According to statistics compiled by the American Bankruptcy Institute, over 60,000 businesses filed for bankruptcy in 2009, the highest annual number of business-related bankruptcies since 1993. By way of comparison, the 2009 business bankruptcy filing levels were nearly 200% greater than in 2006. All signs are that these bankruptcy filing levels have continued unabated this year.
One of the frequent accompaniments of a corporate bankruptcy filing is the initiation of litigation against the directors and officers of the failed company. This litigation often leads to complex questions of D&O insurance coverage. As discussed in the April 2010 paper from ACE Insurance entitled "Financial Crisis: Bankruptcy Implications for D&O Insurance" (here), "bankruptcy poses the greatest threat of personal financial risk and the most complicated [D&O Insurance] coverage issues."
Yet there may be no time when D&O insurance is more important than in bankruptcy. As Paul Ferrillo of the Weil Gotshal firm notes in his April 30, 2010 memorandum "Directors and Officers Liability Insurance in Bankruptcy Settings – What Directors and Officers Really Need to Know" (here), "when a Corporation files for bankruptcy, the D&O policy becomes one of the few protections a director or officer has against lawsuits and claims targeting his or her personal assets."
Because, as the ACE report notes, "bankruptcy has the potential to dramatically complicate D&O coverage issues," it is important at the time the D&O insurance is put in place that these potential issues are taken into account and that the insurance is structured to try to reduce the likelihood of these complications arising in the event of a later bankruptcy.
The Weil Gotshal memo outlines a number of critical steps the company can take in structuring its insurance to address these bankruptcy-related concerns, including the following.
First, in order to avoid the possibility that the insurance is unavailable to defend individuals in bankruptcy related claims due to a policy rescission based on application misrepresentations, the company should incorporate into its insurance program a provision that the Side A coverage (protecting individuals for nonindemnifiable claims) is not rescindable. This provision specifies that the Side A coverage cannot be rescinded and will require the D&O carrier to begin advancing defense costs immediately.
Second, the company’s program should incorporate a Priority of Payments provision that, as described in the Weil Gotshal memo, "created a clear path that allows for the contemporaneous payment of defense costs for directors and officers." The provision specifies that payment of individuals’ defense expense or other loss costs takes priority over those of any insured entity. As the memo notes, this provision "limits the uncertainty of whether a D&O Policy will be immediately available to fund the defense costs of directors and officers who are embroiled in litigation when a company files for bankruptcy."
Third, the policy exclusion precluding coverage for claims against insureds brought by other insureds (known as the "insured vs. insured exclusion) should be amended to carve back coverage to ensure that the policy exclusion is not applied to preclude coverage for claims brought by "a debtor in possession, chapter 11 trustee, creditors, bondholders, all committees and other bankruptcy constituencies."
The Weil Gotshal memo includes a number of other policy prescriptions which, while described within the context of bankruptcy-related concerns, actually are critically important regardless whether or not a company might eventually wind up in bankruptcy, including the following.
First the company should ensure that there is "full severability" in connection with the policy application, so that any insured person’s knowledge of application misrepresentations "should not affect coverage for directors and officers who were unaware" of the misrepresentations.
Second, with respect to the D&O policy’s conduct exclusions (excluding, for example, coverage for criminal or fraudulent misconduct) should be drafted so that they are "triggered only upon a final adjudication of the prohibited …conduct."
Third, it is critically important for companies to attend to questions of limits adequacy and policy structure. Complex claims, of the type that often arise in bankruptcy but that can also arise without regard to bankruptcy, have the dramatic potential to substantially erode or even exhaust available insurance. The amount and structure of insurance acquired should take this dramatic possibility into account.
In particular, with respect to policy structure, board members will want to determine whether the company’s insurance program includes so called Excess Side A insurance or even Excess Independent Directors Liability Insurance (IDL). As the Weil Gotshal memo notes, when D&O claims are filed, the CEOs and CFOs "generally use up most of the coverage" in the Company’s D&O insurance program, "potentially leaving the independent directors with insufficient coverage to resolve the claims against them." Even though IDL policies "are the most underutilized insurance policies," it may be in the board’s interest to purchase IDL insurance as added protection in the event of significant claims against company inside management.
All of these concerns underscore the importance of taking all of these issues into account at the time the insurance is put in place, which in turn highlights the importance of having a knowledgeable and skill insurance professional involved in the insurance acquisition process. As the Weil Gotshal memorandum notes, "a good insurance broker may be able to assist in finding alternative primary carriers or alternative coverage solutions that will better satisfy a Corporation’s needs."
The complex D&O insurance coverage issues that can arise in the event of bankruptcy related claims are a recurring concern that I have previously explored in related posts, most recently here.
Putting Options Backdating Into Perspective: In light of the vivid events in the global financial marketplace in the last couple of years, the options backdating scandal seems both distant and even trifling, at least relatively speaking. However, as Professor Peter Henning points out in an April 30 post on the Dealbook blog (here), the government’s record in prosecuting options backdating may provide important clues to the way the government may proceed in connection with the current financial crisis.
As Henning notes, the options backdating results on the criminal side "were decidedly mixed," with a few trial victories but also with "notable acquittals." In particular, Henning notes, "the cases turned out to be much more difficult to win because the conduct had neither the visceral appeal nor the impact" that prior corporate scandals had. No company’s survival was threatened and the options practices involved accounting and tax issues were murky, allowing defendants to argue successfully in some cases that they did not believe they engaged in wrongdoing.
Henning suggests that "the experience with options backdating prosecutions may be leading prosecutors to adopt a much more cautious approach to cases involving complex financial transactions in which the accounting rules are less than clear." He concludes that "the options backdating cases show how difficult it is to win convictions against senor executives, even when they are directly involved in the transactions," as a result of which "we will see few, if any, prosecutions from the recent financial turmoil when executives can point to the markets as the reason for any harm suffered by their companies."
There is Absolutely No Cause for Alarm: Tom Kirkendall on the Houston’s Clear Thinkers blog recently linked to the classic Monty Python Skit, "How to Irritate People: Airplane" which reminded me in certain air travel woes to which I have been subjected. Please remain comfortably seated while you watch this video, and be certain to reassure yourselves that no one would deliberately set out to irritate anyone like this, now would they?