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By CATHERINE (KIT) CHASKIN, the insurance recovery liaison to the Venture Capital and Emerging Growth Group at Reed Smith

July 2008 was the hottest month in almost three years--for commercial bankruptcies. As many as 5,664 companies sought to liquidate or restructure in July, a 57 percent increase from the 3,611 filings in July 2007. Behind many of these new bankruptcies are individual directors and officers, and the intersection of insurance and bankruptcy is where the rubber meets the road with respect to their D&O insurance.

Therefore, individuals facing claims in bankruptcy could end up paying thousands of dollars in legal fees out of their own pockets just to establish their right to the D&O insurance.

FROM D&O DISPUTES TO BANKRUPTCIES

If there are potentially covered claims against both the company and the individual directors and officers, the fact of entity coverage sets up a potential conflict over the policy limits in bankruptcy.

Back when the company was a going concern and it purchased its D&O insurance, there may have been understandings, agreements or even endorsements granting the directors and officers first dibs on the policy proceeds.

But management can lose, or even cede control, to a trustee whose job it is to maximize funds flowing into the bankruptcy estate. If there is any way the trustee can obtain insurance money to pay claims against the company, they will probably attempt to do so.

At the same time, if the bankruptcy automatic stay applies to the insurance proceeds, the insurer also loses control over its ability to advance defense costs to individual directors and officers. The automatic stay is a powerful tool for the bankruptcy trustee because it halts any act to obtain possession of, or exercise control over, "property of the bankruptcy estate."

In practical terms, this means that, if the D&O policy proceeds are considered to be "property of the bankruptcy estate," then the insurance company is stayed from "exercising control" over that property.

What can ensue is an expensive legal fight between the trustee, the individual directors and officers, and the insurer over control of the policy proceeds. Even though it may seem obvious to an insurance expert, it comes as an unpleasant shock to many directors and officers that the fees required to resolve this conflict are not covered by insurance and must be paid out-of-pocket.

In addition, many courts resolve these disputes by undertaking a "fact intensive inquiry" into whether the debtor company has a "direct interest" in the policy proceeds. The phrase "fact intensive inquiry" should strike fear in the heart of any consumer of legal services, because it often means hundreds of hours of billable work.

There are strategies for avoiding this inquiry, if you understand it.

WINNING STRATEGIES

The first task for the individual directors and officers seeking to regain control of their D&O insurance is to establish that the D&O policy proceeds are not property of the bankruptcy estate.

Courts widely agree that the D&O policy itself is property of the corporation and therefore is property of the bankruptcy estate, but courts are split with respect to whether the policy proceeds are property of the estate in certain situations. A few illustrations:

1. If the policy being considered is a Side-A-only policy, or certain difference-in-conditions or independent director liability policies, the debtor company likely has no direct interest in the policy proceeds, and the trustee in bankruptcy would be wasting their time to seek these proceeds. These types of policies are written solely for the benefit of individuals, and the proceeds would likely be deemed to fall outside the bankruptcy estate.

2. Similarly, if there are no claims against the debtor company, it likely will not be deemed to have a direct interest in the policy proceeds. D&O policies, after all, are liability policies. If there is no chance of company liability, it is difficult for the trustee to assert a direct interest in the insurance. In this situation, it may be helpful for individual directors or officers to enlist the insurer's assistance in quickly seeking an order from the bankruptcy court giving the insurer permission to pay their legal fees.

3. A slightly tougher (but winnable in many jurisdictions) battle looms if the policy being considered also offers Side B coverage to reimburse the debtor company for money it spends indemnifying the directors and officers for covered claims. In this situation, the inquiry becomes more complex.

Some courts have held that where the debtor company's indemnification obligation is "established" and not merely "speculative," then the policy proceeds are property of the bankruptcy estate and are subject to the automatic stay.

Other courts have held that it is more practical to allow the insurer to meet the debtor company's indemnification obligation by paying the individual directors directly. In this situation, the individuals may find their interests are aligned with the insurer's interests: Both want to avoid the expense, hassle and risk of funneling payments through the bankruptcy trustee.

4. Finally, if there are covered claims against both the company and the individual directors and officers, and if the company purchased a D&O policy providing entity coverage for "claims" asserting "wrongful acts," a trustee may be willing to spend money seeking the D&O proceeds.

Some courts are more likely to find that the company has a "direct interest" in the policy proceeds in this situation. They reason that this as a zero-sum game: any insurance limits paid by the insurer to the individual directors and officers are limits that are not available to the trustee to defend or settle claims against the company. The outcome of this type of dispute is highly dependant upon the jurisdiction.

PREVENTIVE MEDICINE

The only sure way for individual directors and officers to avoid paying for these battles is for their company to purchase stand-alone Side-A-only policies, difference-in-conditions policies, or even individual director liability policies for their benefit.

In the regular course of business, however, this is not always fiscally reasonable. If a single D&O policy with Side-A and entity coverage is in the company's best interests, then the company can provide strong arguments in favor of preserving policy proceeds for its directors and officers in the event of bankruptcy. These can include a priority-of-payments clause and well-crafted bankruptcy provisions negotiated up front through the broker and coverage counsel.

Your directors and officers will thank you later.

October 1, 2008

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