Directors & Officers Insurance And Bankruptcy - Whose Insurance Policy Is It Anyway?


Bankruptcy changes everything. Well maybe not everything, but bankruptcy proceedings certainly complicate the already complicated business of litigating directors and officers ("D&O") insurance coverage disputes.

D&O policies insure a company's directors and officers against liabilities arising from their corporate activities. Complications arise when the company files for bankruptcy protection. This article discusses the following issues arising from the intersection of bankruptcy proceedings and D&O coverage litigation: (1) how the Bankruptcy Code's automatic stay provisions affect D&O coverage litigation; (2) whether D&O policies and/or policy proceeds constitute property of the corporate debtor's estate; and (3) whether D&O policies provide coverage for a bankruptcy trustee's action against the debtor's directors and/or officers.
The Bankruptcy Code's Automatic Stay

A corporation's bankruptcy filing automatically stays, among other activities,

(1)the commencement or continuation É of a judicial, administrative, or other action or proceeding against the debtor that was or could have been commenced before the commencement of the case under this title, or to recover a claim against the debtor that arose before the commencement of the case under this title; É.

(3)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 U.S.C. §362(a).

Section 362, therefore, stays all actions against the debtor policyholder, including any actions triggering the "entity coverage" of the corporation's D&O policy.1 The corporation's bankruptcy filing, however, generally does not stay actions against the debtor's directors and officers. See Bedel v. Thompson, 103 F.R.D. 78, 81-83 (S.D. Ohio 1984). Even where the corporation is a co-defendant with its directors and officers, the corporation's filing generally stays the action against the debtor corporation only. See, e.g., Wedgeworth v. Fibreboard Corp., 706 F.2d 541 (5th Cir. 1983).

Courts, however, will stay claims against non-debtor parties, including directors and officers, if they find "such identity between the debtor and the third-party defendant that the debtor may be said to be the real party defendant and that a judgment against the third-party defendant will in effect be a judgment or finding against the debtor."A.H. Robins Co. v. Piccinin, 788 F.2d 994, 1002-03 (4th Cir.), cert. den., 479 U.S. 876, 107 S.Ct. 251 (1986); accord Ochs v. Lipson (In re First Central Financial Corp.), 238 B.R. 9, 19 (Bankr. E.D. N.Y. 1999); In re International Heritage, Inc., 239 B.R. 306, 311 (Bankr. E.D. N.C. 1999). If, moreover, a bankruptcy court deems a D&O policy and its proceeds property of the estate, then any action to exercise control over the policy and its proceeds arguably runs afoul of the Code's automatic stay. Courts, upon this basis, have stayed actions against a corporate debtor's directors and officers reasoning a recovery could diminish the value of the estate's insurance asset.See International Heritage, 239 B.R. at 311; In re Johns-Manville Corp., 33 B.R. 254 (Bankr. S.D. N.Y. 1983).

The Bankruptcy Code's automatic stay does not prevent the debtor from instituting a coverage action against its D&O insurer. If, however, the D&O policy proceeds constitute estate property, then the automatic stay may prevent the debtor's directors and officers from maintaining their own coverage action against the D&O insurer to recover defense and indemnity costs arising from an underlying claim.In re Cybermedica, Inc., 280 B.R. 12 (Bankr. D. Mass. 2002). Because much depends upon whether a D&O policy and/or its proceeds constitute estate property, we now turn to this issue.
D&O Policies And/Or ProceedsAs Estate Property

A debtor's insurance coverage claims present a conceptual quandary for Congress' bankruptcy regime. Some argue that because the insurer's obligation flows from the debtor's alleged wrongful conduct against, and the alleged damages suffered by, a specific underlying claimant, equity requires payment of insurance proceeds directly to the claimant rather than to the debtor's estate to be shared by all creditors. The debtor, through the fortuity of bankruptcy proceedings, should not benefit from its alleged wrongdoing against the claimant by using insurance funds to reduce its obligations to unrelated creditors.

Others argue that bankruptcy law injects overriding public policy concerns into the mix. While it may seem "unfair" to allow trade creditors to share in a tort claimant's recovery, what notions of "fairness" allow a bankrupt to escape his debts through a Chapter 11 filing? Congress enacted the Bankruptcy Code because it determined society benefits by spreading an insolvent's loss among all creditors rather than upon only those creditors lacking the resources to win the race to the debtor's assets. Direct payment to an underlying claimant obviates the Bankruptcy Code's loss-spreading objectives.

Courts generally find D&O policies property of the debtor's estate. This determination, however, hardly advances the ball because neither underlying claimants nor trade creditors can make much use of the insurance contract itself. Creditors and claimants seek access instead to the proceeds payable under insurance contracts, which implicates the Bankruptcy Code's further definition of estate property as "[p]roceeds, product, offspring, rents, or profits of or from property of the estate."11 U.S.C. §541(a)(6). Courts remain split on whether D&O policy proceeds constitute estate property, with decisions driven by the specific facts of each case.Courts, for example, examine whether the insurance proceeds will pay the directors/officers for covered claims or whether the proceeds will reimburse the debtor corporation for indemnifying its directors/officers against covered claims. See First Central Financial Corp., 238 B.R. at 13-14.

If the D&O insurer will pay claims asserted against the directors/officers and not against the corporation, then the policy proceeds likely do not constitute estate property. If, however, the insurer will reimburse the corporate debtor for indemnity payments made to its directors/officers, then the D&O insurance proceeds more likely constitute estate property. In Minoco Group of Cos., 799 F.2d 517 (9th Cir. 1986), the Ninth Circuit rejected the insurer's argument that the D&O policies fall outside the debtor's estate because they benefit only the directors and officers. The court concluded the policies also protect the debtor because they "insure Minoco against indemnity claims made by officers and directors."Id. at 519. The court, therefore, concluded the policies constitute estate property for the simple reason that "the debtor's estate is worth more with them than without them."Id.

Insurers now attempt to contract their way out of this judicial morass.Some policies provide that upon a bankruptcy filing, the insureds:

(a) waive and release any automatic stay or injunction to the extent it may apply in such proceeding to the proceeds of this policy under such Bankruptcy Law; and

(b) agree not to oppose or object to any efforts by the Insurer or any Insured to obtain relief from any stay or injunction applicable to the proceeds of this policy as a result of the commencement of such liquidation or reorganization proceeding.

The courts, not surprisingly, remain split on the enforceability of such provisions. Compare In re Shady Grove Tech Center Associates Limited Partnership, 216 B.R. 386 (Bankr. D. Md. 1998) with In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996).

Some D&O policies also contain language which prioritizes the payment of insurance proceeds "in the event of Loss arising from a covered Claim for which payment is due under the provisions of this policy." These provisions usually require the insurer to pay directors/officers before paying the corporation on either its indemnity or entity coverage claims.And, these provisions specifically provide that "the bankruptcy or insolvency of any É Insured Person shall not relieve the Insurer of any of its obligations to prioritize payment of covered loss." The courts, again, may not enforce these provisions in bankruptcy.
The Insured v. Insured Exclusion

Once the policyholder finally gets to litigate its substantive coverage claims, the D&O insurer will raise the usual litany of defenses.Most of these defenses remain unaffected by the corporation's bankrupt status except for the insurer's so-called "insured v. insured" exclusion.A recent version of this exclusion bars coverage for a claim against a director/officer:

which is brought by or on behalf of an Organization or any Insured Person, other than an Employee of an Organization, or which is brought by any security holder or member of an Organization, whether directly or derivatively, unless such security holder's or member's Claim is instigated and continued totally independent of, and totally without the solicitation of, any Executive of an Organization or any Organization.

Insurers argue this exclusion bars coverage for a bankruptcy trustee's action against the corporation's directors/officers because the trustee simply steps into the shoes, and sues on behalf, of the insured corporation; hence, one insured sues other insureds.

The courts remain split on whether the insured v. insured exclusion bars coverage for a trustee's claims against directors/officers. Certain courts apply the exclusion on the ground that no "significant legal distinction [exists] between the company and the Trustee for the bankruptcy estate."See Reliance Ins. Co. of Ill. v. Weis, et al., 148 B.R. 575 (E.D. Mo. 1992), aff'd, 5 F.3d 532 (8th Cir. 1993); National Union Fire Ins. Co. of Pittsburgh, PA v. Olympia Holding Corp., et al., Case No. 1194-CV-2081-GET (9/18/1995), aff'd without opinion, 148 F.3d 1070 (Table) (11th Cir. 1998).Other courts reject application of the exclusion because:

a bankruptcy trustee charged with a statutory duty and endowed with special statutory powers is an independent and disinterested entity, separate and distinct from the debtor, as well as the pre-petition company, and as such does not strictly "stand in the shoes" of the debtor.

In re County Seat Stores, Inc. et al., 280 B.R. 319, 326 (Bankr. S.D.N.Y. 2002).These courts conclude that trustee lawsuits do not raise the collusion concerns underpinning the exclusion.Id. at 329; Alstrin v. St. Paul Mercury Ins. Co. et al., 179 F.Supp. 2d 376, 404 (Del. 2002).

Policyholders need not subject their insurance recovery to the vagaries of the judicial system because they now can purchase an express exception to the insured v. insured exclusion which applies:

in any bankruptcy proceeding by or against an Organization, [to] any Claim brought by the examiner, trustee, receiver, liquidator or rehabilitator (or any assignee thereof) of such Organization.

Bankrupt policyholders, and their directors and officers, cannot assume business as usual with their D&O insurers.Policyholders must recognize that bankruptcy proceedings affect, procedurally and substantively, their coverage rights, and should make certain their attorneys know how best to protect their interests in this unique environment.

1A D&O policy may provide coverage for direct claims, usually securities-related claims, against the corporate entity itself as opposed to claims against only the corporation's directors and officers.

Published April 1, 2004.