The U.S. Court of Appeals for the Fifth Circuit recently held that a Creditor Exclusion provision in D&O insurance coverage may result in significant limitations on the coverage provided to the D&Os, when the underlying dispute is with a creditor in its capacity as such.

In the case, a company defaulted on its obligations after refinancing its debt, and later filed for bankruptcy. In response, the lenders sued the owners and officers of the company (“the Verbeeks”) in Texas state court, alleging misrepresentation of the company’s financial condition. Once sued, the Verbeeks tendered the litigation to the insurer, Markel, pursuant to directors and officers (D&Os) coverage. Markel, in turn, denied having a duty to defend by citing a Creditor Exclusion provision in the policy denying liability for claims “on behalf of…any creditor” in its “capacity as such”.

The court rejected the Verbeeks’ attempt to frame the issue as “peripheral to the debt”, i.e., one brought by the lenders as injured parties in a misrepresentation dispute (tort), and not in their capacity as creditors (on account of funded debt). Instead, the court ruled in favor of Markel, finding that the underlying litigation stemmed from the lenders’ “roles as defrauded creditors”, on which “the Creditor Exclusion bars coverage”. The discussion focused on the Capacity requirement, namely the circumstances upon which a dispute is coupled with a loan. It was stressed that “all damages originate from the loans the Verbeeks…[allegedly] fraudulently induced” the lenders to extend. The court also rejected the Verbeeks’ argument that the company’s confirmed liquidation plan somehow negates the lenders’ creditor capacity, since the complaint was filed prior to confirmation of the plan and capacity to sue is measured at the time the complaint is filed. In practice, D&Os should be vigilant in reviewing their company’s D&O policies to ensure that they provide meaningful coverage without buried exclusions that may negate coverage at times it is most required.