Ever since “entity coverage” (sometimes called “Side C coverage”) became a part of the standard D & O policy in the mid-90’s, bankruptcy courts have wrestled with the issue whether or not the D & O policy proceeds are property of the estate under Bankruptcy Code Section 541(a) and subject to the automatic stay under Bankruptcy Code Section 362. The directors and officers of the bankrupt company want access to the insurance proceeds to fund defense expense or settlements, but the bankruptcy trustee wants the proceeds preserved so they are available to satisfy the trustee’s own claims, and so the trustee seeks to subject payment of the proceeds to the bankruptcy stay.

A recent decision in the federal bankruptcy court in Delaware arising out of the bankruptcy of World Health Alternatives addressed the issue whether the directors and officers could access the proceeds of the bankrupt company’s D & O policy to settle separate shareholders litigation pending against them.

World Health Alternatives filed for bankruptcy in February 2006. However, prior to the bankruptcy filing, the company and several of its directors and officers had been sued in federal court in Pennsylvania in a securities class action lawsuit (refer here), and in October 2005, plaintiffs filed a separate derivative action. The cases were later consolidated. After the company filed its bankruptcy petition, it was dropped as a defendant from the shareholder litigation. In August 2006, the parties settled the consolidated shareholder action and in November 2006 filed a settlement agreement with the court.

The consolidated shareholder litigation settlement provides for the payment of $1.7 million (the remaining limits under the company’s D & O policy). In addition, the company’s former CEO agreed to transfer 435,000 shares of stock in three other organizations, and the company’s former accounting firm agreed to pay $1 million. The settlement proceeds were tendered into escrow, and the final settlement hearing was scheduled for June 11, 2007.

On May 21, 2007, the trustee in bankruptcy initiated an adversary proceeding in federal bankruptcy court in Delaware against the company’s former directors and officers, alleging, among other things, breaches of fiduciary duty and unjust enrichment. The trustee petitioned the bankruptcy court to enjoin the approval of the shareholder litigation settlement agreement and to direct the transfer of the proceeds of the D & O policy to the trustee.

In an June 8, 2007 opinion (here), Bankruptcy Judge Kevin Gross considered “whether a debtor’s creditors have priority over the debtor’s shareholders in the proceeds of an insurance policy to which both claim entitlement.” The court said that the threshold issue in the petition for a preliminary injunction is whether there is a “reasonable probability that the Trustee will win on the merits of his claim of priority to the proceeds of the policy,” which turns on “whether the proceeds are property of the estate.”

The question the court faced was complicated by the fact that the company’s D & O policy (like most current D & O policies) contained Side A coverage protecting the individuals, as well as Side B coverage providing the company with reimbursement coverage of amounts for which the company indemnified the individual directors and officers, and Side C “entity coverage” protecting the company from its own securities claim liability.

Typically, when a liability policy provides coverage to a debtor, the proceeds of the policy are property of the bankrupt estate. The court said that

When a policy covers the debtor and its directors and officers, and there is risk that payment of the proceeds to the directors and officers will result in insufficient coverage of the debtor, then the proceeds are property of the estate and any attempts to obtain the proceeds are prohibited under the automatic stay.

Judge Gross found, however, that under the circumstances “it appears that the proceeds of the Debtor’s insurance policy are not the property of the estate.” He reached this conclusion because “the policy proceeds which are being used to fund the settlement…are from the Policy’s Coverage A,” and the Trustee “has no right to any Coverage A proceeds.” The court said, quoting with approval from In re Allied Digital Technologies Corp., 306 B.R. 505, 512 (Bankr. D. Del. 2004):

The Trustees’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from the D & O Policy rather than as a potential defendant seeking to be protected by the D & O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.

Because the court found that “there is no reasonable probability that the Trustee would succeed on the merits,” he denied the petition for a preliminary injunction.

On June 11, 2007, the court in the shareholders’ class action in Pennsylvania approved the shareholders’ action settlement and entered final judgment.

Judge Gross noted that there were numerous “other impediments” to the trustee’s recovery under the Policy, including the fact that the trustee did not even file the adversary proceeding against the company’s former directors and officers until after the claims-made D & O policy had lapsed. (As an aside, this fact alone would have been sufficient to dispense with the entire matter, since there would be no coverage in any event under the policy for the trustees’s claim, but the court chose a different line of analysis.)

Judge Gross also noted that the D & O Policy had a “Priority of Payments” provision “which requires that payments first be made to Coverage A insureds.” But while noting that the policy had a priority of payments provision, Judge Gross did not affirmatively conclude that the provision would defeat the trustee’s claims that the policy proceeds are property of the estate.

Though the court in the World Health Alternatives bankruptcy held that the trustee could not prevent the company’s former directors and officers from using the D & O policy proceeds to settle claims against them, there is a split of authority whether D & O policy proceeds are part of the debtor company’s estate and subject to the automatic stay. A priority of payments clause is one approach that some companies have used to try to avoid the assertion that the policy proceeds are part of the estate.

Another way to provide against the adverse effects that could follow in the event that the standard D & O policy (containing entity coverage) is subject to the stay in bankruptcy is to structure the company’s D & O insurance program to include a separate Side A policy that provides coverage solely for the individual directors and officers. Because these policies protect only the individuals, the policies’ proceeds are unlikely to be held part of a debtor company’s estate and therefore would not be subject to the stay in bankruptcy. Excess Side A policies providing so-called “drop down” protection in the event the standard D & O policy is subject to the bankruptcy stay may be the most cost effective protection against this possibility.

A good, brief summary of the issues surrounding the proceeds of the D & O policy in the context of bankruptcy by Kimberly Melvin of the Wiley Rein law firm can be found here.

Special thanks to Adam Savett of the Securities Litigation Watch (here) for the link to the bankruptcy court’s opinion.