What the Enron Bankruptcy Means for Your D&O Insurance Coverage
 
September 17, 2002
 

By now, you’ve got to be sick of hearing about Enron.  It’s impossible for a few days to pass without learning about some aspect of this debacle on TV, in local and national papers, and in countless professional journals.  While I’m sure you’re tempted to tune out the coverage completely, I suggest you fight that urge if your company is about to purchase or renew its Directors’ and Officers’ (D&O) insurance policy.

It is obvious that the repercussions from Enron will have a major effect on corporate governance and auditor oversight.  But you should be aware that the case also offers major cautionary lessons for those who have D&O coverage.  The Enron bankruptcy litigation includes issues related to the company’s D&O policies and what they do and do not cover.  Enough money ($350 million provided by 12 policies) is riding on the outcome of these issues that we are likely to see them litigated fully.  The resulting judicial opinions will play a large role in defining some of the contours of D&O coverage for years to come.

Two major insurance issues that already have surfaced in the Enron bankruptcy proceedings are how a bankruptcy can affect the insureds’ ability to use D&O policy proceeds to pay defense costs, and under what circumstances an insurer can rescind its D&O policy for application fraud.

Bankruptcy Issues 

When a company files a bankruptcy petition, it creates an “estate,” which includes all of the property interests of the debtor corporation as of the commencement of the bankruptcy.  A key question is whether the proceeds of a D&O policy should be treated as a part of the bankruptcy estate.  If the proceeds are considered property of the estate, they will be subject to the bankruptcy court’s jurisdiction and may not be available to pay the defense costs of the directors and officers. In the Enron bankruptcy, a war is raging over this issue. 

The Official Committee of Unsecured Creditors (Committee) of Enron opposed the outside directors’ motion in the U.S. Bankruptcy Court in New York seeking payment from its D&O insurer of millions of dollars of legal fees to defend against a barrage of lawsuits, including class actions alleging violations of the federal securities laws.  The Committee said in its court filings that the D&O policy proceeds are property of the estate and, as such, should be preserved to satisfy the Committee’s own claims against certain Enron directors and officers.  In sharp contrast, the outside directors argued that even though the D&O policies also insure the corporation, they were obtained primarily for the protection of management and thus the policy proceeds are not the property of the estate.  To support this argument, the outside directors relied heavily on an endorsement to Enron’s primary D&O policy that provides a first-priority payment to directors and officers before any payment may be made to Enron.

In an oral ruling from the bench on April 11, 2002, the Bankruptcy Court sided with the outside directors, thus allowing payment by AEGIS, Enron’s lead D&O insurer, of millions of dollars to cover defense costs.  (The Committee appealed this ruling on May 28.  It will be months before there is a decision and that decision, in turn, can be appealed.)

Although no judicial opinion has been published by the Bankruptcy Court, it seems fairly certain that the Court relied on the priority-of-payments provision in an endorsement to Enron’s primary D&O policy.  In its simplest form, such a provision says:  “In the event of Loss arising from a covered Claim, the Insurer shall first pay Loss for which coverage is provided for directors and officers.”  Unfortunately, few insurers include this provision in their basic policy forms.  Therefore, if you do not have this provision in your policy, negotiate for it.  Without it you could be left high and dry when you need your coverage most.

Rescission of Your D&O Policy 

The general rule is that a knowing, material misrepresentation in an insurance application permits an insurer to void the policy.  This rule has been held to apply, not just to misrepresentations in the application itself, but to misrepresentations in the SEC filings that are required to be submitted with the application.

In November 2001, Enron announced that its financial statements for 1997 through the first half of 2001, which were included in its SEC filings, were wrong and would have to be restated.  Following this announcement, several of Enron’s D&O insurers filed motions with the Bankruptcy Court asserting that they have determined that their policies were issued based upon material misrepresentations by Enron and stating that they are not bound by their policies.

Rescission of a D&O policy is an insured’s worst nightmare.  What can you do to protect yourself from this fate?  The most important step is to ensure that you have a broad “application-severability” clause in your D&O policy.  This clause will protect you against falsehoods made by other directors or officers in the D&O application.  A well-drafted clause does two things.  First, it states that no statement in the application, or knowledge possessed by an insured person, shall be imputed to any other insured person.  Second, it provides that the application shall be construed as a separate application for each insured person.  Some policies include such a provision, but most do not.  Expect difficulty in negotiating such a provision in this hard market.

The absence of a “priority-of-payments” provision or “application-severability” clause can mean the difference between coverage and no coverage.  Therefore, it behooves you to make sure your D&O policy is negotiated with all the care, skill and attention to detail your company uses to negotiate its other multi-million dollar contracts.

For more information, contact Stephen  J. Weiss, toll free at 888-688-8500, or via e-mail at sweiss@hklaw.com.