by Christopher Graham and Joseph Kelly

You’re elected a director of a company. Great, you think. What an honor! $$$ too! Well, even better than the honor.

Flash forward. Great becomes not so great. Your company has little money. Creditors are up in arms. Company files bankruptcy. A Chapter 7 liquidation. Bad.

Bad becomes much worse. Your company’s largest creditor is really, really mad. It’s stiffed big time. And it says it was deceived . . . by you, other directors, and your company’s overseas parent. It sues for many millions. It alleges fraud and Federal and state RICO violations. And you’re a target. That’s a heap of trouble.

But lucky for you, there’s a D&O policy. You wouldn’t serve without it. And it’s still effective. $10 million in limits too, though they’re “wasting” for defense fees.

There’s also an “Order of Payments” clause 22:

In the event of Loss arising from a covered Claim for which payment is due under the provisions of this policy, then the Insurer shall in all events:

(a) first, pay Loss for which coverage is provided under Coverage A [(Executive Liability)] and Coverage C [(Outside Entity Executive Liability)] of this policy; then

(b) only after payment of Loss has been made pursuant to Clause 22(a) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverage B(ii) of this policy [(Organization Liability, Corporate Reimbursement)]; and then

(c) only after payment of Loss has been made pursuant to Clause 22(a) and Clause 22(b) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverages B(i) [(Organization Liability, Securities Claims)] and D [(Crisisfund® Insurance)] of this policy.

Your claim, with other directors’ claims, thus has priority over your bankrupt company’s claims.

Your policy also says “The bankruptcy or insolvency of any Organization . . . shall not relieve the Insurer of any of its obligations to prioritize payment of covered Loss under this policy pursuant to this Clause 22.”

So at least you can hire good legal counsel. No worries about paying their bills. You think.

But then your D&O insurer balks, sort of. Yes, it will advance your defense fees and expenses; but only subject to a reservation of rights and only if a bankruptcy court approves.

“Say what? I may not get my fees paid? What about the Order of Payments clause? Why is my insurer saying it needs a court order? What if the court says no? How could it?”

Well, insurance policies are “assets” of your company’s bankruptcy estate, per your Federal appeals court. Maybe policy proceeds are too. Paying your fees thus may violate the “automatic stay.”

Filing bankruptcy automatically stayed “any act to obtain possession of property of the estate or of property from the estate or to exercise control over property of the estate . . . .” 11 USC 362(a)(3). So if the policy or proceeds are “property of the estate,” the stay would bar “any act to obtain” or “obtain possession of” the company’s D&O policy or proceeds, including a request that the D&O insurer pay for your defense.

Because of the bankruptcy filing, a United States Bankruptcy Trustee has charge of your company’s affairs. And trustee may not want your D&O insurer to pay your defense fees. Trustee may have warned your insurer not to pay them. The trustee may want to preserve the proceeds, including perhaps for its own claims against you. And a bankruptcy judge may agree with trustee.

A violation would have consequences. Someone may have to return policy proceeds; maybe the insurer; maybe you. For a willful violation, damages may be awarded including attorney’s fees and costs. And how do you feel about contempt? Yikes! Your insurer naturally also will not want to assume those risks. So it won’t pay without a court saying “It’s okay.”

Are you doomed? You ask the bankruptcy judge for your fees to be paid. You argue the stay doesn’t apply because neither the policy nor its proceeds belong to the bankrupt company’s estate. And even if they do, the court should use its discretion to lift the stay, because the harm to you from a stay outweighs any harm to the estate from lifting it.

You cite Bankruptcy Code section 362(d), providing:

On request of a party in interest and after notice and a hearing, the court shall grant relief from the stay provided under subsection (a) of this section, such as by terminating, annulling, modifying, or conditioning such stay— (1) for cause, including the lack of adequate protection of an interest in property of such party in interest;(Emphasis added)

Other directors move similarly.

Trustee resists. The policy is estate property, trustee says. So are proceeds, trustee says. And if not, the court shouldn’t use discretion to lift the stay; the harm to the estate from lifting it outweighs harm to you and any other directors and officers from keeping it. There’s an investigation of potential claims for the estate’s benefit against you and them, trustee says. So D&O insurance limits must be preserved for those potential claims.

What says the black-robed one? Well, the black-robed one in In Re: Hoku Corporation, Case No. 13-40838-JDP (Bankr. D. Idaho, Mar. 25, 2014), a case with facts generally along those lines, says “Directors win!”

Why? This court decided that under Bankruptcy Code section 362(d) there was “cause” for lifting the stay. As the court explained:

In cases involving D & O policy proceeds, the bankruptcy court should balance the harm to the debtor [company] if the stay is modified with the harm to the directors and officers if they are prevented from executing their rights to defense costs. [Citations omitted]. . . . In a “wasting” policy situation, courts factor whether defense costs might exhaust the coverage available to pay a future covered loss under the policy, or expose the bankruptcy estate to indemnification claims. [Citation omitted]. Further, “clear, immediate, and ongoing” losses to the directors and officers in incurring defense costs trumps only “hypothetical or speculative” claims by the trustee.

Directors were incurring “clear, immediate, and ongoing” and likely covered defense expenses, explained the court. And, under the National Union D&O policy’s “Order of Payments” clause, the D&O insurer must pay them before the bankrupt company’s claim, said the court.

In contrast:

[T]he potential for harm to the estate suggested by Trustee consist of hypothetical, indeed perhaps speculative claims he might pursue against the [directors], or some of them, such that he wants to conserve the total coverage proceeds available under the Policy. However, it does not appear that the bankruptcy estate is currently exposed to any other claims that would generate any claims against Coverage B [(Organization Liability)], nor that the bankruptcy estate would incur any indemnification claims by [directors]. Realistically, Trustee seems to be merely be seeking to protect the estate’s claims against [directors] under Coverage A [(Executive Liability)], a tactic that has been criticized by other courts facing this issue.

With a $10 million policy limit, though “wasting,” “it is likely that the [directors’] claims to the proceeds can be satisfied with ample coverage remaining if needed by the bankruptcy estate to address future claims.”

Under Ninth Circuit case law, the D&O policy belongs to the bankrupt company’s estate, says the court; but given that the stay may be lifted even if proceeds are estate property, there’s no need to address that issue here, though at least one court has done so. See In re Downey Fin. Corp., 428 B.R. 595 (Bankr. D. Del. 2010)(proceeds not estate property if used to pay for D&O defense fees).

What are the lessons for directors, officers, and brokers? In a bankruptcy, a director or officer will not want to rely on a bankruptcy judge to decide whether he or she gets a defense from its D&O insurer. A major reason for buying the insurance is to cover risk from catastrophic events, such as a company’s bankruptcy. The directors and officers want their personal wealth protected. In another scenario, a bankruptcy judge may decide the proceeds belong to the estate and estate harm outweighs director or officer harm; so the directors and officers must pay for their defense themselves. How would a director or officer feel about then? Unhappy, for sure. Angry, maybe. Angry enough to sue a broker? Maybe if there’s enough money on the line?

Are there other solutions? How about a separate side-A policy, only for the directors and officers? Or for independent directors, a stand-alone independent director policy? Are the premiums worth it? For the director or officer, it would seem so. Are brokers always advising their clients of those options? They better be! Do any of you knowledgeable readers have comments? Speak up!

Tags: Idaho, D&O policy, directors and officers liability insurance, management liability insurance, bankruptcy, automatic stay, Order of Payments, Side A policy, independent director liability policy