Bankruptcy and D&O Claims Settlements

Ever since “entity coverage” became a part of the standard directors’ and officers’ policy, bankruptcy courts have wrestled with the question of whether D&O policy proceeds are property of the bankrupt estate and therefore subject to the bankruptcy code’s automatic stay.

The question matters because the bankrupt company’s directors and officers usually need the policy proceeds to fund defense expense or settlements. The trustee, by contrast, wants the proceeds preserved to satisfy the trustee’s own claims. So, the trustee seeks to subject the proceeds to the bankruptcy stay.

A recent decision from the federal bankruptcy court in Delaware arising out of the World Health Alternatives bankruptcy addressed the issue of whether the company’s former directors and officers could access the company’s D&O policy proceeds to settle shareholder litigation pending against them.

In fall 2005, shareholders initiated multiple suits (later consolidated) in federal court in Pennsylvania against the company and former directors and officers. In February 2006, the company filed for bankruptcy, as a result of which the company was dropped as a defendant from the shareholder litigation.

In fall 2006, the parties settled the shareholder litigation and later filed a settlement agreement with the federal court in Pennsylvania. As part of the settlement, the remaining limits under the D&O policy were tendered into escrow, and the final settlement hearing was scheduled for June 11, 2007.

On May 21, 2007, the trustee in bankruptcy initiated an adversary proceeding in Delaware federal bankruptcy court against several of the company’s former directors and officers alleging, among other things, breaches of fiduciary duties and unjust enrichment. The trustee petitioned the bankruptcy court to enjoin the approval of the shareholder litigation settlement and to direct the transfer of the D&O policy proceeds to the trustee.

In a June 8, 2007 opinion, the bankruptcy court considered “whether a debtor’s creditors have priority over the debtor’s shareholders in the proceeds of an insurance policy to which both claim entitlement.” The court said the threshold issue in its consideration of the injunction petition is whether there is a “reasonable probability that the trustee will win on the merits of his claim of priority to the proceeds of the policy,” which turns on “whether the proceeds are property of the estate.”

The D&O policy under consideration (like most current directors’ and officers’ policies) contained Side A coverage protecting individual directors and officers, as well as Side B coverage providing company reimbursement coverage for amounts for which the company indemnified the individual directors and officers. The policy also contained Side C “entity coverage” protecting the company from its own securities claim liability.

Typically, when a liability policy provides coverage to a debtor, the proceeds of the policy are property of the bankrupt estate.

The court said that when a policy covers the debtor and its directors and officers, and there is risk that payment of the proceeds to the directors and officers will result in insufficient coverage of the debtor, then the proceeds are property of the estate and any attempts to obtain the proceeds are there fore prohibited under the automatic stay.

The court said that under the circumstances, however, “it appears that the proceeds of the debtor’s insurance policy are not the property of the estate.”

The court reached this conclusion because “the policy proceeds which are being used to fund the settlement … are from the policy’s Coverage A,” and the trustee “has no right to any Coverage A proceeds.”

Furthermore, the court said the trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from the D&O policy rather than as a potential defendant seeking to be protected by the D&O policy. In this way, the trustee is no different than any third-party plaintiff suing defendants covered by a wasting policy.

Because the court found that “there is no reasonable probability that the trustee would succeed on the merits,” the court denied the trustee’s petition for a preliminary injunction.

On June 11, 2007, the Pennsylvania federal court approved the shareholder litigation settlement and entered final judgment.

Although the World Health Alternatives bankruptcy court held that the trustee could not prevent the company’s former directors and officers from using the D&O policy proceeds to settle claims against them, there is a split of authority whether D&O policy proceeds are part of the debtor company’s estate and subject to the automatic stay.

A “priority of payments” clause, which requires payments to first be made to Side A insureds, is one approach that some companies have used to try to avoid the assertion that the proceeds of the company’s D&O policy would be a part of the company’s estate in bankruptcy.

Another way to provide against the adverse effects that could follow in the event that the standard D&O policy (containing entity coverage) is subject to the stay in bankruptcy is to structure the company’s D&O insurance program to include a separate Side A policy that provides coverage solely for the individual directors and officers. Because those policies protect only the individuals, the Side A policy’s proceeds are unlikely to be held part of a debtor company’s estate and therefore would not be subject to the stay in bankruptcy. Excess Side A policies providing so-called “drop down” protection in the event the standard directors’ and officers’ policy is subject to the bankruptcy stay may be the most cost-effective protection against that possibility.