Disputes over the scope of insurance coverage are common fixtures in the Commercial Division Courts.  Earlier this month, the First Department partially affirmed Justice Sherwood’s decision in Westchester Fire Ins. Co. v. Schorsch et al.  Considering a matter of first impression in the New York Commercial Division Courts, the decision holds that a D&O policy’s “insured versus insured” exclusion does not preclude coverage for claims against corporate officers by a creditor trust.

The affirmance ensures that Westchester Fire will remain among Justice Sherwood’s extensive list of widely-cited insurance coverage decisions (See, e.g., Freedom Specialty Ins. Co. v. Platinum Mgt. (NY), LLC, 2018 NY Slip Op 32233 [denying a D&O insurers’ motion for summary judgment based on a prior and pending litigation exclusion]; Zurich Am. Ins. Co. v Don Buchwald & Assoc., Inc., 2018 NY Slip Op 33325(U) [holding that an intentional tort could be a covered occurrence, triggering a CGL insurer’s duty to defend]; Alexander v. Starr Surplus Lines Ins. Co., 2020 NY Slip Op 30297(U) [granting a preliminary injunction directing a D&O insurer to advance defense costs to a former corporate officer for an investor lawsuit alleging fraudulent inducement]).

RCAP, Bankruptcy and the Creditor Trust

RCS Capital Corp. (“RCAP”) is a wholesale broker-dealer and investment banking advisor.  Backed by billionaire entrepreneur and investor Nick Schorsch, RCAP’s initial success took a major turn in October 2014, when a related company, American Realty Capital Properties, Inc. announced that a $23 million accounting error over the first half of 2014 was left intentionally uncorrected.  The fallout from that accounting scandal included the resignation of executives, investigations into the misconduct, and a plummeting share price of RCAP.

In March 2016, RCAP announced its intention to file for bankruptcy.  With bankruptcy in its near-future, RCAP’s management made a pitch to creditors in order to maintain control over the company: in exchange for the creditors’ supporting RCAP’s proposed plan of reorganization, RCAP would create, upon its emergence from bankruptcy, a trust for the benefit of RCAP’s creditors (the “Creditor Trust”), and it would assign to the Creditor Trust certain causes of action RCAP had against certain of its former directors and officers, including Schorsch and those allegedly responsible for the accounting scandal.

On May 19, 2016, the bankruptcy court confirmed the bankruptcy plan, which included the provisions creating the Creditor Trust.  Under the plan, the Creditor Trust was assigned all of RCAP’s claims against its former directors and officers and was empowered to “enforce, sue on, settle, or compromise . . . all Claims, rights, Causes of Action, suits, and proceedings . . . against any Person without the approval of the Bankruptcy Court [and] the Reorganized Debtors[].”

The Creditor Trust Sues RCAP’s Directors and Officers, Westchester Fire Denies Coverage under the Policy’s “Insured vs. Insured” Provision

After assignment of RCAP’s claims, the Creditor Trust brought suit in the Delaware Chancery Court against certain former directors and officers for, inter alia, their breach of fiduciary duty to RCAP.  The Complaint ties many of its allegations of “disloyal self-dealing” to Schorsch: “In 30 months nearly $1 billion in public stakeholder investments [in RCAP] was destroyed.  Every penny of loss was the result of wrongdoing by Schorsch and his colleagues.”

Schorsch and the additional individual defendants (the “Individual Insureds”) in the Delaware action sought coverage and indemnification under RCAP’s D&O liability insurance policy.  The policy consisted of a primary policy and several layers of excess; Westchester Fire had the seventh layer of excess coverage.  Westchester Fire’s excess policy followed the form of the primary policy, but unlike the primary and the first through sixth excess layers, Westchester Fire denied coverage and refused to advance defense costs.

Westchester Fire based its denial on various grounds, including that D&O coverage of the Individual Insureds in the action by the Creditor Trust as assignee of claims held by RCAP was barred under the policy’s insured vs. insured exclusion.  Specifically, the policy’s insured vs. insured provision excluded coverage for “any Claim made against an Insured Person . . . : by, on behalf of, or at the direction of the Company or Insured Person.”

Insured vs. Insured or “IvI” exclusions are common in D&O policies.  Generally, they prevent a company from expanding its D&O policy into general business insurance by invoking its D&O insurance policy in all cases where the company now disagrees with the actions of certain directors or officers.  In other words, they prevent the company from “push[ing] the costs of mismanagement onto an insurance company just by suing (and perhaps collusively settling with) past officers who made bad business decisions,” Indian Harbor Ins. Co. v. Zucker (6th Cir. 2017).  Like most D&O policies, the IvI exclusion here contained an exception restoring coverage for claims asserted by specified persons who have replaced RCAP’s management and assumed control over RCAP during the pendency of a bankruptcy proceeding.  This “Bankruptcy Trustee Exception” to the IvI exclusion applies to claims “brought by the Bankruptcy Trustee or Examiner of the Company, or any assignee of such Trustee or Examiner, any Receiver, Conservator, Rehabilitator, or Liquidator or comparable authority of the Company.” (emphasis added).

Westchester Fire reasoned that because the IvI exclusion applies to claims asserted by RCAP, and because the Creditor Trust, as assignee of RCAP’s claims, stands in RCAP’s shoes, the IvI exclusion likewise bars coverage in suits brought by the Creditor Trust.  The Bankruptcy Trustee Exception to the IvI exclusion did not apply, Westchester Fire argued, because the limited carve out did not specifically include a voluntary assignee of RCAP’s claims and the Creditor Trust was not a “comparable authority of the Company,” as that phrase is used in the carve out.

Justice Sherwood’s Decision and Partial Affirmance

Justice Sherwood’s April 2019 decision assumed that the Delaware action by the Creditor Trust  triggered the IvI exclusion, but held that the Bankruptcy Trustee Exception restored coverage.  Although the Creditor Trust is not among the specific persons listed in the Bankruptcy Trustee Exception, the trial court held that the catchall phrase in the Bankruptcy Trustee Exception for claims brought by a “comparable authority” of the Company was ambiguous, and that ambiguity must be construed in favor of coverage.  The court accordingly held that the Creditor Trust Action fell within the Bankruptcy Trustee Exception, rendering the IvI Exclusion inapplicable to claims brought by the Creditor Trust.

On appeal, Westchester Fire argued that the Bankruptcy Trustee Exception’s use of the phrase “comparable authority,” was not ambiguous; it referred to authority comparable to a receiver, conservator, or liquidator, and the Creditor Trust was “in no way ‘comparable’” to any of those persons.  Receivers, conservators, and liquidators have control over a company; the Creditor Trust did not have control over RCAP.  Receivers, conservators, and liquidators have fiduciary duties to a company; the Creditor Trust did not have fiduciary duties to RCAP.  And most importantly, receivers, conservators, and liquidators are disinterested—such that they can fulfill simultaneous duties to the debtor and its creditors; the Creditor Trust is not disinterested and works solely for the creditors.  Because the Creditor Trust was more like RCAP itself than a receiver, conservator, or liquidator, Westchester Fire argued, the IvI exclusion applied.

The Individual Insureds argued the contrary: the Creditor Trust was an authority comparable to a receiver, conservator, or liquidator, and accordingly, its claims were subject to the Bankruptcy Trustee Exception to the IvI exclusion.  In fact, the Individual Insureds argued, the Creditor Trust expressly had all the “rights and powers provided in the Bankruptcy Code in addition to any rights and powers granted in the Plan Documents[.]”  So the Creditor Trust’s authority was co-extensive with the powers of any of the other entities listed in the Bankruptcy Trustee Exception.

The First Department, noting that this case raised a matter of first impression, held that the phrase “comparable authority” as used in the Bankruptcy Trustee Exception to the IvI exclusion included the Creditor Trust, and accordingly, the IvI exclusion did not apply to claims brought by the Creditor Trust.  The Court reasoned that because the bankruptcy court approved the reorganization plan, the Creditor Trust was, contrary to Westchester Fire’s argument, more than a naked asignee of the Company’s claims:

Turning to the question of whether the exception for bankruptcy trustees and comparable authorities applies here to restore coverage removed by the insured vs. insured exclusion, we find that the pertinent clauses of the insured vs. insured exclusion and the bankruptcy exception, when read together, are unambiguous.  Their plain language indicates no intent to bar coverage for D & O claims brought by the Creditor Trust, as a post-confirmation litigation trust. . . . [W]hat 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.

Ultimately, although the First Department affirmed Justice Sherwood’s conclusion with respect to the applicability of the IvI exclusion, it held that summary judgment on the coverage obligations was inappropriate in light of material factual disputes regarding whether the insureds engaged in wrongdoing to benefit a separate entity.

Practical Considerations

Going forward, the applicability of an IvI exclusion in a D&O insurance policy will still depend on the language of the exclusion and any bankruptcy trustee exception.  That said, companies headed toward bankruptcy reorganization and their creditors would be wise to give strong consideration to Westchester Fire and the potential bargaining chip it provides.  If  creditors can form a trust and pursue a valuable D&O policy by suing former directors and officers for mismanagement, those creditors might be more willing to support a reorganization plan that includes the assignment of such claims to a Creditor Trust.