As those involved in D&O Insurance claims well know, a recurring D&O insurance problem is the question of whether or not the D&O insurer for a bankrupt company can pay the costs of the bankrupt company’s former directors and officers incurred in defending claims against them. Disputes arise when the individuals seek to have the stay in bankruptcy lifted to allow the insurer to pay their defense expenses. Oftentimes creditors or the bankruptcy trustee will oppose lifting the stay, arguing that the D&O policy proceeds are assets of the bankrupt estate and should be preserved for the benefit of the estate or the creditors rather than expended paying the individuals’ defense costs.
These issues were discussed in a recent case in the Bankruptcy Court for the District of Idaho. In a succinct March 25, 2014 opinion (here), Bankruptcy Court Judge Jim D. Pappas rejected the arguments of the bankruptcy trustee and ruled that the stay should be lifted to allow the D&O insurer to pay the fees that certain former officers of Hoku Corporation incurred in defending claims against them. Hat tip to the Jones, Lemon & Graham’s D&O Digest Blog (here) for the link to the opinion. The D&O Digest’s April 21, 2014 blog post about the opinion can be found here.
Background
Hoku Corporation was a subsidiary of Tianwei New Energy Corporation. On July 2, 2013, Hoku filed a Chapter 7 bankruptcy petition. On August 20, 2013, JH Kelly LLC, the prime contractor for Hoku in the construction of a polysilicon plant in Pocatello Idaho, sued Tianwei and several former directors and officers of Hoku, alleging fraud, racketeering and other misconduct while JH Kelly was constructing the plant.
The individual directors and officers filed a motion in the bankruptcy proceeding requesting the bankruptcy court to determine that the proceeds of Hoky’s D&O insurance policy were not property of Hoku’s bankrupt estate, or in the alternative, granting relief from the automatic stay in bankruptcy to allow the D&O insurer to pay the individuals’ costs of defending themselves in the JH Kelly lawsuit. The bankruptcy trustee filed an objection to the motion, arguing that the proceeds of the policy are assets of Hoku’s bankruptcy estate, and arguing further that payment of the individual’s defense fees would diminish the bankruptcy estate’s potential recovery of its own claims under the Policy.
Hoku’s D&O insurance policy, which had limits of liability of $10 million, included a so-called order of payments provision, specifying that
In the event of Loss arising from a covered Claim for which payment is due under the provisions of this policy, then the Insurer shall in all events:
(a) first, pay Loss for which coverage is provided under Coverage A and Coverage C of this policy; then
(b) only after payment of Loss has been made pursuant to Clause 22(a) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverage B(ii) of this policy; and then
(c) only after payment of Loss has been made pursuant to Clause 22(a) and Clause 22(b) above, with respect to whatever remaining amount of the Limit of Liability is available after such payment, pay such other Loss for which coverage is provided under Coverages B(i) and D of this policy.
The bankruptcy or insolvency of any Organization or Insured Person shall not relieve the Insurer of any of its obligations to prioritize payment of covered Loss under this policy pursuant to this Clause 22.
The March 25 Ruling
In his March 25, 2014 order, the Bankruptcy Judge granted the directors’ and officers’ motion based on his determination that the individuals had shown cause for relief from the automatic stay under Section 362(d)(1) of the Bankruptcy Code.
After first noting that the question of whether or not the proceeds of a D&O Insurance policy are assets of a bankrupt insured company’s bankruptcy estate is “an unsettled question,” the Bankruptcy Judge turned to the question of whether or not the stay should be lifted, saying that “assuming without deciding, the proceeds of the Policy are property of the bankruptcy estate, the Court concludes that good cause has been shown by the Movants under Section 362(d) for relief [from] the automatic stay.”
The Bankruptcy Judge determined that in considering whether or not the individuals had shown cause for lifting the stay that the Court should “balance the harm to the debtor if the stay is modified with the harm to the directors and officers if they are preventing for executing their rights to the defense costs.” The Bankruptcy Judge noted further that “clear, immediate and ongoing losses to the directors and officers in incurring defense costs trumps only ‘hypothetical or speculative’ claims by the trustee.”
The Bankruptcy Judge found that the individuals “are experiencing clear immediate and ongoing defense costs expenses,” adding that under the priority of payments provision in the policy, payments under other coverage provisions of the policy were “subordinate” to payment under the Side A coverage provision under which the individuals sought to have their defense fees paid.
By contrast, the Bankruptcy Judge found that the “potential harm to the estate suggested by the Trustee consist of hypothetical, indeed perhaps speculative claims he might pursue against the Movants.” The Bankruptcy Judge noted that other courts had criticized other bankruptcy trustees for seeking to prevent the payment of individual directors and officers defense fees under Side A.
“All things considered,” the Bankruptcy Court said, “the potential harm to the bankruptcy estate inherent in granting the Movants relief is negligible.” After noting that the policy’s $10 million limit of liability provided “ample coverage,” he concluded that the fees the individuals were incurring in defending the JH Kelly matter represented “a clear, immediate and actual harm that greatly outweighs any speculative and hypothetical harm to the bankruptcy estate.”
Discussion
The kinds of issues discussed here have been a feature of the D&O insurance claims environment for many years, since coverage for the corporate entity became a regular part of the typical D&O policy. When the corporate entity files for bankruptcy, the question that arises is whether as a result of the D&O policy’s entity coverage the policy and its proceeds are assets of the estate. The practical solution that has evolved is that now when individuals want to have their defense fees paid, they will approach the bankruptcy court to obtain what has become known as a “comfort order” to allow the D&O insurer to pay the individuals’ defense fees (as discussed in greater detail here).
As I noted in a prior post (here), the granting of these types of comfort orders is now something of a “standard” procedure. However, even though these practices are now well established, and have been employed in such high profile proceedings as the Lehman Brothers bankruptcy (refer here) and the MF Global bankruptcy (refer here), trustees like the one here will continue to agitate on these issues. (Admittedly, other problems arose in those high profile cases but not with respect to the question of whether or not a comfort order was appropriate.)
Nevertheless we still have situations like this one where Trustees try to throw up roadblocks to the payment of individuals’ defense fees based on the speculative notion that the policy proceeds need to be preserved for rights of recovery the Trustee not only has not established yet but even has not yet asserted. In that respect, I think there is something to the suggestion of the Bankruptcy Court here that bankruptcy trustees may warrant criticism for putting up these kinds of obstructions to the enforcement of contractual rights based on such speculative grounds.
I have always thought that these recurring problems are the result of a fundamental misconception of the D&O insurance policy. For obvious reasons, claimants and creditors want to establish that the D&O insurance policy exists for their protection and benefit. For less obvious reasons, some courts fall for this, which I have always found frustrating.
The fact is that insurance buyers purchase D&O insurance to protect the insured persons from liability. No one pays insurance premium as a charitable act for the benefit of prospective third party claimants. Liability insurance exists to protect insured persons from liability, not to create a pool of money to compensate would-be claimants. The very idea that claimants who have not even established their right of recovery from the insureds should be able to deprive the insureds of their right to use their insurance to protect themselves stands the entire insurance proposition on its head.
All of that said, there are recurring issues involved with the administration of these kinds of comfort orders, particularly, as discussed here, when court insist on asserting so-called “soft caps” on the amount of defense fees that can be paid or otherwise requiring ongoing Court supervision.