Nan Roberts Eitel

Nan Roberts Eitel is a partner in the commercial litigation section of the New Orleans firm of Jones, Walker, Waechter, Poitevent, Carrere & Denegre. Her practice includes both bankruptcy and directors and officers insurance matters. Nan received her A.B. from Georgetown University and her law degree from the University of Virginia .

Until the widespread availability of entity coverage in recent years, D&O policies covered only the individual liability of the directors and officers and the corporation's indemnification obligation to the directors and officers. Generally there was no coverage for liability of the corporation itself.

With the advent of entity coverage during the 1990s, a corporation now can be insured for claims such as those based on securities violations or wrongful employment practices and which are attributable to the entity and not the directors and officers. This entity coverage was developed in response to difficult situations involving an “allocation of loss” between insureds and insurers when securities claims were asserted against both insureds (directors and officers) and noninsureds (corporations) in the same suit. Allocation of loss disputes also could arise in situations involving covered and uncovered claims. Such disputes often ensued over the allocation of both litigation expenses and settlements or judgments between insured and uninsured codefendants.

By providing coverage for the corporation itself, insurers sought to avoid allocation disputes. But attempts at solving the allocation problem inadvertently created new problems that could leave directors and officers without insurance in the event of a corporate bankruptcy. Other common provisions in D&O policies may also preclude coverage during bankruptcy and are discussed below.

Problem No. 1: D&O Policy Proceeds May Be Deemed Bankruptcy Estate Property and Consequently Unavailable to the Directors and Officers

Upon the filing of bankruptcy, an estate is created which consists of “all legal or equitable interests of the debtor in property as of the commencement of the case.”1 In addition, an automatic stay becomes effective upon the filing for bankruptcy relief. This automatic stay generally prohibits all enforcement actions against the debtor or property of the estate.2 If the D&O policy or its proceeds are deemed to be estate property, the directors and officers could find their claims against the policy subject to the automatic stay. Even worse, some or all of the policy proceeds could be deemed to belong exclusively to the estate of the corporate debtor. As a consequence, the directors and officers could find themselves uninsured. If so, the sole remedy would be for the directors and officers to look to the insolvent corporation for indemnification. Such claims against the corporation, even if allowed, would likely be subordinated to all other creditors under bankruptcy law and remain unpaid.

Although no case has yet interpreted whether a D&O policy containing entity coverage would be estate property, prudent corporate directors and officers should avoid being a test case and possibly finding themselves without the benefit of insurance protection.

Recommendations

Corporations should consider obtaining excess coverage for directors and officers (Side A coverage) to provide “drop down” protection in the event corporate bankruptcy prevents indemnification or the collection of insurance proceeds. If underlying primary or excess insurance is unavailable for any reason, such excess insurance could be structured to “drop down” and provide coverage for the directors and officers only. Since the corporation would not be an insured under such an excess policy, any proceeds should remain outside the control of the bankruptcy court.

Another means of potentially protecting directors and officers in the event of corporate bankruptcy is to add a priority-of-payments clause to the D&O policy. Priority-of-payments clauses require that losses under the insurance policy be paid in a particular priority: Coverage A, then Coverage B, then Coverage C. Assuming the priority-of-payments clause is not contingent upon the filing of bankruptcy, 3 it should offer additional protection for individual directors and officers. The desired effect could be that the directors' and officers' losses or indemnification claims would be paid first, and the corporation's liability would be covered only if policy proceeds were left.4 No court, however, has yet construed the validity of such a clause in bankruptcy proceedings.

Some may argue that eliminating entity coverage altogether from D&O policies would avoid the loss allocation and payment problems such coverage can create. However, entity coverage generally has been a positive development in D&O insurance and has helped avoid many costly and protracted allocation disputes. No solvent corporation should sacrifice entity coverage protection based on the remote possibility of bankruptcy.

Problem No. 2: Insured vs. Insured Exclusion

If a corporation is in a Chapter 7 (liquidating) bankruptcy or if a trustee is appointed in a Chapter 11 reorganization, a trustee may sue the corporation's directors and officers. Even the debtor-in-possession (“DIP”) in a Chapter 11 case could sue the directors and officers, particularly if there has been a change in management, a situation that often occurs when a company has financial problems. Indeed, a bankruptcy proceeding is one of the most likely events to give rise to lawsuits against directors and officers. Such suits, however, may be subject to the D&O policy's “insured vs. insured” exclusion and leave directors and officers uninsured.

“Insured vs. insured” exclusions preclude coverage for claims brought by one insured against another insured. If the exclusion is present, and if a claim is asserted against the debtor's directors and officers on behalf of the bankruptcy estate, those claims may be excluded from coverage. To date, only one reported case has denied coverage for claims asserted on behalf of a debtor's estate against a director and officer based on the “insured vs. insured” exclusion.5 In that case, the court reasoned that because the debtor's rights to sue were simply transferred to the estate upon the bankruptcy filing, for purposes of litigation there was no significant legal distinction between the debtor and its bankruptcy estate.6 Consequently, the directors and officers were uninsured for the asserted claims.7

While one case has squarely held that suits on behalf of a bankrupt's estate against directors and officers fall within the exclusion, another case has held to the contrary.8 In Pintlar, the bankrupt estate's claims had been assigned to a litigation trust. The court acknowledged that if the claim belonged to the prefiling entity, the “insured vs. insured” exclusion would apply.9 The court also recognized that the Supreme Court has defined a DIP as the same entity as the prefiling debtor,10 although a DIP is afforded different rights and obligations.11 Nevertheless, the court found that the suit was not brought by the corporation or on its behalf because the prefiling corporation and DIP were nonexistent12 by that time. The court further decided that the litigation trust was not the alter ego of the debtor.13 In addition, the court reasoned that the asserted claims were essentially those of a shareholder and, therefore, should be treated as a derivative action and covered.14 As a result, the Pintlar court ruled that the “insured vs. insured” exclusion did not bar coverage for the claims.15

Recommendation

The “insured vs. insured” exclusion in every D&O policy should contain an exception for claims brought on behalf of bankruptcy estates. Because trustees, creditors' committees, or DIPs are unlikely to bring collusive suits, insurers should be willing to carve out such an exception.

Problem No. 3: Presumptive Indemnification

Many D&O policies contain “presumptive indemnification” provisions which assume that the corporation will indemnify directors and officers to the fullest extent allowed by law. The purpose of presumptive indemnification provisions is to prevent the corporation from avoiding the substantial deductible under Coverage B (corporate reimbursement), by simply refusing to indemnify the directors and officers. Such a refusal would then force the director or officer to rely on Coverage A of the policy, which usually has a minimal or no deductible.

In addition, the bylans or other governing documents of most corporations contain provisions requiring the corporation to indemnify its directors and officers to the fullest extent permitted by law. Simply put, if a corporation can legally indemnify its directors and officers, then it must. Thus, a corporation could not “collusively” deny indemnification to avoid the larger retention or deductible under Side B coverage. But during a bankruptcy proceeding, the corporation may be prevented from making or may be unable to make such indemnification. With the typically large retention under coverage B, the presumptive indemnification provisions in a D&O policy can leave the individual director or officer largely uninsured, at least for the retention amount.

Recommendation

Corporations should seek to eliminate presumptive indemnification provisions from D&O policies. Some insurers have attempted to avoid the presumptive indemnification problem by creating an exception for financial insolvency, but this exception may not be enforceable as an ipso facto clause.16 The better solution is the elimination of presumptive indemnification altogether.

Conclusion

Bankruptcy is usually the last thing on the mind of a director, officer, or risk manager of a solvent corporation. However, the failure to address the potential for bankruptcy when purchasing or renewing D&O coverage can have undesirable consequences at a time when directors and officers are most in need of insurance protection. By the time such protection is needed, it is too late to effect changes in coverage. Directors, officers, and risk managers should therefore review their D&O policy in light of potential coverage during bankruptcy when the policy is purchased. By so doing, they can potentially increase the likelihood that D&O coverage will be there when it is needed, even during bankruptcy.

Notes

1. 11 U.S.C. § 541(a)(1).

2. 11 U.S.C. § 362.

3. U.S.C. § 365(e)(1) prohibits contract termination or modification merely because of a bankruptcy filing or a debtor's insolvency; such contract provisions are commonly referred to as ipso facto clauses. For example, adding policy provisions for the protection of the directors and officers that would be triggered by the company's filing of bankruptcy, such as a preset allocation or priority of payments clause that would come into play only in the event of bankruptcy, may not be enforceable in the event of bankruptcy.

4. It is important to note that changes in coverage that increase the coverage of the directors and officers at the expense of the corporation's coverage, such as priority of payments or allocation clauses, might be subject to revocation if made within one year of bankruptcy filing.

5. Reliance Ins. Co. of Ill. v. Weis, 148 B.R. 575 (E.D. Mo. 1992), aff'd, 5 F.3d 532 (8th Cir. 1993), cert. denied sub nom, Plan Comm. of Bank Bldg. & Equip. Corp. v. Reliance Ins. Co. of Ill., 510 U.S. 1117 (1994).

6. Id.

7. In an analogous situation, some courts have held that suits by receivers of financial institutions are not covered because the receiver stands in the shoes of the failed institution and thus falls within the “insured vs. insured” exclusion. E.g., Mount Hawley Ins. Co. v. Federal Sav. & Loan Ins. Corp., 695 F. Supp. 469 (C.D. Cal. 1987); contra American Cas. Co. v. Sentry Fed. Savings Bank, 867 F. Supp. 50 (D. Mass. 1994) (collusion concern not present when the RTC is an adverse party).

8. Pintlar Corp v. Fidelity & Cas. Co., 205 B.R. 945 (Bankr. D. Idaho 1997).

9. Id. at 947.

10. Nat'l Labor Relations Bd. v. Bildisco & Bildisco, 465 U.S. 513 (1984). Whether Bildisco eliminated the DIP as a “new entity” theory altogether or simply eliminated it in the context before the Court continues to be the subject of debate. Given that this is the Supreme Court's only pronouncement on the issue, the better reasoned approach is that the prefiling debtor and DIP are the same entity.

11. Id.

12. Id.

13. Id.

14. Id. at 948.

15. Id. at 947.

16. U.S.C. § 365(e)(1) prohibits contract termination or modification merely because of a bankruptcy filing or a debtor's insolvency; such contract provisions are commonly referred to as ipso facto clauses. For example, adding policy provisions for the protection of the directors and officers that would be triggered by the company's filing of bankruptcy, such as a preset allocation or priority of payments clause that would come into play only in the event of bankruptcy, may not be enforceable in the event of bankruptcy.