Directors’ and officers’ liability (D&O) insurance, which is often purchased in large part to protect directors’ and officers’ personal assets in the event of insolvency, may help to mitigate the risks of these lawsuits. But not all policies are created equal. It is critical for all companies, even those not at current risk of insolvency, to review their D&O policies and other potentially applicable insurance prior to or in tandem with considering bankruptcy protection. This is especially true for companies that are nearing renewal or in the process of renewal or placement of coverage, and have the opportunity to seek to negotiate terms. When negotiating terms or reviewing policies, companies and their directors and officers should keep in mind several potential issues with respect to how D&O insurance may respond in the event of a corporate bankruptcy, including but not limited to who can access the policy proceeds after a bankruptcy filing, and whether the policy’s “Insured v. Insured” exclusion bars any potential claims asserted by trustees, creditors’ committees, or debtors-in-possession.
Policy proceeds in bankruptcy: Who has access?
Most D&O policies contain three types of standard coverage:
- The “Side A” insuring agreement provides coverage for defense costs, settlements, and judgments arising from claims brought against directors and officers when the company cannot or is legally unable to provide indemnification.
- The “Side B” or “corporate reimbursement” insuring agreement reimburses the company for defense costs, settlements, and judgments arising from claims or suits brought against directors and officers when the company is allowed or required to provide indemnification.
- The “Side C” or “entity coverage” insuring agreement provides coverage for defense costs, settlements, and judgments arising from claims or suits brought directly against an entity. Public companies are typically covered only for securities claims under Side C, but private companies may have broader coverage.
When a company enters bankruptcy with a D&O policy that has shared limits that cover both individuals under the Side A insuring agreement and the company under the Side B or Side C insuring agreements, it is possible that creditors or others will argue that proceeds of the policy (including proceeds that could go towards covering the defense costs of individual directors and officers) are the property of the bankruptcy estate. If the proceeds are determined to be the property of the estate, the automatic stay provisions of the Bankruptcy Code may restrict individual directors and officers from accessing the proceeds absent an order modifying the stay.
Although today it is generally accepted that D&O policies are primarily intended to cover directors and officers and should not be the property of a company’s bankruptcy estate, when disputes have arisen, courts have reached different conclusions depending on the facts and circumstances of the case and the specific policy language.1
When placing or renewing a D&O policy, there are at least two ways to avoid or mitigate the risk of a court declaring that policy proceeds are assets of the estate.
First, the policy should contain a clear “priority of payments” clause. A priority of payments clause evidences that any coverage provided under the policy is principally intended to protect and benefit the insured persons, by requiring that in the event of competition for the proceeds of the policy, loss under Side A will be paid first, followed by loss under Side B or Side C.2 Similarly, policies should also provide that bankruptcy or insolvency of any insured company shall not relieve the insurer of its obligations under the policy, including the insurer’s obligation to prioritize payments, and in the event a bankruptcy proceeding is commenced, the insureds will not object to any efforts by the insurer or on behalf of the insured company or the insured individuals to obtain relief from any stay or injunction.
Second, if financially feasible, companies should consider purchasing stand-alone Side A-only “difference-in-conditions” (also known as Side A DIC) coverage that protects only directors and officers. This is “sleep at night” coverage that should respond when both the company is unable to or refuses to indemnify directors and officers, and the underlying traditional D&O insurers cannot respond for a multitude of reasons, including because payment of policy proceeds is stayed by order of a bankruptcy court. Because the company is not covered under these policies, the proceeds of the policies should be paid directly to the directors and officers and should not be interfered with by the bankruptcy estate.
What is the impact of the Insured v. Insured exclusion?
Insured v. Insured exclusions, which are found in a variety of forms in almost all D&O policies, generally bar coverage for claims asserted by or on behalf of the insured corporation or its directors or officers against other parties insured under the D&O policy. These exclusions were first developed in the early 1980s as a response to claims asserted by struggling banks against their own officers to access the proceeds of their D&O policies. Thus, one of the main rationales for development of the Insured v. Insured exclusion was to avoid “collusive” lawsuits by the company against its own officers.
In the context of bankruptcies, insurers have asserted that the Insured v. Insured exclusion precludes coverage for claims brought on behalf of the debtor company by a bankruptcy or litigation trustee, creditors’ committee, or debtor-in-possession (DIP) against the directors or officers, because those entities have stepped into the shoes of the company. The majority of courts have correctly held that bankruptcy trustees are outside the scope of the Insured v. Insured exclusion because they are a distinct entity from the insured and there is no risk of collusion because they owe a duty to the bankruptcy estate – not the debtor.3 There are, however, a handful of cases that have held the opposite.4
To avoid any uncertainty or the possibility of a dispute, companies should verify that the Insured v. Insured exclusion in its policies contains important carve-outs or exceptions to the exclusion for (among other things): (a) non-indemnifiable defense costs incurred by an insured person; (b) in any bankruptcy proceeding, any claim brought by an examiner, trustee, receiver, liquidator, rehabilitator or creditors’ committee (or any assignee thereof) of the insured entity; and (c) claims brought by an insured entity as a DIP against an insured person.
Other important considerations
Finally, when placing or renewing a D&O policy, there are several other considerations to keep in mind, which will assist in securing D&O coverage in bankruptcy and otherwise. These considerations include, but certainly are not limited to:
- Narrow the definition of “application” (if any), and carefully review all statements in policy applications or renewal applications. Policy applications are typically made part of the policy itself. Ideally, the application should be limited to the specific application for the particular policy, and should not include past applications for prior policies. In addition, to the extent the application incorporates the company’s public financial filings, the definition should be limited to filings made only within the 12 months prior to the inception date of the policy. Further, before submitting any application to a broker or insurer, companies should carefully review the questions asked and the proposed answers to make sure that they are as accurate as possible in light of potential financial uncertainty over the course of the next policy period.
- Is the policy fully non-rescindable? Making the policy fully non-rescindable can be of value even if there is an exclusion for claims based on alleged misrepresentations in the application process. At minimum, Side A coverage should be non-rescindable, and the policy should be severable so that a misrepresentation in the application by one insured person does not affect coverage for other insured persons.
- Are there broad definitions of “claim” and “loss”? A broad definition of a covered “claim” would cover not only lawsuits and administrative proceedings, but also investigations, requests to produce documents, or requests to enter into a tolling agreement. Covered “loss” typically includes defense costs, settlements and judgments. A broad definition would also cover certain fines and penalties or punitive damages, pre- and post-judgment interest, plaintiffs’ attorneys fees, and other items, depending on the policy and the insureds.
- Are there narrowed exclusions? Side A policies typically have fewer exclusions than “full-side” policies that cover claims made against the entity itself, or which reimburse the organization for any loss for which it indemnifies individual insureds. Exclusions for fraud and illegal profit in all policies should be narrowly drafted. Wrongful conduct of one insured should not be imputed to another. And with respect to COVID-19-related claims, any bodily injury and property damage exclusions should be narrowed where possible to apply only to claims “for” bodily injury and to not cover claims for financial damage associated with bodily injury claims, and should include exceptions for securities claims and defense costs.
At-risk companies should undertake a holistic review of their primary and excess D&O insurance policies, as well as other insurance policies in their portfolio. In addition, companies that are preparing for renewals should leave extra time for negotiations given the current climate. If you have any questions about the content of this article or the current state of your company’s coverage for D&O claims, COVID-19 liabilities, or otherwise, please contact one of the authors of this article or any other member of Reed Smith’s Insurance Recovery Group.
Our Reed Smith Coronavirus team includes multidisciplinary lawyers from Asia, EME and the United States who stand ready to advise you on the issues above or others you may face related to COVID-19.
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- See, e.g., Aetna Cas. & Sur. Co. v. Jasmine, Ltd. (In re Jasmine, Ltd.), 258 B.R. 119, 128 (D.N.J. 1999) (entire D&O policy part of the bankruptcy estate); Homsy v. Floyd (In re Vitek Inc.), 51 F.3d 530, 538 (5th Cir. 1995) (trustee authorized to use D&O proceeds to settle mass tort litigation against debtor to the detriment of insured officers). Compare In re World Health Alternatives Inc., 369 B.R. 805, 811 (Bankr. D. Del. 2007) (proceeds were not property of estate and directors and officers were entitled to use Side A coverage to settle securities fraud case where debtor had no Side B indemnification claim); In re La. World Exposition Inc., 832 F.2d 1391, 1401 (5th Cir. 1987) (proceeds benefitting directors and officers were not part of the estate).
- See, e.g., In re MF Global Holdings Ltd., 469 B.R. 177, 193 (Bankr. S.D.N.Y. 2012) (“courts have given effect to priority of payment provisions in authorizing access to policies to advance defense costs to individual insureds”); In re Downey Fin. Corp., 428 B.R. 595, 607 (Bankr. D. Del. 2010) (enforcing the “clear chain of priority among the three types of coverages” in the subject policy).
- See, e.g., Sharp v. Essex Ins. Co. (In re C.M. Meiers Co.), 527 B.R. 388, 403 (Bankr. C.D. Cal. 2015); In re County Seat Stores, Inc., 280 B.R. 319, 328- 329 (Bankr. S.D.N.Y. 2002).
- See, e.g., Biltmore Assocs. v. Twin City Fire Ins. Co., 572 F.3d 663, 677 (9th Cir. 2009); Indian Harbor Ins. Co. v. Zucker, 860 F.3d 373, 378 (6th Cir. 2017).
Client Alert 2020-320
