A policy that is Side A-only will generally be the safest.

Corporate bankruptcy is a traumatic event that raises a range of questions for all parties involved. Unfortunately, as bankruptcy rates have remained stubbornly high, more and more companies are being required to overcome a number of complex challenges connected with Chapter 11 and other bankruptcy filings.

For directors of a public company that may be in bankruptcy proceedings or headed that way, many of the challenges they face relate to their responsibilities to the company and their duty to protect the rights of stakeholders. The responsibilities of a director at a solvent company are clear and well known, with fiduciary duties of care and loyalty owed solely to the shareholder. As a company approaches the zone of insolvency, however, these duties of care broaden, even if the company is not actually in bankruptcy.

CZ‘Courts have held that directors of companies in the zone of insolvency owe fiduciary duties to their creditors as well as their shareholders,’ explains Carol Zacharias, pictured left, deputy general counsel at ACE Group. ‘Once a company is actually insolvent, courts hold that directors owe fiduciary duties to creditors, and no longer to shareholders.’

With these shifting fiduciary duties come shifting liabilities, and as recent events have shown, shareholders are becoming more aggressive about protecting their positions as companies approach insolvency (for fear of not retaining rights after filing). Plaintiffs are also bringing cases after bankruptcy filings which expose directors to significant and real risk of personal financial loss.

All about context

Basically, directors owe duties in four different contexts: the solvent company; the insolvent company; the insolvent company in bankruptcy; and the solvent company in bankruptcy. Each context creates it own liabilities, and companies must understand these differences when acquiring insurance coverage for directors.

Understanding who can bring suits in which context is vital to understanding the language and limits of coverage. In some circumstances, it may be necessary for directors to acquire personal coverage outside of that which is provided by the company.

Tony Davis, a partner at Baker Botts, notes that there is some uncertainty about whether creditors have enhanced rights before the actual point of insolvency. The Crédit Lyonnais case, which suggested that creditors can have expanded rights before the official point of insolvency, was considered ‘distressing and controversial’ by some. Other courts, such as the Southern District of New York, have rejected ‘zone of insolvency’ theory, arguing that ‘creating a pre-insolvency duty of care to creditors would distort – and potentially conflict with – the incentive structure for corporate managers that the law of fiduciary duties has been erected to create.’

Jenner & Block partner Linda Kornfeld says there are several insurance and indemnification issues a director must consider when acquiring a directors and officers (D&O) policy. These questions must be asked when formulating and negotiating the policy in order to ensure adequate protections in the event of a corporate bankruptcy. Kornfeld believes companies must ask: Who owns the D&O insurance proceeds – the debtor/entity, or the directors and officers? What is the effect of an automatic stay on the insurer’s ability to advance defense costs to the directors and officers? What are the key provisions that directors and officers should negotiate for or against to achieve maximum protection in the event of a bankruptcy?

The real issue surrounding D&O indemnification in a bankruptcy stems from the fact that under US Bankruptcy Code Section 362a, an automatic stay is placed on any litigation against the debtor company. That might be good news for the company, but it does not necessarily apply to the directors and officers.

‘Since the directors are not in bankruptcy, bankruptcy does not change the possibility of litigation against them,’ Zacharias points out. ‘Existing litigation by shareholders and regulators will continue and, in fact, may be filed with increased frequency.’

Feeding frenzy

Zacharias says the possibility of personal lawsuits raises heightened concerns about corporate indemnification and D&O insurance to protect directors and officers targeted in ongoing proceedings. ‘In addition, directors may see actions by creditors, lenders, customers, depositors and borrowers, alleging misconduct ranging from gross mismanagement to fraud,’ she explains. ‘Once bankruptcy is filed, these actions may be filed by a trustee in bankruptcy seeking to maximize the size of the estate for the benefit of the creditors.’

The basic problem, as Kornfeld highlights, is that ‘If a company becomes subject to a bankruptcy proceeding, the company will likely be unable to fund its D&O indemnification obligation.’

As a simple overview, Side A coverage is payable directly to the directors and officers, whereas Side B coverage is payable to the corporation for claims of wrongful acts by directors and officers. Side C is payable directly to the entity for its wrongful acts. This is usually limited to securities claims for public companies.

The main points to consider are:

(i) Will the filing of bankruptcy convert the underlying Side B claim to a ‘non-indemnifiable’ Side A claim under the policy?

(ii) If the D&O policy also provides Side C coverage, it may be considered by the courts as an asset of the bankruptcy estate.

(iii) If the policy is an asset of the bankruptcy estate, are the ‘proceeds’ frozen so that the insurer cannot pay Side A claims to the   directors and officers?

(iv) What provisions can be included in a D&O policy to help ensure that directors and officers are indemnified under the policy in bankruptcy?

The question of indemnification expenses is dependent on whether the courts consider the D&O policy and its proceeds separately in determining whether they are the property of the debtor’s bankruptcy estate.

Most courts consider D&O policies to be the property of the company’s estate, but the more critical issue is whether the D&O policy proceeds are the property of the estate. This question typically arises when an insurer is asked to advance defense costs to directors and officers or make other payments under the policy when the company is in bankruptcy. Many courts have held that where the debtor does not have a ‘direct interest’ in the proceeds of a D&O policy, the proceeds are not the property of the bankruptcy estate, but there have been instances of courts finding that insurance proceeds are in fact the property of the estate, meaning they can be ‘frozen.’

Craft policy language carefully

As with all contracts, the language of a D&O policy is important. Zacharias explains the steps that need to be taken prior to signing the policy to help maximize coverage. First, stipulate that the ‘insured versus insured’ exclusion does not apply to suits brought by the trustee (who may sue directors or officers). There should be no regulatory exclusion, as some companies may be subject to significant regulatory scrutiny upon bankruptcy and regulatory takeover. There should be no bankruptcy exclusion, as the exclusion may eliminate coverage when executives most need protection. Change of control language should exclude events that may happen in bankruptcy, like changes in a majority of board positions or a significant sale of assets, because these may suddenly terminate coverage.

To maximize the arguments against freezing the policy proceeds, several steps can be taken.

(i) The policy should have a ‘priority of payments clause’ which provides that the policy proceeds will be paid first for the directors and officers and only thereafter for the entity. This supports the position that the policy proceeds should not be frozen as part of the entity’s bankrupt estate because the proceeds are first and primarily for directors and officers, who are not bankrupt.

(ii) There should be a policy clause in which the entity agrees to waive the automatic stay.

(iii) Insuring only directors and officers (Side A-only) demonstrates that the policy proceeds were never intended for the bankrupt organization and as such should not be subject to the automatic stay. Hence, elimination of coverage for the company maximizes the chance that the policy will not be subject to the stay. Having Sides B and C coverage may muddy the waters and raise the possibility of assets being deemed property of the estate and thus subject to the stay.

(iv) Executives may be successful in asking bankruptcy courts for interim payments under the policy, in spite of the imposition of an automatic stay.

In short, a policy that is Side A-only will be the safest, one containing both Sides A and B is riskier, and one including Side C presents the most risk for directors. Other policy considerations that will help protect coverage delivery in bankruptcy are definitions of ‘financial insolvency’ and ‘presumptive indemnification’, a waiver of automatic stay provision and excess policy considerations.

An advancement of defense costs provision is also a must-have in the view of Kornfeld. ‘If the D&O policy does not specify that an insurer must pay defense costs as they are incurred, then the directors and officers may find themselves in a situation where they are obligated to pay millions of dollars of defense costs out of their own pockets until a claim is finally resolved and the insurer is obligated to pay the covered defense costs and the damages,’ she says.

As the business environment becomes more complicated, it is even more important that D&O insurance policies be intelligently and accurately formulated to ensure that proceeds will be extended in all foreseeable circumstances. Failure to do so will put directors and executives at a very real risk of personal financial liability.

Side A policy trends

The Towers Watson 2011 directors and officers liability survey found that 57 percent of respondents purchased an excess Side A or Side A difference-in-conditions policy in 2011. When asked what was the main impetus driving the purchase decision, 71 percent cited breadth of coverage, a significant increase over the 45 percent response in 2010. Such a meaningful increase demonstrates that organizations understand the myriad benefits a comprehensive Side A program offers. Protection against bankruptcy, both for the underlying insurer and for the respondent’s organization, also experienced a sizable increase in responses, with 15 percent and 12 percent increases respectively.

As you might expect, the larger the organization, the more likely it is to purchase Side A coverage. For private organizations specifically, the majority of firms with total assets in excess of $1 billion purchased excess Side A coverage. Conversely, over three-quarters of smaller firms with under $250 million in assets reported not doing so.

From a market capitalization standpoint, over three-quarters of public company respondents (78 percent) purchased excess Side A coverage, and purchase of this coverage was well represented irrespective of company size.

Reasons for purchasing excess Side A policy:

Breadth of coverage
2011  71%
2010  45%

Concern about large loss
2011  47%
2010  45%

Protection against bankruptcy of underlying insurer
2011  42%
2010  27%

Protection against bankruptcy of the organization
2011  40%
2010  28%

Board member required it
2011  24%
2010  29%

Premium savings
2011  10%
2010  9%

2011  6%
2010  8%

Source: Towers Watson 2011 directors and officers liability survey