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Under Siege: The Effect of Bankruptcy on D&O Protections, Contributed by Marla H. Kanemitsu, Dickstein Shapiro LLP

Friday, February 24, 2012

While business bankruptcy filings decreased in 2011 overall, the bad news is that there were still almost twice as many filings in 2011 as in 2007.1 And while the economy is showing signs of growth, the recovery will not come soon enough for some companies to avoid bankruptcy. Eastman Kodak, MF Global, American Airlines’ parent company AMR Corp., and Borders are just a few of the high profile bankruptcies filed in 2011 or the first few months of 2012.

When a business files for bankruptcy, people start pointing fingers, and the blame frequently falls on the company’s directors and officers. For example, Eastman Kodak filed for bankruptcy on January 19, 2012, and a putative class action against certain of its directors and officers was filed a mere eight days later.2 Other plaintiffs’ law firms already have announced that they are conducting investigations with the intent of filing similar suits in the future.3

Directors and officers typically have certain protections available to help shield them from liability. Two primary forms of protection are corporate indemnification and directors’ and officers’ (D&O) insurance. When a corporation is solvent, these protections generally operate as intended. However, when a corporation enters into bankruptcy, the protections can come under attack, leaving directors and officers vulnerable just when the risks they face are at their peak. Directors and officers should be aware of the risks, discussed below, and, to the extent possible, take steps to guard themselves from these attacks.

CHALLENGES TO SECURING INDEMNITY FROM THE BANKRUPTCY ESTATE

In order to attract the best possible leadership, corporations are generally required to indemnify their directors and officers for any attorneys’ fees and legal expenses the directors and officers incur to defend themselves against civil, criminal or investigative actions arising out of their corporate duties. These indemnification obligations can be found in indemnification statues, corporate charters or bylaws, and in contracts with the corporation. In some cases, corporations also may provide indemnification for certain types of judgments or settlements for which the directors and officers may be held liable.

Once a corporation files for bankruptcy, a director or officer who is otherwise entitled to indemnification has nothing more than a claim against the bankruptcy estate, and must attempt to obtain payment for that claim as would any other creditor. In general, only “allowed” claims are paid (in whole or in part) in the bankruptcy. Thus, to obtain indemnification, the first hurdle a director or officer must overcome is establishing that his or her claim should be “allowed.” Here, directors and officers have met with mixed success.

Under the Bankruptcy Code, a claim must be disallowed as a matter of federal law if three criteria are satisfied: (1) the claim is for reimbursement or contribution, (2) the claim is contingent, and (3) the claimant is co-liable with the debtor for the claim.4 A claim for indemnity is considered a claim for “reimbursement,” so the first requirement typically will be satisfied for directors’ and officers’ indemnification claims.5

For the two remaining requirements, it is important to distinguish between a director’s or officer’s claim for indemnification for liability that may eventually be owed to the party that sued it, versus a director’s or officer’s claim for advancement of defense costs incurred to defend itself in the litigation. With respect to indemnity for liability, a party that seeks to defeat the director or officer’s indemnification claim—such as a debtor or bankruptcy trustee—may argue for disallowance of the claim on the basis that it is contingent. A claim is contingent if it has “not yet accrued” and “‘is dependent on some future event that may never happen.’”6 If the underlying suit for which the directors and officers seek indemnification is not yet resolved, courts will likely determine that the claim is contingent.7 However, directors and officers may still be able to establish that they have an allowed claim by attacking the co-liability prong of the disallowance statute. In some cases, the underlying suit may be asserted solely against the directors and officers, or, if the suit also names the debtor as a defendant, it may be the case that the debtor and directors and officers would be co-liable only on some, but not all, of the claims.8 In either situation, the directors and officers may be able to establish that the co-liability requirement is not met, and the claim should be allowed.

With respect to defense costs, the contingency prong should not be satisfied as to that portion of defense costs already incurred by the directors and officers. Thus, a director’s or officer’s claim for defense costs that already have been incurred should not be disallowed. Similarly, there is support for the proposition that future defense costs are merely unliquidated, rather than contingent, and therefore should be allowed.9

With respect to future defense costs, the co-liability prong will be most important. Because a debtor generally cannot be co-liable for directors’ and officers’ defense costs, the co-liability requirement arguably cannot be satisfied, and the claim should be allowed.10 However, several courts have refused to examine directors’ and officers’ claims for defense costs separately from claims for indemnity of any liability to the underlying claimant. These courts have held that if there is a potential for co-liability in the underlying action, any amounts sought by way of indemnification “on account” of the underlying action, including defense costs, will be disallowed.11Notably, however, the court in In re RNI Wind Down Corp. reached a different conclusion where the only claim in dispute was one for advancement of defense costs.12 In that case, the officer had waived any claim for indemnification for the underlying causes of action at issue in the lawsuits. The court highlighted that fact in its ruling, and a subsequent court refused to apply the RNI Wind Down holding where the directors and officers had not similarly waived their indemnification rights.13 Thus, RNI Wind Down and the advance waiver in that case may provide a roadmap for directors and officers seeking to ensure that their claim for advancement of defense costs is allowed by the bankruptcy court.

Even if a director or officer succeeds in establishing that his or her claim should be allowed, recovery is not guaranteed. Allowed claims are typically treated as general unsecured claims, and therefore may not be entitled to substantial recovery.14 Further, certain types of claims can be subordinated.15 Given these challenges, indemnification from the corporation ultimately may have limited value to directors and officers.

CHALLENGES TO SECURING COVERAGE UNDER D&O INSURANCE

Given the difficulties for obtaining a meaningful recovery from the corporation’s bankruptcy estate, D&O insurance may be the principal and last line of defense for directors and officers of bankrupt corporations. D&O liability insurance is designed to protect directors and officers against claims alleging that they committed wrongful acts in their capacity as directors and officers. D&O insurance generally should be available to directors and officers, even when the corporation has filed for bankruptcy. However, when directors and officers of a bankrupt corporation attempt to obtain coverage under a D&O policy, they may be challenged by the debtor, bankruptcy trustee, creditors, or other directors and officers that also have a claim to the coverage. Whether the directors and officers can access coverage generally turns on the type of D&O policy and the claims at issue.

D&O policies typically provide coverage to directors and officers (known as “Side A” coverage) and to the corporate policyholder for amounts it incurs to indemnify the directors and officers (known as “Side B” coverage). Many D&O policies also provide so-called “entity” coverage, which provides the debtor corporation with coverage for certain types of claims asserted directly against the corporation.

If the D&O policy does not provide entity coverage and no claim has been made that would implicate the Side B coverage, courts generally have held that the proceeds of the policy belong to the directors and officers, not the debtor’s estate.16 Thus, the directors and officers typically are able to access the coverage immediately to pay defense costs as they are incurred.17 In these cases, disputes may nonetheless arise amongst the directors and officers if there are insufficient limits available to provide coverage for all of the directors’ and officers’ aggregate liabilities. Since limits of liability are generally accessed on a first-come-first-served basis, a director or officer may seek to reach a quick settlement to ensure that its liability is covered, while leaving less coverage available to the other directors and officers. In these cases, the bankruptcy court may nonetheless step in to ensure an equitable allocation of the coverage.

In contrast, if a claim is asserted against the debtor that implicates the Side B coverage, even if the D&O policy does not have entity coverage, some courts have held that the policy proceeds may constitute property of the bankruptcy estate. These courts reason that allowing the directors and officers to access the defense coverage under the D&O policies would deplete the policy limits, which would, in turn, increase the debtor’s exposure to the indemnification claims.18

The issue is further complicated when the D&O policy at issue also provides entity coverage for the debtor. In such cases, courts typically hold that the D&O policy constitutes property of the bankruptcy estate that cannot be diminished without the approval of the bankruptcy court.19 However, courts have split on whether the proceeds of a D&O policy ultimately should be considered property of the estate or property of the directors and officers. The cases generally turn on whether there is a pending claim against the debtor, or a viable claim could still be made against the debtor, that could implicate the entity coverage. If no such claim exists or could arise (e.g., the applicable statute of limitations has run), courts generally have held that the proceeds of the policy belong to the directors and officers, who are able to access the coverage immediately.20

At the underwriting stage, some potential solutions to avoid these problems may be available. One option is to seek to have a “priority of payment” provision included in the D&O policy. Typically, priority of payment provisions specify that the losses of the directors and officers will be paid first and that the corporate policyholder’s losses will only be paid after the directors and officers are paid in full and only to the extent proceeds remain. Thus, there should be no dispute as to the directors’ and officers’ right to access coverage. Another potential solution is to purchase separate Side A-only coverage, which provide only direct coverage to the directors and officers. Yet another solution is to request that a pre-petition waiver of the Bankruptcy Code automatic stay be included in the D&O policy. This type of provision provides that the insureds agree not to oppose or object to any efforts by a director or officer to obtain relief from the automatic stay in order to obtain immediate access to the coverage. In the absence of these types of provisions, directors and officers should nonetheless be entitled to coverage under D&O policies for their defense costs and liabilities. However, they may face challenges in order to enforce their rights.

CONCLUSION

Serving as a director or officer of a corporation can have many benefits, but it is not without risks. This is particularly true when the corporation goes into bankruptcy. However, even in the face of increased risks from bankruptcy, directors and officers can take steps to protect and enforce their indemnification and insurance rights to the maximum extent possible. Given the highly complex nature of both bankruptcy and insurance law, directors and officers who find themselves in this situation should consult counsel to fully evaluate their options and rights.

Marla Kanemitsu is a partner in the firm’s Insurance Coverage Practice. In addition to her insurance work, Ms. Kanemitsu has extensive experience representing clients in class action and other complex litigation involving consumer products and services.  

Disclaimer  

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