Lehman Bankruptcy, Defense Expenses, and D&O Insurance

The September 2008 collapse of Lehman Brothers resulted in the largest bankruptcy filing in U.S. history, as well as an explosion of litigation and regulatory actions and investigations. In the pending bankruptcy proceedings a recent motion by the debtor's counsel details the massive legal costs accumulating in the various legal proceedings and also raises some interesting D&O insurance implications.

Special thanks to Wayne State University Law Professor Peter Henning, who provided me with copies of the bankruptcy-related documents and who previously these issues on the Dealbook blog, here.

On July 27, 2010, counsel for the debtor filed a motion in the Lehman Brothers bankruptcy proceeding under Bankruptcy Code Section 362 for relief from the automatic stay in order to allow certain of Lehman's excess D&O insurers to advance defense expenses.

According to the motion papers, for the policy period May 16, 2007 to May 16, 2008, Lehman carried an aggregate of $250 million in D&O insurance, consisting of a $20 million primary policy and sixteen layers of excess insurance. A copy of the Lehman primary policy, which is included in the bankruptcy pleadings, can be found here.

In March and November 2009, respectively, the bankruptcy court previously entered orders granting relief from the stay to allow defense fees to be paid first from the $20 million primary policy and then from the $15 million first excess policy.

However, the motion papers note, submitted defense fee statements already exceed the limits of liability of the first excess policy (i.e., the aggregate fees already exceed $35 million). The motion seeks relief from the stay to allow the second excess insurer, whose policy provides limits of $10 million in excess of $35 million, to advance defense expenses.

The motion goes on to state that the second excess policy's $10 million excess of $35 million limits are likely to be exhausted "by August of this year." (That is, fees apparently already have or are about to top $45 million.) Accordingly the motion asks for relief from the stay for third excess policy, which provides limits of liability of $10 million excess of $45 million.

The third excess policy may also soon be exhausted. The motion suggests that the third excess policy may be exhausted by October. So the motion also asks for relief from the stay for the fourth excess policy, which provides limits of $15 million in excess of $55 million.

In answer to the obvious question of how so much defense expense could be accumulating so rapidly, the motion provides a brief recitation of the various proceedings in which the company's former directors and officers are involved. First, there are the various securities class action lawsuit which have been brought by Lehman security holders. Then there are the various securities lawsuits which have been brought against former directors and officers in connection with the plaintiffs' purchases of mortgage-backed securities. There are also additional actions or arbitrations which have been brought against certain individuals in connection with Lehman-issued securities, auction rate-securities and other alleged conduct.

In addition, the U.S. Department of Justice as well as the SEC and the New Jersey Bureau of Securities have "commenced formal grand jury and regulator investigations concerning the circumstances surrounding the collapse of the Lehman enterprise and have issued various requests and subpoenas," according to the motion papers.

All of these various proceedings undoubtedly took on a heightened sense of urgency after the March 11, 2010 release of the report of the bankruptcy examiner, Anthon Valukas, in which he referred, among many other things, to what he regarded as "actionable balance sheet manipulation."

In light of all of these various proceedings and given the fact that each of the individuals undoubtedly has their own counsel, it may be unsurprising that defense fees are accumulating so rapidly. Indeed, as Professor Henning notes in his Dealbook post, the fees seem to have been accumulating more rapidly in recent months, to the point that the fees now seem to be running at about $5 million a month. At that rate, even the fourth excess policy is likely to be exhausted before year's end.

Given the size of Lehman's insurance tower, there may be no immediate reason for the individual defendants to be alarmed. Even were the fourth excess policy to be soon exhausted, that would still leave $180 million in insurance available to cover the defense expenses.

But even if there may be no immediate cause for alarm for the individuals, the events so far and that likely lie ahead do present some noteworthy issues.

First, the sheer volume of defense expense so far dramatically underscores the enormous potential for a catastrophic claim to produce astonishing levels of defense expenses. To be sure, the Lehman collapse, as the largest bankruptcy in U.S. history, may represent an extreme case. But it is not as if the Lehman situation is the only case where enormous defense expenses have rapidly accumulated. To cite just two examples, in prior posts I have detailed the huge defense expenses that accumulated in the Broadcom options backdating lawsuit (refer here) and in connection with the Collins & Aikman bankruptcy (refer here).

In that regard, it should noted that not only has the pace of defense fee accumulation in the Lehman case accelerated in recent months, but the fees seem likely to accumulate even more quickly if the SEC were to file an enforcement action or the DoJ were to file criminal charges. As astonishing as are the fees that have accumulated already, it seems possible (arguably, probable) that even more astonishing fees could lie ahead. Professor Henning's blog post, linked above, discusses these possibilities in greater detail.

While it is still only the catastrophic claims circumstances that produce these kinds of enormous fees, these cases do raise some very serious questions about traditional notions of limits adequacy. The fact is that the most important purpose of D&O insurance is to ensure that the individual directors and officers are protected in the event that the corporate entity is unable to indemnify them. These catastrophic claims scenarios demonstrate how challenging it may be to ensure that the D&O insurance can provide sufficient protection at the point where it is most needed.

One answer to this challenge may be the one that Lehman itself apparently followed, which is to buy very significant amounts of D&O insurance. Of course, not every company can afford to purchase anywhere near the amount of insurance that Lehman did. (To put the Lehman insurance program into perspective, the primary policy alone - which was written over a $10 million corporate reimbursement retention - cost Lehman more than $2 million. Clearly Lehman was willing to invest very substantial sums for its executives' protection.)

For that matter, it remains to be seen if even the huge amount of insurance that Lehman put in place will be sufficient to protect the individuals from all of the defense expenses that may lie ahead. If the SEC were to file an enforcement action and the DoJ were to pursue criminal charges, it is not impossible that the accumulating defense expenses could test even the remaining limits

(And that is without even allowing for the possibility, raised by Professor Henning in his blog post, that one or more of the excess insurers might seek to disclaim coverage - "You know how insurance companies can be," he comments.)

There are no easy solutions to these kinds of concerns, although one consideration that should be taken into account is D&O insurance program structure. That is, in addition to considering the question of how much insurance is enough, the question of what structure of insurance should be put into place should also be considered. Among other things, one particular question is whether specific parts of the program should be designated solely for the protection of specific individuals (for example, outside directors) as one way to ensure that no matter what happens there is always a specific pot of money available for the protection of those individuals.

In any event, the consequences following the Lehman collapse are continuing to unfold and undoubtedly have much further to run. The astonishing accumulation of defense expense seems likely to continue if not accelerate. Whether or to what extent any of the D&O insurance might be available to pay settlements or judgments remains to be seen.

This last point, about possible funds for settlements or judgments, does underscore an issue that could well become critically important later on. That is, the D&O insurance tower that is responding to these various proceedings is the one that was in place for the period May 2007 to May 2008. However, Lehman filed for bankruptcy in September 2008. There is in fact, according to footnote 6 of the debtor's memorandum in support of the motion for relief from the stay, a separate $250 million insurance tower that was in place for the period May 16, 2008 to May 16, 2009.

The 2007-2008 tower presumably is the one that is responding to these various proceedings because the first of the shareholder lawsuits apparently was filed in February 2008, during the policy period of the earlier tower, and later filed proceedings apparently have been treated as interrelated with the first filed claim, and therefore relate back to the date the first claim was made.

Given the huge amount of money at stake and in light of the fact that the 2007-2008 tower is being substantially eroded, it seems probable that someone will find it worthwhile to try to establish that one or more of the various claims triggered the 2008-2009 tower. (Indeed, it may well be that this type of effort is already well underway in one or more disputes or proceedings.) Before all is said and done in connection with the fallout from the Lehman collapse, there could be many twists and turns.

With as many as 17 different D&O insurers involved in this claim, there undoubtedly are quite a number of professionals in the D&O insurance industry involved in this matter. With a situation like this, there could be some pretty good scuttlebutt. I encourage anyone involved in this matter who is willing to share to post a comment using this blog's comment function (anonymously if necessary). I am certain there is a lot more going on in this claim than can be discerned from the bare face of the pleadings.

Finally, for those practitioners who would appreciate insight into how the D&O insurance policy operates in the bankruptcy context, the debtor's motion makes some pretty interesting reading. The motion not only shows how the the policy proceeds are administered and monitored in light of bankruptcy procedures, but it also illustrates how various key policy provisions (for example, the priority of payments clause) are intended to operate.

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.