In a decision rendered earlier this year by the Sixth Circuit Court of Appeals, the court examined the difference between a debtor and a debtor-in-possession in the context of the “insured verses insured” exclusion contained in a D&O liability policy.

Indian Harbor Insurance Company v. Zucker, et al, arose in connection with the bankruptcy case of Capital Bank Corp. After failing in its efforts to reorganize, Capital proposed a liquidating plan of reorganization. As a result of negotiations with its creditors committee, the plan included a provision that created a liquidating trust to pursue claims on behalf of creditors. The estate assigned various claims and causes of action to the trust.

Following confirmation, the trustee of the liquidating trust brought an action against Capital’s officers and directors alleging various breaches of fiduciary duty. In response, the D&O insurer brought a declaratory judgment action in federal district court based on diversity jurisdiction. The insurer sought a determination that it was not obligated to defend the liquidating trustee’s action or to pay the claims asserted. It relied on the so-called “insured versus insured” provision of the D&O policy, which excluded from coverage “any claim made against an Insured Person…by, on behalf of, or in the name or right of, the Company or any Insured Person.” The district court held that the exclusion was legally effective to preclude coverage under the policy and the trustee appealed to the Sixth Circuit Court of Appeals.

The Court of Appeals affirmed the district court’s decision, holding that the policy exclusion was applicable to the action brought by the liquidating trustee. The ruling began by noting that the policy exclusion would have applied if had Capital assigned its claims to a third party outside of a bankruptcy case. The liquidating trustee sought to distinguish the current case by arguing the distinction between Capital in its capacity as a pre-petition debtor and the debtor-in-possession that existed following the commencement of Capital’s bankruptcy case.

The court rejected the liquidating trustee’s position following a somewhat selective analysis of the Bankruptcy Code. It noted that under section 1101, the “debtor in possession means the debtor” and the debtor (Capital) was the entity that commenced the bankruptcy case. It went on to note the Bildisco decision in which the Supreme Court rejected the notion that a bankruptcy filing created a “wholly new entity.” The court next considered the powers granted to a debtor in possession by section 1107(a) of the Bankruptcy Code. That section generally grants to a debtor in possession all the rights of a trustee in a bankruptcy case. Those trustee powers are set forth in section 704 of the Bankruptcy Code. The court found it “revealing” that the incorporating provision of section 1107 did not include section 704(a)(4), which requires a trustee to “investigate the financial affairs of the debtor,” since Capital (as debtor-in-possession) could not investigate itself. The court used that element as a basis to conflate the debtor and debtor-in-possession. The decision then seemed to suggest that had a trustee been appointed in the Capital bankruptcy case, the “insured versus insured” exclusion would not have prevented a coverage under the D&O policy.

The court acknowledged earlier decisions in which the debtor in possession and the pre-bankruptcy debtor were recognized as legally distinct. However, it went on to conclude that “even if settings remain in which it makes good sense to treat the debtor and debtor in possession as legally distinct, this is not one of them.”

The analysis by the court concluded by acknowledging that a bankruptcy filing creates a new distinct entity: the bankruptcy estate, and that the breach of fiduciary duty claims became property of that estate following the filing. However, the court reasoned that the estate is only a nominal entity and could not act on its own, needing a debtor-in-possession or a trustee to act on its behalf. It then found an action by the debtor-in-possession would be covered by the “insured versus insured” policy exclusion.

The Sixth Circuit’s decision seems to suffer from two analytical flaws. First, it appears to unnecessarily differentiate between a trustee and a debtor in possession as representatives of a bankruptcy estate. The essence of the chapter 11 debtor in possession is that it functions with essentially all the rights and powers of a bankruptcy trustee. The non-incorporation of section 704(a)(4) reflects the logic that an entity could not investigate itself. However, it does not support the notion that there is a dramatic legal distinction between the authority of a debtor in possession and that of a trustee. Both serve as the representative of the estate and the estate is acknowledged as distinct from the pre-bankruptcy debtor.

Secondly, the decision seemingly ignores provisions establishing the distinct character of the bankruptcy estate. The estate is given causes of action that could not be pursued by a debtor. There is nothing inherently avoidable about a preference payment to a creditor, but the Bankruptcy Code gives the estate the ability to avoid those transfers, through either a trustee or a debtor in possession. The estate is also given the ability to assert other claims that could not be asserted by the debtor itself, to avoid transactions that would be unassailable by the debtor and to reject agreements that would be binding on the pre-petition debtor. All of those notions support the distinction between the legal rights and character of the estate and those of the debtor. Those elements also support the notion that the estate should be able to recover in actions not covered by the D&O policy if brought by the debtor, such as the breach of fiduciary duty actions in this proceeding. The ultimate beneficiaries of any recovery would be creditors and not the debtor, another distinction that seems to have been ignored in the opinion.

It may be possible to avoid the import of the Sixth Circuit’s decision by appointment of a trustee to initiate a legal action that would otherwise be at risk. However, this seems an artificial response without any substantive legal basis. The opinion in this case may have created an unnecessary limitation on the rights of the bankruptcy estate.