Bankruptcies: The Importance of D&O Liability Insurance

 
Saturday, August 1, 2009
 
It is imperative that D&O Liability Insurance be reviewed before a bankruptcy filing.  Below are some of the reasons.

Relying on D&O insurance. In the event of a company’s bankruptcy, the automatic-stay provision of the Bankruptcy Code protects the company from lawsuits, but actions against the directors and officers are not stayed. They must therefore rely on their D&O insurance.  Directors’ and officers’ liability insurance generally provides coverage for the directors and officers but also for the company if it must indemnify those individuals. The D&O portion of the policy usually requires the insurer to cover all losses resulting from wrongful acts for which the directors and officers are not indemnified, while the company portion covers losses incurred by the company as a result of its obligation to indemnify. Losses generally include damages, judgments, settlements, and legal defense costs. D&O policies may also be written with entity coverage, which would cover losses the company faces as a result of securities litigation or employment practice claims.

Policy’s fate during bankruptcy. Courts have generally held that the insurance policy itself is the property of the bankrupt’s estate but that the proceeds are not. However, if the policy provides coverage for the debtor as well as the directors and officers and if it is subject to an aggregate limit, the value of the policy to the debtor will be diminished if the directors’ and officers’ claims are paid. Deductibles and self-insured retentions ("SIRs") may also give rise to coverage issues. Insurers have argued that, when multiple policies are in place, the SIRs and deductibles must be paid on all the policies before the insurance proceeds from any one policy are due. Courts have rejected that argument, distinguishing the usual rule of horizontal exhaustion (which requires exhaustion of all primary policies) by noting that SIRs and deductibles are not primary insurance but contractual terms. The policy may explicitly require that the debtor pay the deductible or SIR from its own funds, but for a bankrupt company, this can be an insurmountable hurdle. At least one court has held that the debtor can satisfy the SIR requirements of one insurance policy by using the proceeds from another.

Common defenses. When the claim against the insureds alleges fraud, the insurer may attempt to rescind the policy, arguing that the application failed to disclose the fraud. The insured will argue that its knowledge of a potential risk does not mean that it purposely made a material misstatement in its application. At least one court has agreed that fearing a potential lawsuit, while troubling with the benefit of hindsight, is not material misrepresentation. Another area of conflict arises because D&O policies generally exclude coverage for insured-versus-insured lawsuits. In bankruptcy cases, the trustee often brings a claim against the former directors and officers. Some courts have held that the trustees’ claims are made on behalf of the estate and not the company, so the insured-versus-insured exclusion is inapplicable.

Practical steps.  There are several steps that corporate counsel can take to ensure D&O coverage remains despite the company’s declaration of bankruptcy. Review all D&O policies to evaluate the level of coverage and to make sure that the policy requirements are being met. If possible, purchase separate policies, one for entity coverage and the other for directors’ and officers’ liability. When double polices are not practical, the sole policy should have separate limits for the entity insurance and the D&O coverage. Negotiate the terms to ensure that bankruptcy will not be a termination event and to include a waiver of the automatic stay.
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