Creditor Exclusion<br><b><i><font="-1">The Perils of D&O Coverage</b></i></font>

In 2012, Color Star, a wholesale distributor of flowers, refinanced its existing debt with a $52.5 million credit facility with three lenders (the Lenders). Color Star, however, defaulted on its obligations under the credit facility and later filed for bankruptcy. The Lenders commenced two lawsuits (which were later consolidated) against the officers and owners of the company, the Verbeeks, in Texas state court. The lawsuits alleged that the Verbeeks, who also served as personal guarantors of the credit facility, participated in a scheme to induce the financial institutions to fund the credit facility, by misrepresenting Color Star's financial condition. The misrepresentation included an alleged “overvaluing [of] Color Star's inventory by at least $6.6 million.” The Lenders affirmatively asserted that they would not have provided the credit facility had they known Color Star's true financial condition.

Once sued, the Verbeeks tendered the litigation to Color Star's D&O insurer, Markel American Insurance Company (Markel). The latter denied coverage citing to the Creditor Exclusion provision in the policy. Under the terms of the exclusion, coverage is not available for claims asserted “on behalf of … any creditor” in its “capacity as such.” On the same date that Markel denied coverage, it brought a declaratory judgment action seeking a judicial declaration that it had no duty to defend or indemnify the Verbeeks for the claims asserted by the Lenders. Markel argued that the underlying litigation was commenced by the Lenders, who are creditors suing in their capacity “as such,” and is thus excluded from coverage.

Trial Court Proceedings

Both Markel and the Verbeeks filed cross motions for summary judgment. In their motion, the Verbeeks argued that the Lenders were suing as investors, rather than in their capacity as creditors. In order to determine the Lenders' capacity, the magistrate judge invited the parties to file supplemental briefings on the distinction between a creditor-debtor relationship and an investment relationship, referring specifically to SEC v. Howey Co., 328 U.S. 293, 66 S. Ct. 1100 (1946), which provides a “baseline distinction between 'investment contracts' and other types of transactions.” Under Howey, the court explained, a contract is an investment contract and not merely a loan when “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

The magistrate judge found in favor of Markel, holding that the Lenders' capacity in the underlying litigation was that of creditors, not investors, because they sought damages in the amount of principal and interest they were entitled to receive under the credit facility, not for speculative value of lost investment. The district court adopted the magistrate's report and recommendation, and entered final judgment in favor of Markel.

Fifth Circuit: Analysis

Duty to Defend

Texas law, which governed the case, establishes certain principles that govern coverage disputes. First, an insurer's duty to defend is governed by the “eight corners rule,” pursuant to which “the duty to defend is determined solely by the terms of the policy and the pleadings of the third-party claimant.” Therefore, if all of the alleged facts found in these documents are excluded by the policy, the insurer is under no duty to provide defense. Second, the court must not look into the legal theories asserted, but rather focus solely on the facts alleged in the third party's (here, the Lenders) complaint. Third, the insurer bears the burden to establish that an exclusion to coverage applies. Finally, doubts concerning an exclusion are resolved in the insured's favor.

Next, the court turned to the Creditor Exclusion provision in Color Star's D&O policy:

The Insurer shall not be liable to pay any Loss on account of, and shall not be obligated to defend, any Claim brought or maintained by or on behalf of:
…
Any creditor of a Company or Organization in the creditor's capacity as such, whether or not a bankruptcy or insolvency proceeding involving the Company or Organization has been commenced.

The central issue is, thus, the capacity requirement, i.e., whether the underlying litigation — which is undisputedly brought by creditors (the Lenders) — was brought by them in their capacity as such. The Verbeeks argued that the capacity requirement can only be satisfied when creditors of Color Star sue to recover debt owed by Color Star.

This element, they argued, was not satisfied because the Lenders did not sue on account of Color Star's debt, but on account of the defendants' alleged financial misrepresentation, which, according to the Verbeeks, is “peripheral to the debt.” Although not stated as such by the court of appeals, it appears that the Verbeeks essentially argued that the Creditor Exclusion applies when the liability is based on Color Star's breach of contract, but not when their liability is based on an independent tort. Following this logic, Markel's duty to defend the Verbeeks could be excused if, for example, they were sued on their personal guaranties of the credit facility.

The court rejected these arguments and found that the Creditor Exclusion applies, given that the “factual allegations in the underlying state court litigation indicate that all damages originate from the loans the Verbeeks and others fraudulently induced the state court plaintiffs to extend to Color Star.” The court held that “because the origin of the damages stems from the state court plaintiffs' roles as defrauded creditors of Color Star, the Creditor Exclusion bars coverage.”

Duty to Indemnify

As for the duty to indemnify, the court of appeals noted that it is ordinarily distinct and separate from the duty to defend. In most cases, the duty to indemnify can only be adjudicated after the underlying litigation has been concluded. Under Texas law, however, in some cases both the duty to defend and the duty to indemnify can be determined on the pleadings. Such circumstances exist when “the insurer has no duty to defend and the same reasons that negate the duty to defend likewise negate any possibility the insurer will ever have a duty to indemnify.” Since the duty to defend and the duty to indemnify were both subject to the Creditor Exclusion, there were no legitimate grounds to defer decision until the conclusion of the litigation.

Impact of Color Star's Bankruptcy

The district court entered judgment on the duty to indemnify sua sponte. That was clear error, argued the Verbeeks, since it deprived them of the opportunity to brief and argue the issue. On appeal, however, the only legal argument they asserted in that regard was that the confirmation of Color Star's bankruptcy plan after the Lenders' brought the action stripped the Lenders of their pre-petition creditor status.

The court of appeals rejected this argument, since the Creditor Exclusion reads in the disjunctive; it applies to “any Claim brought or maintained by” a creditor, rather than “brought and maintained” by a creditor. Since the Lenders were creditors at the time they commenced the state court litigation, they brought the claim as creditors.

There are two additional points that support the court's conclusion, although not addressed by the court. First, we are aware of no authority that magically transforms creditors to non-creditors simply because a Chapter 11 plan has been confirmed. Such transformation could occur when creditors are paid in full on the effective date of the plan, or when creditors' claims are channeled to a trust. Conversely, such transformation does not occur when the plan subjects the debtors to future payment obligations to their creditors. The Verbeeks, however, failed to explain the structure of Color Star's Chapter 11 plan. Second, the Creditor Exclusion specifically provides that it applies “whether or not a bankruptcy or insolvency proceeding … has been commenced.” It would appear, therefore, that the exclusion applies without giving effect to the insured company's bankruptcy filing.

Conclusion

D&O coverage is of critical importance to officers and directors. At times, it could be the only thing that protects them from financial ruin. As a result, notwithstanding these policies' length and complexity, experienced insurance counsels should be engaged to them and to ensure that they do not contain surprising and serious gaps in coverage. As the Markel case shows, coverage may not be available when it is needed the most.

*****
Shmuel Vasser and Yehuda Goor are, respectively, partner and law clerk in Dechert LLP's Bankruptcy, Business Restructuring and Reorganization Group, resident in the New York office. The views expressed herein are the authors' and not necessarily those of the firm.

The U.S. Court of Appeals for the Fifth Circuit recently held that a Creditor Exclusion provision in directors and officers (D&Os) insurance policies may result in significant limitations on the coverage provided to the D&Os when the underlying dispute is with a creditor acting in its creditor capacity. Markel Am. Ins. Co. v. Verbeek (5th Cir. Sep. 27, 2016). See http://bit.ly/2fkNY1a.

In the Markel case, the owners and officers of Color Star Growers of Colorado, Inc. (Color Star) were sued by lenders who provided the company with a credit facility to refinance its debt. It should be noted that nowhere are the defendants referred to as directors as well. The lenders alleged that the individual defendants misrepresented the company's financial condition in procuring the loan. The defendants tendered the litigation to Color Star's D&O insurer requesting it to defend the litigation as required by Color Star's D&O insurance policy. The insurer refused citing the policy's Creditor Exclusion.

Background

In 2012, Color Star, a wholesale distributor of flowers, refinanced its existing debt with a $52.5 million credit facility with three lenders (the Lenders). Color Star, however, defaulted on its obligations under the credit facility and later filed for bankruptcy. The Lenders commenced two lawsuits (which were later consolidated) against the officers and owners of the company, the Verbeeks, in Texas state court. The lawsuits alleged that the Verbeeks, who also served as personal guarantors of the credit facility, participated in a scheme to induce the financial institutions to fund the credit facility, by misrepresenting Color Star's financial condition. The misrepresentation included an alleged “overvaluing [of] Color Star's inventory by at least $6.6 million.” The Lenders affirmatively asserted that they would not have provided the credit facility had they known Color Star's true financial condition.

Once sued, the Verbeeks tendered the litigation to Color Star's D&O insurer, Markel American Insurance Company (Markel). The latter denied coverage citing to the Creditor Exclusion provision in the policy. Under the terms of the exclusion, coverage is not available for claims asserted “on behalf of … any creditor” in its “capacity as such.” On the same date that Markel denied coverage, it brought a declaratory judgment action seeking a judicial declaration that it had no duty to defend or indemnify the Verbeeks for the claims asserted by the Lenders. Markel argued that the underlying litigation was commenced by the Lenders, who are creditors suing in their capacity “as such,” and is thus excluded from coverage.

Trial Court Proceedings

Both Markel and the Verbeeks filed cross motions for summary judgment. In their motion, the Verbeeks argued that the Lenders were suing as investors, rather than in their capacity as creditors. In order to determine the Lenders' capacity, the magistrate judge invited the parties to file supplemental briefings on the distinction between a creditor-debtor relationship and an investment relationship, referring specifically to SEC v. Howey Co. , 328 U.S. 293, 66 S. Ct. 1100 (1946), which provides a “baseline distinction between 'investment contracts' and other types of transactions.” Under Howey , the court explained, a contract is an investment contract and not merely a loan when “the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.”

The magistrate judge found in favor of Markel, holding that the Lenders' capacity in the underlying litigation was that of creditors, not investors, because they sought damages in the amount of principal and interest they were entitled to receive under the credit facility, not for speculative value of lost investment. The district court adopted the magistrate's report and recommendation, and entered final judgment in favor of Markel.

Fifth Circuit: Analysis

Duty to Defend

Texas law, which governed the case, establishes certain principles that govern coverage disputes. First, an insurer's duty to defend is governed by the “eight corners rule,” pursuant to which “the duty to defend is determined solely by the terms of the policy and the pleadings of the third-party claimant.” Therefore, if all of the alleged facts found in these documents are excluded by the policy, the insurer is under no duty to provide defense. Second, the court must not look into the legal theories asserted, but rather focus solely on the facts alleged in the third party's (here, the Lenders) complaint. Third, the insurer bears the burden to establish that an exclusion to coverage applies. Finally, doubts concerning an exclusion are resolved in the insured's favor.

Next, the court turned to the Creditor Exclusion provision in Color Star's D&O policy:

The Insurer shall not be liable to pay any Loss on account of, and shall not be obligated to defend, any Claim brought or maintained by or on behalf of:
…
Any creditor of a Company or Organization in the creditor's capacity as such, whether or not a bankruptcy or insolvency proceeding involving the Company or Organization has been commenced.

The central issue is, thus, the capacity requirement, i.e., whether the underlying litigation — which is undisputedly brought by creditors (the Lenders) — was brought by them in their capacity as such. The Verbeeks argued that the capacity requirement can only be satisfied when creditors of Color Star sue to recover debt owed by Color Star.

This element, they argued, was not satisfied because the Lenders did not sue on account of Color Star's debt, but on account of the defendants' alleged financial misrepresentation, which, according to the Verbeeks, is “peripheral to the debt.” Although not stated as such by the court of appeals, it appears that the Verbeeks essentially argued that the Creditor Exclusion applies when the liability is based on Color Star's breach of contract, but not when their liability is based on an independent tort. Following this logic, Markel's duty to defend the Verbeeks could be excused if, for example, they were sued on their personal guaranties of the credit facility.

The court rejected these arguments and found that the Creditor Exclusion applies, given that the “factual allegations in the underlying state court litigation indicate that all damages originate from the loans the Verbeeks and others fraudulently induced the state court plaintiffs to extend to Color Star.” The court held that “because the origin of the damages stems from the state court plaintiffs' roles as defrauded creditors of Color Star, the Creditor Exclusion bars coverage.”

Duty to Indemnify

As for the duty to indemnify, the court of appeals noted that it is ordinarily distinct and separate from the duty to defend. In most cases, the duty to indemnify can only be adjudicated after the underlying litigation has been concluded. Under Texas law, however, in some cases both the duty to defend and the duty to indemnify can be determined on the pleadings. Such circumstances exist when “the insurer has no duty to defend and the same reasons that negate the duty to defend likewise negate any possibility the insurer will ever have a duty to indemnify.” Since the duty to defend and the duty to indemnify were both subject to the Creditor Exclusion, there were no legitimate grounds to defer decision until the conclusion of the litigation.

Impact of Color Star's Bankruptcy

The district court entered judgment on the duty to indemnify sua sponte. That was clear error, argued the Verbeeks, since it deprived them of the opportunity to brief and argue the issue. On appeal, however, the only legal argument they asserted in that regard was that the confirmation of Color Star's bankruptcy plan after the Lenders' brought the action stripped the Lenders of their pre-petition creditor status.

The court of appeals rejected this argument, since the Creditor Exclusion reads in the disjunctive; it applies to “any Claim brought or maintained by” a creditor, rather than “brought and maintained” by a creditor. Since the Lenders were creditors at the time they commenced the state court litigation, they brought the claim as creditors.

There are two additional points that support the court's conclusion, although not addressed by the court. First, we are aware of no authority that magically transforms creditors to non-creditors simply because a Chapter 11 plan has been confirmed. Such transformation could occur when creditors are paid in full on the effective date of the plan, or when creditors' claims are channeled to a trust. Conversely, such transformation does not occur when the plan subjects the debtors to future payment obligations to their creditors. The Verbeeks, however, failed to explain the structure of Color Star's Chapter 11 plan. Second, the Creditor Exclusion specifically provides that it applies “whether or not a bankruptcy or insolvency proceeding … has been commenced.” It would appear, therefore, that the exclusion applies without giving effect to the insured company's bankruptcy filing.

Conclusion

D&O coverage is of critical importance to officers and directors. At times, it could be the only thing that protects them from financial ruin. As a result, notwithstanding these policies' length and complexity, experienced insurance counsels should be engaged to them and to ensure that they do not contain surprising and serious gaps in coverage. As the Markel case shows, coverage may not be available when it is needed the most.

*****
Shmuel Vasser and Yehuda Goor are, respectively, partner and law clerk in Dechert LLP's Bankruptcy, Business Restructuring and Reorganization Group, resident in the New York office. The views expressed herein are the authors' and not necessarily those of the firm.