The intersection of bankruptcy and directors’ and officers’ liability insurance

April 2016 | SPOTLIGHT | BANKRUPTCY & RESTRUCTURING

Financier Worldwide Magazine

The legal issues arising from disputes over the extent of coverage for directors and officers (D&O) liability insurance can be complex and diverse. While there are many different D&O products, such insurance often covers: (i) non-indemnifiable losses suffered by a company’s D&Os; (ii) indemnifiable loss sustained by D&Os which is reimbursed by the company; and (iii) direct coverage for the entity. However, when the added complication of a corporate bankruptcy is introduced, an entirely new set of considerations emerge.

The automatic stay and relief

US bankruptcy law provides for the creation of an ‘estate’ upon filing that comprises all the debtor’s property interests at the time the case is commenced. The estate also immediately receives an automatic stay for any litigation matters and debt collection efforts. The purpose of the stay is to provide protection from creditors by stopping all collection efforts, harassment or foreclosure actions, thereby allowing the debtor the opportunity to reorganise its affairs. Unless modified by the court, the stay is effective through the termination of a bankruptcy, and generally cannot be waived by the debtor.

Therefore, if an insurance policy and its proceeds are property of a debtor’s estate, they will be subject to the automatic stay. As result, no payments of any kind may be made under the policy unless relief from the stay is granted. The imposition of the stay can quickly become problematic, because when the D&Os of a bankrupt corporation are targets of a lawsuit, the proceeds of the insurance policy may be their sole resource of funds in order to defend themselves. Significantly, the automatic stay only applies to property of the estate (the entity that filed for bankruptcy); therefore, it does not enjoin lawsuits against the company’s D&Os.

US courts have widely held a debtor’s insurance policy is part of its bankruptcy estate and is subject to the automatic stay. In general, courts have supported their rulings by reasoning that because the company pays for a given insurance policy, the policy is therefore owned by the entity (despite the fact that the policy may be for the benefit of the company’s D&Os). However, the question of whether the policy’s proceeds are estate property is more unsettled. In examining this question, courts will conduct fact-sensitive inquiries into the structure of the policy at issue, as well as the competing interests of the insureds.

Including a ‘priority of payments’ clause in a D&O policy can allow individual D&Os to potentially maximise the chance that a bankruptcy court will lift an automatic stay. Such a provision provides that in the event of multiple demands made for coverage under different insuring agreements, the individuals should be the primary beneficiaries of a policy, not the corporation. Policies may include a liquidation endorsement that allows D&Os to potentially minimise adverse consequences by agreeing to waive the automatic stay in case of bankruptcy.

Regardless of whether policy proceeds are considered property of the estate, the practical solution is to get an order from the bankruptcy court granting relief from the automatic stay, commonly known as a ‘comfort order’. Such an order allows an insurer to advance defence costs without running afoul of the bankruptcy court. In recent years, US courts have issued comfort orders without reaching the issue of whether the policy proceeds are property of the estate. Some of the most significant factors courts use when evaluating applications for comfort orders include whether good cause exists to issue such an order, the potential prejudice to the debtor, any hardship to non-bankrupt parties (i.e., the D&Os who may otherwise be entitled to the policy proceeds). In circumstances where a debtor has a particularly compelling interest in the proceeds of a policy, a court may only grant relief from the automatic stay with certain caveats, such as imposing a cap on the disbursement of the policy’s proceeds to D&Os, or by requiring oversight of all fees to be paid. Of course, further complications can ensue regarding the amount of the cap, or what happens once the cap is exhausted.

Changing claims and claimants

As noted earlier, while the automatic stay applies to actions against the bankrupt company, lawsuits brought directly against the D&Os can continue. In the absence of a bankruptcy proceeding, such lawsuits would ordinarily be brought by shareholders. However, once a company has declared bankruptcy, new lawsuits may be asserted by a creditors’ committee, a bankruptcy trustee or a liquidating trust – all while the original lawsuit brought by the shareholders remains pending.

These additional lawsuits can lead to competing or parallel matters being litigated simultaneously. For insurers, such a scenario can lead to increased defence costs to reimburse. Lawsuits brought by a trustee acting on behalf of the bankrupt entity or a debtor-in-possession may also trigger a common provision found in D&O policies which excludes coverage from lawsuits when one insured sues another (i.e., an ‘insured-versus-insured’ exclusion). Meanwhile, problems can arise for individual insureds as well. First, multiple lawsuits can lead to quicker depletion of the pool of money to be used for their defence. Additionally, while lawsuits by shareholders often allege violations of securities laws, lawsuits brought by a bankruptcy trustee commonly allege that the D&Os breached their fiduciary duties to the company in performance of their duties. With a limited pool of insurance resources available, complications inevitably arise when determining how to apportion damages of fund the settlement value for the two lawsuits. In a similar vein, bankruptcy trustees have typically been viewed as objective and reasonable actors, focusing on marshalling the estate’s assets to pay creditors. However, law firms which represent bankruptcy trustees often get paid based on a percentage of the amounts they recover, thus incentivising them to try and maximise potential sources of revenue – including insurance policy proceeds.

Other issues arise when a bankruptcy trustee or other party initiates a suit against former D&Os, and the insurer raises legitimate coverage issues. In some cases, the individuals agree with the trustee to enter into a consent judgment and then subsequently assign their insurance rights to the trustee in exchange for a covenant not to execute the judgment against them. Such actions can prove to be very complicated for insurers to work through, as they raise the issue of whether the trustee actually suffered a covered loss under a D&O policy.

Worldwide bankruptcy considerations

Bankruptcy proceedings involving foreign insureds have their own set of concerns. For example, while the issue of whether an insurance policy’s proceeds are property of a bankrupt company’s estate is well-litigated in the US, other countries (such as Bermuda and the Cayman Islands) have very few decisions regarding the exact same issue. Both insurers and insureds who find themselves dealing with an international bankrupt company may find themselves engaging multiple sets of counsel depending on the country in which the bankruptcy proceeding takes place.

Often, insureds are incorporated in, or have their principal place of business outside of the US, but still engage in substantial business inside the US marketplace. In such circumstances, the US bankruptcy law provides that a bankruptcy trustee in a foreign jurisdiction may file an ‘ancillary’ bankruptcy proceeding in the US. The US Bankruptcy Court recognises the foreign proceeding as the ‘main’ proceeding, but can issue orders to assist with the marshalling of assets or discovery in the US. The automatic stay also only takes effect once the bankruptcy court recognises the foreign proceeding and affects the debtor and property within US jurisdiction. However, the automatic stay will not be in effect after the filing of a Chapter 15 petition until the court recognises the foreign proceeding.

Michael B. Chester is a principal at Skarzynski Black LLC. He can be contacted on +1 (212) 820 7752 or by email: mchester@skarzynski.com.

Michael B. Chester

Skarzynski Black LLC