Chief’s] discharge” and “may seek post-discharge relief by filing a motion to reopen the case and file the appropriate pleadings.”

We’re not sure what the court was suggesting here. That insurer as Chief’s potential creditor, with the right to recoup advanced defense fees, could have prevented Chief from discharging that obligation in bankruptcy? Or that insurer after discharge might reopen Chief’s bankruptcy case to recoup fees advanced for Chief’s defense? Would that relief undermine Chief’s “fresh start”? The opinion doesn’t get into any of these issues or otherwise provide sufficient explanation. But as a practical matter, it doesn’t appear there would be much hope for insurer to recoup any fees.

Comments: It’s not unusual for a claimant to seek bankruptcy court permission to sue a party, but only for tapping that party’s insurance. D&O policies often state explicitly that “The bankruptcy or insolvency of an Insured Person shall not relieve the Insurer of its obligations under the Policy.” Sometimes there’s only a single target defendant. So there’s no issue about “empty chair.” Just a need to allow suit so claimant may prove a claim after defendant’s discharge in bankruptcy and potentially satisfy it, but only via insurance. The insurer isn’t off the hook simply because the insured is discharged from personal liability.

What was unusual here is a policy placing a defense obligation on Chief and allowing insurer to recoup advanced fees from Chief. That was insurer’s hook for arguing that allowing FDIC’s suit would deprive Chief of the “fresh start” from bankruptcy discharge. But in this court’s view, if FDIC’s suit against Chief were allowed, the real battle would be between FDIC and insurer, with Chief having no material skin in the game. Chief would have no personal liability to FDIC for the claim. Only the D&O insurance was in play. Nor could the D&O insurer recoup fees from Chief, given Chief’s prior discharge.

Tags: Georgia, management liability policy, D&O insurance policy, directors and officers liability insurance, bankers professional liability policy, professional liability, FDIC, failed bank, director, bankruptcy, discharge, insured versus insured exclusion, insured vs. insured exclusion, IvI exclusion, section 524, real party in interest, necessary party, discharge injunction

Category: D&O Digest, Professional Liability Insurance Digest Comment »


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