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By STEVE TUCKEY, who has written on insurance issues for a decade for several national media outlets

While spectacular bankruptcies that befell Bear Stearns & Cos. Inc., Lehman Brothers and the all-but-in-name event for AIG have dominated the news recently, more nonhousehold name businesses are going under as the Great Recession takes its toll.

For decades, directors' and officers' (D&O) insurance has offered protection against financial hardship stemming from their duties. But bankruptcies, and in particular those of banks, pose new challenges for risk managers with companies looking to attract the best talent to the boards at a time when it is needed the most.

The first challenge is making sure the insurer will be around to pay the claim.

"Watching your company purchase directors' and officers' insurance during the current financial crisis is a little like playing Russian Roulette," said Timothy Burns, Madison, Wis.-based attorney for Perkins Coie, noting that trying to discern the dangers lurking beneath D&O insurers' balance sheets is virtually impossible.

Burns also recommends relatively small layers of coverage to guard against the potential of a troubled carrier holding all the eggs. He dismissed suggestions that several smaller layers make settlement more difficult because of so many parties, and even suggested it could make it easier.

"No insurer stands to lose as much as settling a case, and insurers are more likely to pay a small D&O loss than a large one," he said.

The concern most potential directors fear is a bankruptcy of the company they will oversee. For the result could be a company unable to indemnify them in the event of any lawsuit that could arise from angry employees or shareholders looking to assign blame. This concern is magnified if there is some sort of accounting or other malfeasance involved.

Jack Flug, New York City-based managing director for Marsh's financial and professional liability practice, said many directors are engaging independent counsel to study the D&O protection before they join large companies, or those that have been the targets of extensive litigation in the past.

These potential directors have every right to fret some over the bankruptcy ramifications of their liabilities.

A report published earlier this year by Philadelphia-based ACE USA noted that the rate of bankruptcy filings has more than doubled in the past two and a half years, while the 207 bankruptcies of publicly traded companies was the third highest in a single year since 1980.

"Bankruptcies are a lagging economic indicator, tending to follow the poor financial news by a period of three quarters or more," said Carol Zacharias, report co-author and ACE senior vice president.

Bank failures have more than kept pace with the number of other events and pose a greater threat of a lawsuit.

"Regulators pull out the books prepared to sue, wanting money back in the till to help people survive, and quell public frustration," Zacharias said.

Bankruptcies can come in the Chapter 7 variety, in which the entity is eventually dissolved, or in the Chapter 11 variety, in which a company is reorganized for future operation under new management. In any case, a petition freezes the company's debts, assets, liabilities, which have important ramifications for D&O insurance.

If the D&O policy and proceeds are subject to the freeze, only the bankruptcy court can authorize the insurer to pay for defense costs and other expenses of the directors and officers.

Zacharias said creditors could oppose spending insurance proceeds, which they could recover for themselves. "The majority of court rulings, although not all, have held that D&O policies, but not proceeds, are property of the estate," she said.

Those proceeds are more likely assets of the bankrupt estate if the D&O policy provides coverage for claims against the entity. "Some courts see the addition of direct coverage for the corporation as changing the policy into a vehicle for both individual and corporate protection," she said.

And that is where the strength of the so-called Side-A protection, or coverage for the directors and officers for costs not indemnified by the corporation.

Rick Grimes, executive vice president for Somerset, N.J.-based Professional Risk Solutions, said nonrescindable Side-A coverage and Separate Side A-only insurance could be the answer.

"In the event the company enters bankruptcy and a court freezes the D&O policy as an asset of the bankruptcy estate, this policy will provide protection," he said.

In addition, Side-A excess difference-in-conditions coverage would respond if the limits of the primary insurer were ever exhausted by defense costs or a settlement, he said.

Paul Ferrillo, New York City-based attorney with Weil, Gotshal & Manges, said potential directors and officers looking at the risk of their new posts could make sure the company's D&O policies contain a full severability clause so that in the cause of fraud on the part of some directors and officers, the innocent would still enjoy full coverage.

"One type of full severability provisions requires that the D&O insurance carrier in order to rescind coverage in its entirety must prove actual knowledge of the fraudulent acts to every individual covered under the D&O policy," he said.

And what happens when a bankrupt entity gains new owners through either an asset sale or a court restructuring? A D&O policy termination could result with so-called "tail coverage" of usually about a year for claims made after the termination date. That tail coverage, however, requires a premium that creditors may object to.

"If the management of a corporation is aware that Chapter 11 is a near-term possibility, it should consider making payments under the tail coverage that would alleviate some concerns that the subsequent payments under the tail coverage may be rejected," Ferrillo said.

A director or officer could find himself on the short end of the D&O indemnification stick if the corporation itself brings the suit as a so-called debtor in possession. The so-called "insured vs. insured" exclusion is aimed at ensuring directors and officers do not collect from an action they themselves initiated. Many policies contain a carve-out for such bankruptcy related claims.

"This standard carve-out is a trap for those unfamiliar with how Chapter 11 bankruptcy proceedings work," Ferrillo said. "It is essential for a corporation to add language to the carve-out for the insured vs. insured exclusion that includes claims brought by a debtor in possession, Chapter 11 trustee, creditors, bondholders, all committees and other bankruptcy constituencies," he said.

Numerous other caveats exist to make the Side-A coverage as "bullet-proof" as possible against creditors and other stakeholders looking to salvage as much as possible out of the carcass of a bankrupt enterprise.

Carriers continue to develop products to meet the need.

Flug said that in some instances when you have troubled companies looking to attract the requisite kind of talent to turn them around, there is a different kind of Side-A coverage known as independent director liability coverage.

"This is only for independent directors and so management of the company has no access to it," he said.

Such coverage could represent the final icing on the cake for those big names who may have headed large companies in the past. They could bring a patina of respectability to a company looking to recover a tarnished reputation, but fear putting their personal fortunes in jeopardy.

Despite the troubled economic times, Flug does not see any drought of board talent that may be skittish about lawsuit-happy shareholders or other stakeholders.

"From all accounts and everything that I have heard, it seems just the opposite," he said. Organizations, however, are becoming more selective and even regimented in looking for board members who have significant experience and "can lend credibility from a corporate strategy standpoint, from an auditing standpoint," he said.

In other words, if O.J. Simpson ever makes it out of jail, it's unlikely he will be asked to sit on any more audit committees like he may have been in the past.

August 1, 2010

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