More About D&O Insurance and Bankruptcy

More About D&O Insurance and Bankruptcy

 Although D&O insurance represents an important risk management tool for every company, the protection that a D&O insurance policy affords directors and officers is particularly important in the bankruptcy context, when the company is no longer able to indemnify the individuals. Yet, as industry practitioners know, a number of issues recur in the bankruptcy context, particularly as creditors and bankruptcy trustees seek to preserve policy proceeds while the failed company’s directors and officers are seeking to rely on the policy to defend themselves against pending claims.

The problem of trying to fund individuals’ defense expenses under the D&O insurance policy while the insured company is in bankruptcy is a recurring theme on this blog (refer, for example, here and here). Over time, a number of standard practices have evolved to facilitate defense expense funding in the bankruptcy context. For example, it is now fairly standard for the insureds and the insurers to approach the bankruptcy court to seek a “comfort order” allowing the insurer to fund the individuals’ defense expenses, notwithstanding any objections of the creditors or the bankruptcy trustee to the use of policy proceeds for these purposes.

Though these procedures are now routine, problems still nevertheless emerge, as discussed in an October 22, 2013 memorandum from the Lowenstein Sandler law firm entitled “How to Handle D&O Coverage in a Bankrupt Co.” (here).

As the memo’s authors note, while bankruptcy courts now routinely grant the requests of the insurers and the insureds to allow the D&O insurance to be used to fund the individuals’ defense, the order is often subject to an interim funding cap (sometimes called a “soft” cap) and accompanied by a requirement that the parties provide periodic updates on defense expenditures. To see an example of a recent case in which a bankruptcy court entered an order allowing the insurance to be used to fund the individuals’ defense subject to an interim cap and reporting requirements, refer here.

The authors refer to other recent cases where the order permitting the individuals’ defense expenses to be funded subject to an interim cap and reporting requirements. One of the cases the authors refer to is the high profile MF Global case. As discussed here, in April 2012, the bankruptcy judge lifted the stay in the MF Global bankruptcy to allow the company’s insurers to fund the company’s former directros and officers’ defenses, subject to an interim cap of $30 million and to reporting requirements. The law firm memo notes that the creditors and claimants who had opposed the order appealed the ruling to the district court, which affirmed the ruling, and have now appealed to the Second Circuit. The appeal is scheduled to be argued in late November.

One inherent problem with the use of interim funding caps became apparent in the MF Global case this summer, when the parties returned to court in order to try to get approval to fund defense expenses in excess of the initial $30 million cap. As discussed in a June 28, 2013 Law 360 article entitled “MF Global Judge Rips $40 Million Defense Cap Request” (here, subscription required), U.S. Bankruptcy Judge Martin Glenn took a negative view of defense requests to increase the interim cap to $40 million. He expressed concern that the defense expenses had so quickly reached the cap, particularly given that the case had barely gotten underway. According to the report, Judge Glenn said “individual insureds may have the right to coverage. They don’t have the right to a blank check.”

On September 20, 2013, Judge Glenn deferred ruling on the request to increase the cap, in light of the pending appeal. As discussed here, the executives recently asked the court to reconsider his ruling, in light of the fact that their defense expenses to date have exhausted the amounts within the initial cap, and that without relief they are unable to maintain their defenses in the ongoing proceedings.

As the law firm memo’s authors note, a bankruptcy court’s limitations imposed in interim funding agreements present a number of problems; first, the existence of interim caps and reporting requirements

puts directors in the awkward position of having the party that is suing them looking over their shoulders as they defend themselves and in a position of potentially scaling back a vigorous defense for fear of a future petition to limit the insurer’s reimbursement obligation for defense costs incurred.

The ruling also provides the committee with the added benefit of being able to “look behind the curtain” during settlement discussions to know exactly how much insurance money is available.

The other problem with the conditions bankruptcy courts place on the funding orders is demonstrated in the MF Global case; the interim funding cap creates the possibility that the court might refuse to increase the cap, putting the individual defendants in “limbo” as they are unable to access additional defense cost coverage for the claims pending against them.

The memo’s authors suggest that the funding problem in the MF Global case could have been avoided if it had had different wording the priority of payments clause in its D&O insurance policy. These clauses, which are now standard in most D&O insurance policies, address how the D&O insurance policy’s limits of liability are to be paid out so that the liabilities of the individual insureds are to be given priority and paid first. The authors suggest that the possibility that the problems the MF Global directors and officers are now facing could have been averted if its policy had the type of priority of payments provision that “unambiguously state that the corporate entity and any successor, trustee or receiver has no rights to the insurance policy proceeds until all claims asserted against the individual insureds have been resolved.”

There is no doubt that stronger wording of the priority of payments provisions is desirable and that policyholders should always endeavor to obtain the wording that is most protective of the individuals’ payment priority. However, I am not entirely sure that a different wording in the priority of payments provision alone would have been sufficient to avoid the problems the former MF Global officials are now facing.

First of all, MF Global’s policy not only has priority of payments provisions, but those provisions were instrumental in Judge Glenn’s initial ruling lifting the stay and allowing the individuals’ defense costs to be paid. As discussed here, in his initial ruling, Judge Glenn considered it particularly important that the primary D&O policy had a provision giving priority to payments under the insuring provisions that protects the individuals. Judge Glenn specifically stated about these provisions that “coverage potentially afforded to the Individual Insureds for non-indemnifiable losses must be paid prior to any payments for matters implicating coverage potentially provided to the Debtors.”

Second, Judge Glenn’s decision to defer a ruling on the individuals request to increase the cap apparently was based on the pendency of the appeal of his initial ruling lifting the stay and allowing the interim funding. His views on the petition to raise the interim funding cap seem to have been influenced more by what he viewed as the surprising magnitude of the fees incurred to date, rather than any specific interpretation of particular policy provisions.

I am not certain that different wording of the priority of payment provisions alone would eliminate the now fairly standard bankruptcy court practice of granting an order lifting the stay to allow D&O insurance to fund defense expenses subject to an interim cap and reporting requirements. The courts’ insistence on these requirements is more about the maintenance of judicial control than it is about the provisions of the insurance policy. In many bankruptcy cases (for example, even in the high profile Lehman Brothers bankruptcy) these judicial requirements are administered routinely and without incident. The problems involved in the MF Global case arguably are a reflection of circumstances unique to that case – particularly the pendency of the appeal.

I have always thought that all of these recurring bankruptcy court problems are the result of a fundamental misconception of the D&O insurance policy. For obvious reasons, claimants and creditors want to establish that the D&O insurance policy exists for their protection and benefit. For less obvious reasons, some courts fall for this, which I have always found frustrating.

The fact is that insurance buyers purchase D&O insurance to protect the insured persons from liability. No one pays insurance premium as a charitable act for the benefit of prospective third party claimants. Liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants. The very idea that claimants who have not even established their right of recovery from the insureds should somehow be able to deprive the insureds of their right to use their insurance to protect themselves stands the entire insurance proposition on its head.

All of that said, I agree completely with the memo’s authors that the wording of the priority of payments clause is critically important, and that the time to address these concerns is at the time the coverage is placed.

A Final Note: The memo’s authors suggest that in light of the fact that D&O insurance policy wordings can be negotiated and that wordings are constantly changing, directors and officers “should consult with experienced coverage counsel and/or make a commitment to remain abreast of key changes in the policy forms.” I agree that the involvement of coverage counsel can be useful in the policy placement process. We frequently work with outside counsel when we place policies for our clients and generally find counsel’s involvement to be productive.

However, the memo’s authors also state the following in support of their contention that outside counsel should be involved in the D&O insurance placement process: “most individual officers will rely on their insurance brokers to ‘take care’ of policy placement and review of the policy terms. This is a mistake.”

Although we often work with our clients’ outside counsel in connection with policy placements, in the vast majority of the placements on which we work, there is no involvement of outside counsel. The fact is that in most instances there is absolutely no need for these companies to incur the added cost of outside counsel in the insurance placement process.

Of course it is important for companies to insure that they have knowledgeable, skilled broker involved in placing their insurance. If the company has taken care to ensure that it has a capable broker involved, it is not a “mistake” for the company to rely on the broker.

In some D&O insurance placements, counsel should be involved, and in other cases it is helpful to have counsel involved. Fortunately, in the vast majority of D&O insurance placements, there is no need for companies to incur the cost of outside counsel – and the suggestion that it is a “mistake” for those companies to rely on their brokers is unwarranted. Again, if the company has taken care to ensure that its broker is knowledgeable and experienced, the company is completely justified and conducting itself prudently in relying on their broker.

Fortunately, I find that knowledge outside lawyers involved in the placement process fully appreciate that the broker has a valuable and important role to play.

Read other items of interest from the world of directors & officers liability, with occasional commentary, at the D&O Diary, a blog by Kevin LaCroix.

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