Directors and officers have become common targets for litigation. Class actions are everywhere. The recently enacted Sarbanes-Oxley Act emphasizes the role of directors as gatekeepers and their responsibility to ensure good accounting practices and compliance with SEC regulations. Bankruptcy trustees and creditors committees see directors and officers as deep pockets who may increase the recovery for creditors.
As a company moves towards insolvency, the responsibilities of a director become more complex. The directors' fiduciary duty expands from representing shareholders to include responsibility to creditors. Business events unfold quickly. Disclosure of adverse events can significantly impact the business' chances for recovery. Yet, a public company must make instantaneous decisions as to whether events must be disclosed to shareholders.
In a healthy business, directors look to corporate indemnification for the defense of lawsuits and protection against judgments. When bankruptcy strikes, the sole recourse of the directors and officers will be to the D&O insurance policy.
What is a D&O Policy?
A directors and officers insurance policy provides coverage against third party litigation. These policies typically provide defense costs and pay certain judgments entered against officers and directors. The policy is normally obtained by the business entity which owns the policy and pays the required premiums.
a) Persons Covered
When D&O policies were first created, the only coverage was for the personal protection of officers and directors, so-called Side A coverage. Later, the insurance companies added reimbursement to the corporation for the cost of indemnifying officers and directors, so-called Side B coverage. More recently, the insurers have offered direct entity coverage to the corporation which would cover damages which are assessed against the entity, so-called Side C coverage. In the present market, Side C coverage may be unavailable.
The definitions used in a policy are critical. If one is counting on coverage as an "officer" it is wise to examine precisely the definition of "officer" because the policy definition may be limited to executive officers or those officially appointed by the Board.
b) Policy Limits
One of the first considerations with respect to a policy is the proposed amount of coverage. The policy limit will be an aggregate amount for legal defense costs and claims paid. There will be one aggregate limit for all the coverages: Side A, Side B and Side C. Normally, there is no order of priority–although it is possible to negotiate a priority for the Side A coverage.
One analytical approach to determining an appropriate policy limit is to identify the total market capitalization of the company and deduct the shares held by insiders. The market capitalization held by outsiders provides a measure of the maximum damages that could be sought in securities litigation. Studies indicate that the overwhelming number of class action suits settled for something between 8% and 12% of the maximum damage claim, leading to the suggestion that 8% to 12% of the market capitalization held by outsiders is an appropriate amount of coverage. Often the cost of premiums and the lack of available insurance will dictate a lower amount of coverage.[1]
c) Retention
A second important consideration is the amount of retention, i.e., deductible. In 2000, a retention of $250,000 was common. In 2002, the ordinary retention has been increased to $1,000,000, meaning that the corporation or the individual defendants are self-insured for the first $1,000,000.
d) Claims Covered
Typically, a D&O policy insures against negligence as contrasted with intentional dishonesty by directors and officers. The scope of coverage will be determined by certain defined terms and the extent of the exclusions.
The affirmative statement of coverage normally is found in the term "claim" which typically includes asserted violations of the securities laws (other than insider trading), breaches of duties as a director and claims asserted by employees for improper discharge or discrimination. Until the recent stock market crash resulting in an explosion of class action litigation, most claims under D&O policies were in the nature of employee claims. In 2002, the claims are more commonly shareholder class actions under Rule § 10(b)(5) of the Securities Act of 1934.
The scope of coverage will be dramatically reduced by a number of exclusions. These exclusions normally take away coverage for insider trading, illegal payments, criminal acts, transactions resulting in personal profit, fraud and claims by one insured against another insured. The policy will also exclude claims that are not promptly reported to the insurer within strict time limits.
The most troublesome exclusion is the one for claims by one insured against another insured. This exclusion was meant to protect the insurer against collusion among insiders. However, it has the effect of denying coverage to an officer who is sued by another officer or director. If there is entity coverage under the policy (Side B or Side C), it may also exclude coverage when the corporation brings suit against an officer or director.
e) Allocation
Allocation is the notion that responsibility for a claim may be shared among insured and non-insured parties. When coverage under the D&O policy runs exclusively to directors and officers, the insurance company may take the view that a non-insured is 40% responsible for an alleged claim and thereby limit its coverage (including defense costs) to 60% of the amount incurred. Outside directors in particular should seek waiver of allocation and seek 100% coverage for claims regardless of whether a non-insured has contributed to the loss.
A closely related, but different concern, is the exclusion of coverage for activity in a capacity other than as an officer or director. When the person seeking coverage is a shareholder or has a separate business relationship with the company, the insurance company may defend or provide only partial coverage on the grounds that the person was acting wholly or partially in another capacity when the claim arose.
f) Claims Made
All D&O policies are written on a claims-made basis, meaning that the policy provides coverage only for litigation arising from events during the time period the policy is in effect. The policy will require a written statement to the insurance company of potential claims within a short period after expiration of the policy (typically 30 days) and provide coverage for litigation that arises within a specified time from the disclosed claim. There is obviously a premium on imaginative, careful and complete articulation of potential claims at the expiration of a policy. Failure to describe a claim will mean termination of coverage.
g) "Tail" Coverage
In the unfortunate circumstance that the corporations is unable to renew D&O coverage, the company may be able to purchase a "tail" policy. A "tail" extends the time period for another year or two for making claims, although the claims must arise out of events that occurred during the time the policy was in effect. It is useful to negotiate a provision in a D&O policy that commits the insurer to offer this coverage and, if possible, at a pre-determined cost.
h) Application Process
One of the most important aspects of D&O insurance is the application submitted to obtain the policy. The insurance company will require detailed, written explanation of any existing claims and require a statement as to the knowledge of the company and the insureds as to any basis for other claims. Failure to accurately complete the insurance application permits the insurance company to seek revocation of a policy should a claim arise from events that were not properly disclosed. Unfortunately, the outside directors seldom review or participate in completion of the application–yet may find their coverage revoked for lack of proper disclosure in the application.
In connection with renewal of D&O insurance, there is a significant premium in renewing the insurance with the existing company. A renewal application will normally not require a filing of a complete application and thereby avoids a possible defense for the insurance company.
i) Specialized Broker
The process of obtaining a D&O insurance policy begins with the engagement of a sophisticated insurance broker. D&O insurance is a specialty area where day-to-day experience is important. D&O policies are not in a standard form. There are significant variations among companies and meaningful room for negotiation. Not all brokers and not all policies are created equal.
Is the Policy Available in Chapter 11?
D&O policies have been the subject of a number of recent decisions from bankruptcy courts, often with results that surprise directors and officers who thought they had coverage.
If an insurance policy is property of the estate, the directors and officers need relief from the automatic stay to make a claim and obtain defense costs under the policy. When the debtor is covered under the policy, any payments to officers and directors reduce the coverage available to the debtor. Where the debtor is making claims against former officers and directors, the debtor is likely to be more aggressive seeking to deny the benefits of the insurance to people perceived as wrongdoers.
a) Property of the Estate
Courts have reached different conclusions as to whether coverage under a D&O policy is property of the estate. Typically, the debtor has obtained and owns the policy. Most courts have adopted the approach that the proceeds payable under the policy are different from ownership of the policy. In re CHS Electronics, Inc. 261 B.R. 538, 542 (Bankr. S.D. FL. 2001) citing In re Goodenow, 157 B.R. 724 (Bankr. D. Me. 1993). Another court has stated that the question of whether the proceeds are property of the estate must be analyzed in light of the facts of each case. In re First Central Financial Corp., 238 B.R. 9, 16 (Bankr. E.D. NY 1999).
A common starting point for the legal analysis is the Eleventh Circuit decision In re Louisiana World Exposition, Inc., 832 F.2d 1391 (5th Cir. 1987). The case involved a policy providing only Side A coverage to officers and directors. The debtor argued that claims by the estate against the officers and directors gave the estate an interest in the policy. The court found that an unadjudicate claim from an estate does not give the debtor a property interest in the policy.
The CCH Electronics case involved Side B (reimbursement to the debtor for indemnification claims) and Side A (direct coverage for directors and officers). The court found that the proceeds under the Side A coverage were not property of the estate where the policy limits were sufficient to cover any claim the debtor might make under Side B coverage. In re CHS Electronics, Inc. supra at 543; accord, In re Youngstown Osteopathic Hospital Association, 271 B.R. 544 (Bankr. N.D. Ohio 2002).
Where the policy includes Side C coverage (direct coverage to the debtor for losses), courts typically conclude that the policy is property of the estate and the directors and officers must obtain relief from the automatic stay to make a claim for defense costs. In re Cybermedia, Inc., 280 B.R. 12 (Bankr. D. Ma. July 2, 2002) Rosenthal, J.
In the Cybermedia case, the Chapter 7 Trustee brought suit against two former directors and officers on several counts, including breach of fiduciary duty. The trustee objected to the payment of defense costs by the insurance company. The former directors and officers argued that the estate has no interest in the policy because the bar date for claims of indemnification from the former officers and directors as well as for claims by third parties had passed. The trustee argued that payment of defense costs reduced the funds available to the estate if the trustee were to win a judgment. Judge Rosenthal found that "The majority view is that insurance policies are property of the estate and protected by the automatic stay provisions of Section 362(a)(3) of the Code." supra at 16.
The court then considered the balance of harm as between the estate and the former officers and directors in considering whether to lift the automatic stay. The court found that the harm to the estate was speculative, while the denial of defense costs to the former officers and directors was real and immediate. The court lifted the stay supra at 20.
The court noted that it was not deciding the issue of whether the officers and directors were ultimately entitled to coverage should they be found guilty of conduct that was excluded under the policy nor would the court require submission of fee applications by counsel to the former officers and directors as a condition of reimbursement under the policy. supra at 19.
The Cybermedia case followed a similar decision issued by Judge Kenner on April 2, 2002. In her case, the debtor confirmed a liquidating plan providing that the debtor would pursue causes of action against former directors and officers for the benefit of creditors. The D&O insurer was reluctant to pay defense costs of the former officers and directors without relief from the automatic stay and the injunctions entered in connection with plan confirmation. The D&O insurer brought an adversary proceeding for clarification. The policy provided Side A and Side B coverage.
The insurer (and the former directors and officers who were nominal defendants) brought a motion for summary judgment. The insurer argued that the estate had no interest under the Side B coverage because the insurer would pay the directors and officers directly under the Side A coverage, meaning that there would be no claim against the company for indemnification.
The court denied summary judgment finding that claims for indemnification might exceed the scope of Side A coverage, thereby finding that the court could not as a matter of law rule that the estate had no interest in the policy. The court ruled that absent some specific agreement as to priority, the insureds had an equal claim to the coverage. Without making any final ruling, the court authorized payments of up to $600,000 for defense costs. In re Boston Regional Medical Center, Inc., 2002 W.L. 31545755 (Bankr. D. Ma. April 2, 2002).
A similar outcome occurred in a more recent decision by Judge Gerber in New York involving Adelphia Communications. "Decision on Motions With Respect to D&O Policies," November 15, 2002, Docket No. 1105, 2002 W.L. 3155 7175. After concluding that the insurance was property of the estate, the court sought to balance the interests of the directors and officers against the interests of the estate concluding that each of the officers could receive up to $300,000 in defense costs. See also In re Enron Corp., 2002 W.L. 1008240 (Bankr. S.D. NY 2002).
b) Insured vs. Insured Exclusion
A suit by the corporation against directors and officers will normally result in a denial of coverage if there is Side B or Side C coverage. The insurance company will invoke the "insured vs. insured" exclusion. An interesting bankruptcy issue emerges when the plaintiff is a Chapter 7 or Chapter 11 trustee and the insurance company denies coverage to directors and officers.
The analysis requires careful consideration of the defined terms in the D&O policy. The trustee will argue that the estate rather than the "company" is bringing the action and therefore the exclusion does not apply.
In a recent decision, Judge Kenner ruled that an insurance policy should be interpreted against the insurance company as the draftsman. She further found that trustee was not the same as the company and that the directors and officers were entitled to coverage under the policy. The case arose through a declaratory action by the trustee seeking an affirmative determination that the directors and officers were covered so that the estate would have a fund to reach. In re Molten Metals Technology, Inc., 271 B.R. 711 (Bankr. D. Ma. January 3, 2002), aff'd Gray v. Executive Risk Indemnity, Inc., 2002 W.L. 92 3936 (D. Ma. May 6, 2002). Accord, Alstrin v. St. Paul Mercury Insurance Company, 179 F.Supp 2d 376 (D. Del 2002); In re County Seat Stores, Inc., 280 B.R. 319 (Bankr. S.D. NY 2002), but see Reliance Insurance Co. of Illinois v. Weis, 148 B.R. 575 (E.D. Mo. 1992); National Union Fire Insurance Co. v. Olympia Holding, 148 F.3d 1070 (11th Cir. 1998).
c) Jurisdiction
These insurance coverage disputes often involve a question of whether the bankruptcy court has jurisdiction. Judge Kenner has ruled that a determination as to whether the insurance coverage is property of the estate is a core matter. In re Boston Regional Medical Center, Inc., supra at 2. Judge Kenner has also ruled that interpretation of whether a policy provides coverage in light of the "insured vs. insured exclusion" is subject only to the Bankruptcy Court's non-core jurisdiction. In re Molten Metal Technology, Inc., supra at 714; accord In re G-1 Holdings, Inc., 278 B.R. 725 (Bankr. D.N.J. 2002), but see In re County Seat Stores, Inc., 2002 WL 141875 (S.D. NY 2002) (denying a motion to withdraw the reference on a coverage dispute on the grounds the dispute was a core proceeding.).
Conclusions
D&O Insurance is a complicated product that requires close scrutiny. Directors and officers should actively participate in the purchase and negotiation of a policy, especially as a company approaches insolvency.
Directors and officers are best protected by a policy which exclusively provides coverage to them (Side A coverage) without any coverage for the entity (Side B and Side C). Combined coverage makes it likely that the D&O coverage will be considered property of a bankruptcy estate. If the policy is property of the estate, the directors and officers will need to seek relief from stay to obtain coverage even for defense costs.
Under many circumstances, a trustee will want a declaration that the D&O policy provides coverage to directors and officers so that the trustee has a fund to satisfy a judgment or the directors and officers have a fund for settlement. In other circumstances where the defendants have substantial assets, the trustee or debtor in possession may seek to prohibit coverage in order to create leverage for a settlement and to keep the policy limits from being depleted through the defense of officers and directors.
Serving as a director is a dangerous proposition, made more dangerous by the prospect that a bankruptcy court may limit or bar coverage otherwise provided under a D&O insurance policy.
[1] An insurance broker recently provided an estimate that policy limits of $10,000,000 with a $1,000,000 retention would cost $1,000,000 in today's market. Insurance companies are currently demanding premiums double or triple of those available a year ago as well as substantially increased retentions and substantially narrowed coverage.
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