By DONNA L. WILSON, a founding partner of the insurance recovery practice group of Kelley Drye & Warren LLP, in the Washington, D.C. office; JOHN W. MCGUINNESS; and JENNIFER BEST VICKERS, both litigation associates in the same practice group
The ongoing credit crisis is placing directors and officers in the cross-hairs of litigation being brought by disgruntled shareholders in securities lawsuits and trustees in bankruptcy, as well as in government investigations and enforcement actions.
While directors and officers look to their directors' and officers' (D&O) insurance coverage for defending against these actions, the ever growing risk of bankruptcy among many companies as a result of the deteriorating economy can complicate the recovery of the insurance to which these directors and officers are entitled.
While D&O policies historically were created to provide directors and officers with coverage for their defense costs and liabilities, the scope of D&O policies has expanded over time to include coverage for the costs incurred by the "named entity" corporation while indemnifying its directors and officers, and in defense of particular claims asserted directly against the corporation.
Given this unique structure, multiple claims filed against a company and its directors and officers at one time present the very real concern that the policy limits could be entirely exhausted without substantially covering the defense costs and liabilities incurred by the directors and officers.
In fact, it has been estimated that as a result of claims relating to the credit crisis insurers will pay out more than $6 billion in D&O coverage. It has been reported that the D&O losses are so great at this point that the payouts have already exceeded the earned premium on those policies.
Further complicating the issue is that it has not always been clear that when a company has filed for bankruptcy the directors and officers can collect on the proceeds of the policy. Again given the unique structure of D&O insurance, bankruptcy courts have long struggled with the question of whether D&O policies, or their proceeds, are assets of a bankrupt corporation's "estate," and thereby subject to the automatic stay under the Bankruptcy Code and are not recoverable by directors and officers.
Accordingly, before coverage is provided under D&O policies, courts are being compelled to first determine whether the D&O policy proceeds are assets of the bankruptcy estate.If the proceeds are not considered assets of the bankruptcy estate, courts then determine how the proceeds are allocated under the policy, and whether coverage is barred by the "insured v. insured" exclusion.
When determining whether D&O policy proceeds are property of the debtor's estate the court must ask who owns the liability under the policy. Generally speaking, if the D&O policy is a Side A-only policy, the directors and officers are the sole beneficiaries and the proceeds are typically not considered a part of the bankruptcy estate.
Like Side A coverage, Side C or "Entity" coverage generally provides a clear answer as to whether directors and officers can access the proceeds from their D&O policy. Because a Side C policy plainly provides the debtor company with a direct benefit, policy proceeds can be used to defend or settle claims against the company, for example, courts typically determine that it is property of the bankruptcy estate.
This is particularly troubling for directors and officers because typically all types of coverage under a D&O policy have a single shared limit of liability. In these circumstances, where multiple insureds, including the company, pursue D&O limits on a first-come first-served basis, coverage may be unavailable to the individual insureds at the precise time it is needed the most--when their company has filed for bankruptcy.
The equation becomes more complicated where the policy also provides reimbursement coverage.There, courts are split on who owns the policy benefits.
Side B coverage provides a benefit to the debtor by reimbursing the company for indemnifying directors and officers for covered claims.Some courts have held that Side B coverage is not property of the debtor estate where the debtor's duty of indemnification is speculative, however, where the debtor company must actually indemnify the directors and officers, they become an asset of the bankruptcy estate and the debtor is entitled to the proceeds.
Other courts have held that where it is determined that the policy may benefit the estate, the proceeds are an asset of the bankruptcy estate and are indeed subject to the automatic stay.In any event, where courts have determined that the proceeds of a D&O policy are assets of the debtor's estate, a legal battle often has ensued to determine whether the directors and officers, the insurer, or the trustee control the proceeds of the policy, the fees for which are not covered by insurance.
In order to guard against the exhaustion of policy proceeds without individual insureds receiving substantial coverage for losses incurred, some D&O policies provide a clear framework for allocation, such as the inclusion of an "order of payout" provision. These provisions generally specify the order in which claims triggering multiple coverage clauses are paid.
Typically, order of payment provisions specify that losses implicating Side A coverage are paid first, followed by losses covered under Side B coverage, and, if limits remain, losses covered by Side C are paid. However, where these provisions are ambiguous courts may allow companies in dire straights--for example, after filing for bankruptcy ? to "cut the line" and determine that the policy is an asset of the estate.
BARRED BY EXCLUSIONS?
This exclusion eliminates coverage for claims brought by parties that are themselves insureds under the policies.The purpose of the exclusion has generally been understood as preventing collusive activity between two or more insureds. Given the recent wave of subprime-related litigations and bankruptcies, and the exorbitant amounts being paid out for D&O coverage, insurers have taken the position that this exclusion eliminates coverage for claims asserted by the trustee against the companies' directors and officers.Insurers have argued that coverage is denied because the trustee is merely stepping in the shoes of the policy insured--the company--in an action against the company's directors and officers.
While this argument has met with mild success, a majority of courts have held that the "insured v. insured" exclusion does not apply to claims brought by a bankruptcy trustee or estate representative because there is no real threat of collusion and the bankruptcy estate is a separate legal entity, created by the federal bankruptcy law.Further, some policies provide that claims brought by a bankruptcy trustee are excepted from the "insured v. insured" exclusion. In these tough financial times, where subprime lenders face ruinous lawsuits, a record number of companies are filing for bankruptcy, and insurers are making record payouts on D&O policies that exceed their premiums, directors and officers must ensure that their D&O policies will cover their defense costs and liabilities.
To that end, directors and officers would be well served to insist that their companies obtain Side A only policies, with clear allocation of proceeds language, and exceptions to the "insured v. insured" exclusion for claims brought by bankruptcy trustees in order to avoid having to bear the significant financial burden of defending these actions and paying for any consequent liabilities.If these steps are taken, directors and officers may remain covered by D&O insurance.
April 15, 2009
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