The Applicability of the “Insured vs. Insured” Exclusion in a D&O Policy in Federally Governed Receivership Cases: The Legal Status of the FDIC When It “Steps Into the Shoes” of Defunct Financial Institutions

By: Ekaterina Long

With a surge in security class actions and merger and acquisition transactions, executives across the borders face an ever-increasing liability exposure.[1] The increase in potential executive liability fuels a need for Directors and Officers (“D&O”) insurance policies.[2]

While the D&O policies do offer an executive liability protection, such protection is far from being ironclad, considering the presence of various exclusions within a typical D&O policy.[3] One of the more important exclusions—the “insured vs. insured”—is the focus of this note.[4]

Generally speaking, the “insured vs. insured” exclusion applies to preclude insurance coverage when a corporation files a lawsuit against its director or officer or when a director or officer sues another director or officer within the corporation for bad actions they committed while in their official capacities.[5]

In the United States, much of the litigation involving this exclusion arises in the context of the corporation’s bankruptcy and centers on the issue of whether courts view a corporation’s successor in interest as an “insured.”[6]

Viewing the successor in interest as an “insured” would trigger the application of the “insured vs. insured” exclusion, meaning that a director or officer allegedly responsible for bad actions would be unable to claim the benefits of the D&O coverage and the aggrieved shareholders or third parties with standing would potentially be unable to recover the loss that resulted from the director’s or officer’s bad actions.[7]

Conversely, viewing the successor in interest as separate from the “insured” would mean that the “insured vs. insured” exclusion would be inapplicable and the D&O coverage would potentially exist.[8]

To illustrate, in St. Paul Mercury Insurance Company v. Federal Deposit Insurance Corporation, the Ninth Circuit affirmed a California district court’s decision by restricting the exclusion’s application to the Federal Deposit Insurance Corporation (the “FDIC”) that assumed the legal status of the insured bank’s receiver.[9] Specifically, in St. Paul Mercury, the FDIC sued the bank’s directors and officers for tortious conduct in operating and managing the lending function of what eventually became the defunct bank.[10]

The Ninth Circuit agreed with the lower court’s holding that the “insured vs. insured” exclusion was ambiguous and that it failed to contain an express reference to the FDIC as receiver.[11] By so holding, the Ninth Circuit underscored that the FDIC is not an ordinary successor in interest and cannot be understood to act merely “on behalf” of the insured bank.

Rather, when the FDIC placed a bank in a federally governed receivership upon the bank’s insolvency, the FDIC assumed a unique position of representing several interests, including those of the defunct bank.[12] By its holding, the Court essentially guides the carriers to amend the D&O policy to expressly state that the “insured vs. insured” exclusion encompasses the FDIC as receiver or to engraft a plain and unambiguous regulatory exclusion.

Interestingly, the Court’s decision should come as no surprise to the carriers of the D&O policy. In the past two decades, American courts have consistently rejected the carriers’ argument that the “insured vs. insured” exclusion should apply to bar coverage when the claims against the directors and officers are brought by the insured corporation’s trustee or a bankruptcy estate’s representative in an attempt to recover under the insured’s D&O policy.[13]

In this regard, the Eleventh Circuit’s reasoning behind its 2014 decision in St. Paul Mercury Insurance Company v. Federal Insurance Corporation rhymes with that of the Ninth Circuit.[14] In that case, the FDIC sued two bank officers in a Georgia district court, alleging gross negligence and breaches of fiduciary duty in approving loans in violation of the insured bank’s loan policy and prudent lending practices and in failing to remediate these violations.[15]

The district court granted summary judgment to the insurer, finding no duty to defend or indemnify the defunct bank. Most salient to this note was the court’s finding that the “insured vs. insured” exclusion unambiguously applied to bar coverage to the FDIC once it stepped into the bank’s shoes.[16]

On appeal, the Eleventh Circuit found the exclusion to be ambiguous, reversed the district’s court’s grant of summary judgment in the insurer’s favor, and remanded the case instructing the court to consider extrinsic evidence to determine the parties’ intent as it specifically applied to the exclusion.[17]

Of note, the Eleventh Circuit traced the parties’ disagreement about the application of the exclusion to the FDIC to the 1994 U.S. Supreme Court decision in O’Melveny & Myers v. FDIC.[18] Specifically, the parties disagreed about the import of the phrase “steps into the shoes” that the Supreme Court used in O’Melveny when it referred to the FDIC as it assumed receivership.[19]

The FDIC argued that it “steps into a number of pairs of different shoes—as it were the wingtips of the Bank, the pumps of any stockholder, the loafers of any accountholder, and the tennis shoes of any Bank depositor—because the FDIC sues to recoup not only its own losses, but also the losses of depositors and other creditors. In light of this unique role, . . . [the FDIC] is not equivalent of the insured bank for purposes of insured v. insured exclusions [sic].”[20] The insurer disagreed and asserted that the FDIC “‘steps into the shoes’ of the bank and is subject to all defenses that could have been asserted against the bank.”[21]

Without explicitly acknowledging that it agreed with one or another party, the Eleventh Circuit cited a Georgia district court’s decision in Progressive Casualty Insurance Company v. FDIC[22] for the proposition that when the FDIC assumes receivership, it brings claims to recover for the bank’s depositors, creditors, and shareholders. As such, the FDIC assumes several functions—a fact that the “insured vs. insured” exclusion fails to adequately capture as it is phrased.[23] This failure renders the exclusion ambiguous and, in all practicality, fatal to the insurer’s defense of non-coverage.

As two of the most notable, the Eleventh and the Ninth Circuits’ decisions only reaffirm the courts’ general stance on the issue of the exclusion’s application to successors in interest in the context of receiverships. The D&O carriers should take heed to amend the exclusion to accord with the “insured vs. insured” exclusion’s legal progeny.