An increase in U.S. business bankruptcies and the expansion of entity coverage in directors & officers (D&O) policies is having a particularly troubling, yet unintended consequence: creating the vulnerability of the bankruptcy estate "hijacking" the policy's proceeds, putting corporate directors and officers at risk, in spite of coverage. 
The existence of entity coverage in D&O policies has caused bankruptcy courts to hold that the D&O policy and the policy's proceeds are, in some cases, assets of the bankruptcy estate, and since the assets of the bankruptcy estate are subject to an automatic stay, the directors and officers may be prohibited from gaining access to policy proceeds. This is not universally the case, and bankruptcy court decisions have varied. But the danger exists.
U.S. business bankruptcy filings increased 52 percent from 2008 to 2009, according to the federal court system's fiscal year statistics. The Web site www.uscourts.gov reports that there were 58,721 business bankruptcy filings during the federal judiciary's fiscal year ending September 30, 2009, compared with 38,651 filings for fiscal 2008. Filings have continued to increase during the current fiscal year. While the economic climate is troubling enough, corporate directors and officers may be even more concerned to learn that insurance protection under D&O liability policies may be severely restricted in the event of corporate bankruptcy.
Originally created to protect the personal assets of individual directors and officers, D&O policies expanded during the 1990s to include coverage for claims against the corporate entity itself--ranging from securities claims entity coverage for publicly traded companies, to full entity coverage for privately owned companies and nonprofit organizations. A fundamental conflict spawned by entity coverage is the competition between the corporate entity and the directors and officers for access to the policy's finite limits of liability. This can be a problem even absent corporate bankruptcy, but it becomes more acute in bankruptcy situations.
Consider hypothetical XYZ Corp. in bankruptcy, with a pending lawsuit against the company's directors and officers. The directors and officers would ordinarily rely on indemnification by the company and/or the D&O insurance policy to help them pay defense costs and any eventual settlement or judgment. But because of the bankruptcy, indemnification by XYZ Corp. is not a possibility, and the automatic stay prevents access by the directors and officers to D&O policy proceeds, absent the bankruptcy court's approval. As a result, the directors and officers are left to pay their own legal expenses and any eventual liability.
An additional concern is that the very status of the D&O policy may be impaired by bankruptcy. Depending on the policy's cancellation and change in control provisions, the bankruptcy may trigger the policy into run-off (meaning that coverage under the policy continues, but only for acts that took place prior to the bankruptcy filing), or in rarer cases, may even trigger automatic policy cancellation. Also consider the example of a company entering Chapter 11 bankruptcy, in which corporate activities continue, but under the fiduciary care of a debtor-in-possession. The debtor-in-possession is formed as a separate legal entity from the company, and therefore is not necessarily an insured under the D&O policy.
There are several D&O policy provisions that directors and officers and their insurance agents or brokers should look for to help ensure that the policy will remain in force even in bankruptcy and do what it was originally intended to do--protect the personal assets of directors and officers:
- Include in "priority of payments" language (also known as "order of payments" language) a provision that, in the event of claims against directors and officers and the entity itself, the D&O policy will first pay non-indemnifiable claims of directors and officers (Side A claims) before paying indemnifiable claims on behalf of the corporation (Side B claims) and claims against the corporation itself (Side C claims). This would not prevent an entity-only claim from depleting policy limits, but in the event of concurrent claims against the entity and directors and officers, it would dictate that the D&Os be paid first.
- Automatically include in the definition of "insured" a debtor-in-possession or equivalent status to provide ongoing coverage after a bankruptcy filing. As mentioned earlier, the debtor-in-possession is a separate legal entity from the insured company, and would not itself be an insured under the policy absent this provision--nor would directors and officers acting on behalf of the debtor-in-possession.
- Amend the ever-present "insured vs. insured" exclusion to exempt (i.e., carve back) claims made against directors and officers by the bankruptcy trustee, creditors' committee and other bankruptcy creations that are deemed to be insureds under the policy. This is to prevent the exclusion of claims made by such parties against directors and officers.
- Include a provision by which the insurance company and all insureds agree to waive and release any automatic stay that may apply to the D&O policy and/or the policy proceeds, and agree not to oppose any efforts to obtain relief from such stay. Otherwise, as mentioned earlier, the automatic stay could operate to prevent the payment of policy proceeds to or on behalf of directors and officers.
- Review the D&O policy's cancellation and change in control provisions to be sure that bankruptcy does not trigger automatic termination of the policy or conversion to run-off status.
- Guard against presumptive indemnification language that would impose a "Side B" retention on directors and officers when there is no indemnification provided by the corporation. The policy's "Side A" coverage for non-indemnifiable claims against directors and officers is always written with no retention. But some policies are worded to presume indemnification by the corporation "to the fullest extent permitted by law" to impose the Side B retention, which can be sizeable. The directors and officers should guard against the possibility of having to bear the cost of such retention when the corporation does not actually provide indemnification.
It is now possible with some D&O policies to include a dedicated "Side A" limit in addition to the policy's aggregate limit of liability. Such limit would not be accessible to entity claims, and would be preserved even if the policy's aggregate limit is depleted by "Side B" or "Side C" claims. Additionally, "Side A"-only policies have been available for several years now, and the purchase of an excess "Side A" policy in addition to the traditional D&O policy has become more common. Also available are enhanced versions of excess "Side A" that include "difference in conditions" features which provide the added benefit of dropping down to cover claims that--for any of several reasons--are not paid by the underlying traditional D&O policy.
You will note that this article does not provide specific recommended wordings for the policy provisions discussed above. That is because D&O policy language can vary greatly from policy to policy, and agents must be careful to ensure that the various wordings mesh well with the existing language of the policy in each case. Too often, a D&O policy comes to resemble Frankenstein's monster--a homely, malfunctioning construction of mismatched parts. Agent/brokers, attorneys and underwriters should work in concert to be certain that the desired provisions are drafted appropriately.
