Business Law 1

Corporate Bankruptcy May Deprive Directors and Officers of D&O Insurance

Thomas Henry Coleman, Troy and Gould Professional Corporation, Los Angeles, contributing author of Advising and Defending Corporate Directors and Officers published by CEB.

Enron, K-Mart, Global Crossing: large, publicly-held corporations have recently taken cover in Chapter 11 bankruptcy.
In the past year, overwhelming economic forces have swamped a number of corporations whose corporate governance was inept, if not corrupt. Whatever the cause of the descent into Chapter 11, the directors and officers of large, publicly-held corporations in bankruptcy have inevitably been sued by plaintiff class-action lawyers who assert securities fraud claims against both the corporation and its officers and directors, relying on SEC Rule 10b-5 and other anti-fraud provisions. Claims frequently include allegations of “accounting irregularities” that may have presented an overly optimistic statement of the business’s finances. In other cases, such as Enron, pervasive corruption and gross financial-statement deceptions have doomed the company to bankruptcy.

Securities Class Actions
Already, in Enron’s case, the most prominent class-action plaintiff’s litigators are proceeding with massive lawsuits. Direct attacks on Enron itself are barred by the automatic stay in bankruptcy (11 USC §362), as are some types of shareholders derivative actions. However, the automatic stay does not prevent securities class actions from rolling forward against officers and directors, who expect that they will be covered and defended by directors and officers liability insurance (“D&O Insurance”).

Directors’ and Officers’ Liability Insurance (D&O Insurance)
D&O Insurance was for many years generally in two parts (“Two-Part Insurance”). The first part of the insurance directly provided coverage and defense for the directors and officers. The second part provided coverage and defense to the corporation for directors’ and officers’ indemnification claims. Recently, D&O Insurance has been broadened, so that many contemporary D&O Insurance policies consist of three parts (“Three-Part Insurance”). The Three-Part Insurance provides coverage and defense as before; and, in addition, coverage and defense directly to the corporation in connection with its alleged violations of the securities laws.

Three-Part Insurance
The three parts of typical contemporary Three-Part Insurance include coverage and defense for (1) the directors and officers, (2) the corporation’s obligations to indemnify them for their liability and defense costs under applicable state corporation laws and the corporation’s organizational documents and (3) in an extension beyond Two-Part Insurance, coverage and defense to the corporation itself as a primary insured, with respect to shareholders’ securities claims against the corporation.

A solvent corporation, free of the constraints of bankruptcy, may be afforded some latitude in how D&O Insurance payments will be allocated among the corporation and its directors and officers. However, in bankruptcy, the directors and officers may be severely disappointed over the allocation of D&O Insurance.

Allocation of D&O Insurance
Before the addition of direct corporate securities liability coverage, courts usually held that to the extent coverage was provided directly to the directors and officers, the D&O Insurance and its proceeds were not property of the estate. In re Pintlar Corp. (Pintlar Corp. v Fidelity & Cas. Co.) (9th Cir 1997) 124 F3d 1310; In re Edgeworth (Houston v Edgeworth) (5th Cir 1993) 993 F2d 51, 55; In re Louisiana World Exposition, Inc. (Louisiana World Exposition, Inc. v Federal Ins. Co.) (5th Cir 1987) 832 F2d 1391, 1398.

On the other hand, the indemnification provisions of the D&O Insurance were more likely to be viewed by the Bankruptcy Court as property of the estate. In re Louisiana World Exposition, Inc., supra, 832 F2d at 1400. Even in those situations, however, the Bankruptcy Court would not likely view the proceeds of the policy as property of the estate, because the real insureds were the directors and officers, and not the indemnifying corporation. In re First Cent. Fin. Corp. (Ochs v. Lipson) (Bankr EDNY 1999) 238 BR 9, 16.

The D&O Insurance’s direct securities liability provision may leave the directors and officers uninsured.
The current Three-Part Insurance, adding the corporation itself as a direct, primary insured on securities claims, exposes the entire policy to payment of the “direct” securities claims against the corporation, leaving nothing at all to pay for defense or coverage of the directors and officers. For example, if the D&O Insurance policy limits were $100,000,000 and securities violation claims totaled $150,000,000, the Debtor corporation might receive all proceeds, leaving the directors and officers exposed to uninsured claims of $50,000,000.

The Bankruptcy Court may then be called upon to make difficult allocations. The Court may decide that liability insurance bought and paid for by the bankrupt corporation, containing insuring agreements for its own primary benefit, should be entirely property of the estate – including proceeds – even though additional insuring agreements benefit the directors and officers. In that event, the Bankruptcy Court would rule that the entire policy limits go to the estate and might also rule that such proceeds become general funds of the estate, to be distributed ratably to creditors, in accordance with the priority scheme of bankruptcy. The distribution might explicitly exclude the directors and officers, because under Bankruptcy Code section 502(e), indemnification claims may be disallowed entirely, or they may be subordinated under section 510(b) or (c) to the claims of all creditors. See Nan Roberts Eitel, Now You Have It, Now You Don’t: Directors’ and Officers’ Insurance After a Corporate Bankruptcy, 46 Loy L Rev 585 (Fall 2000).

In advising directors and officers negotiating the terms of Three-Part D&O Insurance policies, you should try to obtain specific allocation provisions in the event of a corporate bankruptcy. Moreover, if you are retained to represent directors and officers where a corporate bankruptcy is being considered, you should carefully review the D&O Insurance and advise the directors and officers whether, and to what extent, any D&O Insurance they are relying on may or may not be available to them – and be prepared for battle against a creditors committee, the bankrupt corporation or a bankruptcy trustee.

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