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In the wake of the subprime mortgage crisis and the now unfolding unprecedented global credit crisis, the public has been exposed to severe weaknesses in the global financial system. With the liquidity crisis of American International Group and high-profile bank failures, the vulnerability of seemingly unsinkable financial institutions has become all too apparent.
Repercussions of heightened regulatory scrutiny and huge market cap losses will include additional shareholder litigation, potentially implicating policies issued to directors and officers of companies directly and indirectly impacted by the crisis. We are already witnessing insolvency-related changes in control that are reminiscent of the savings-and-loan crisis of previous decades.
There are several ways in which the insolvency of an insured company may impact D&O coverage, potentially forcing carriers to forfeit their contractual rights or disallowing insureds’ recovery of policy proceeds. Accordingly, directors and officers may find themselves having to personally fund defense expenses.
D&O carriers may also encounter difficulties with third parties administering the debtor’s estate. For example, an insurance carrier attempting to resolve a claim at an early stage may be pressured to waive the retention as a condition for obtaining the trustee’s consent to settlement.
Insolvency may also impact certain policy terms, and corresponding public policy and statutory frameworks may serve to trump otherwise applicable provisions.
First, bankruptcy may affect which type of coverage is triggered under D&O policies. The bankruptcy court’s automatic stay may prevent a company from indemnifying its executives, thereby resulting in the application of Side-A coverage, which is generally not subject to retention.
On the other hand, if a D&O policy provides for presumptive indemnification and Side-A coverage is not tied to actual indemnification, Side-B coverage might be triggered without regard to the company’s insolvency, leaving the directors and officers with a retention that they may be required to personally fund.
However, in response, some D&O policies now include exceptions to presumptive indemnification where companies are unable to indemnify due to financial impairment or insolvency.
Insolvency may also circumvent the applicable retention in contravention of the D&O policy’s very terms, which often require the insured to actually pay the retention as a condition precedent to coverage. If strictly construed, insolvency may leave the insured incapable of paying the retention, thereby relieving the carrier of its obligations.
However, in the interest of protecting third-party creditors, some courts have not favored strict construction, and certain states have enacted legislation requiring carriers to include policy provisions prohibiting the company’s insolvency from relieving the carrier of its coverage obligations. Many insurers now include similar provisions in their policy forms.
In this context, the majority of courts addressing the issue have taken a practical approach, typically requiring the carrier to provide coverage in excess of the retention amount without regard to whether the insured actually paid the underlying retention (although some courts have taken a hard-line approach barring all coverage in the absence of actual payment).
We note that courts tend to focus on the retention provision’s language, as well as statutory laws governing liability insurance. Notably, these cases also shy away from using a bankruptcy trustee’s broad powers under the Bankruptcy Code as a method of circumventing retentions, thereby presumably favoring this approach in other insolvency situations outside of bankruptcy.
The practical effect of the majority view would force carriers to pay claims earlier but theoretically would not increase their financial exposure, as the retention amount would remain uncovered. However, this result may not provide much consolation for D&O carriers when the insured is financially unable to pay the retention and the policy provides for advancement of defense costs.
Presumably, as an insolvent company is liquidated, an insurer seeking reimbursement of defense costs advanced to the company would possess only a general unsecured claim against the company’s estate. However, in the event that an insolvent insured cannot fund the defense costs within the retention, it would not be prudent from a claim-handling perspective for D&O carriers to refuse advancement and be faced with a default judgment situation.
Insolvency may also impact the applicability of insured-versus-insured exclusions. Such exclusions, which bar D&O claims brought by other insureds, were originally fashioned as an impediment to collusive lawsuits.
In bankruptcy, a threshold issue exists as to whether the trustee constitutes an insured or a legally separate entity. Although not settled, many bankruptcy courts permit such trustees—who are generally viewed as disinterested parties not strictly standing in the debtor’s shoes—to circumvent the insured-versus-insured exclusion. However, the issue may be less settled for suits commenced by debtors-in-possession under Chapter 11 of the Bankruptcy Code, given the increased possibility of collusion.
There is also no bright-line rule in the context of suits brought by FDIC receivers after taking control of failing banks.
For instance, in rejecting the applicability of insured-versus-insured exclusions, some courts have emphasized the anti-collusion rationale. Other courts that disregard this rationale may rule that the insured-versus-insured exclusion bars coverage for FDIC suits.
On the other hand, courts that put great weight on the rationale may nonetheless preclude coverage if the receiver commencing the suit does not appear to be an adverse party.
Courts have also addressed the issue by analyzing the capacity in which the FDIC brought suit. If the agency is viewed as a successor stepping into the insured’s shoes, the exclusion may be enforceable. In this regard, complex allocation issues may ensue under circumstances involving multiple FDIC capacities (i.e., successor, shareholder, creditor, or depositor).
Of course, coverage for FDIC suits may nonetheless be precluded if the D&O policy contains a regulatory exclusion.
Insolvency may also have implications for D&O policies and their proceeds, primarily due to rules pertaining to what constitutes “property” of the estate, as defined by the Bankruptcy Code.
If considered estate property, coverage for directors and officers may be hindered by the automatic stay.
The complexity of this issue is exacerbated by multiple insuring clauses providing coverage for the entity, on the one hand, and the directors and officers, on the other. In the absence of Side-C entity coverage, D&O policies should be safeguards to protect the directors and officers. Therefore, while the policies themselves are generally considered estate property, courts often distinguish between the policy and its proceeds.
Many courts have taken the position that, in the context of Side-A and Side-B coverage, the company does not have a direct interest in the D&O policy’s proceeds. However, in subsequent decisions, some courts have concluded that the proceeds of a D&O policy constitute estate property where coverage for executives’ defense costs would deplete the policy’s limit of liability.
This issue gains complexity when D&O Policies also include Side-C coverage for the entity. Under this framework, policies serve dual functions for both executive and corporate protection. Given the commingling of the proceeds between individual and entity coverage, some courts consider D&O policy proceeds as part of the bankruptcy estate. Other courts have focused on whether any pending claims potentially implicate entity coverage.
Given the nuances presented by these insolvency issues, it is important to pay close attention to the coverage afforded under the policy, whether Side-A only, Sides A, B, and C coverage, or Side-A Difference-in-Conditions (DIC) coverage (which generally provides excess Side-A coverage that could drop down to serve as the primary policy in the event of certain conditions being met, such as a bankruptcy court’s imposition of the automatic stay).
Depending on the claim, the terms and conditions of each coverage part should be closely evaluated.
As the financial crisis continues to unfold, we will likely see more D&O claims involving insolvent companies. We are already seeing an increase in the frequency of these claims and will continue to evaluate their impact on D&O policies in the months ahead.
NOTE: THIS INFOG MIGHT LOOK BETTER IF WE PUT THE TWO SET OF BULLET POINTS SIDE BY SIDE