Directors and Officers Liability Insurance and the Subprime Credit Crisis
As companies try to sort out the impact of the subprime credit crisis, many directors and officers are asking whether their D&O insurance will protect their personal assets if their company files for bankruptcy due to the subprime credit crisis.
Unfortunately, the protection provided by D&O policies varies significantly – especially when it comes to protecting directors and officers in a bankruptcy situation. Many “off-the-shelf” policies fall short or have significant holes in their coverage. Fortunately, most insurers will agree to amend their policies to provide stronger protection if asked. The following outlines why some D&O policies may not cover subprime related bankruptcy claims and provides some examples of provisions that should be included to better protect officers and directors in case of a subprime related company bankruptcy.
Why Some D&O Policies May Not Cover Subprime Related Bankruptcy Claims
A typical D&O insurance policy offers three main types of protection:
- Side A coverage, which protects individual directors and officers when the company may not indemnify them by law or for public policy reasons, or cannot indemnify them due to financial insolvency.
- Side B coverage, which protects the company by reimbursing the company for amounts it pays to its directors and officers as indemnification.
- Side C coverage, which protects the company for its own wrongful acts. Side C coverage is typically limited to securities actions in public company D&O policies but this type of coverage may provide broader protection in private company and nonprofit company policies.
Although most claims are paid under either the Side B or Side C coverage of the D&O policy, Side B and Side C coverage can have some real disadvantages from the perspective of directors and officers in the context of a company bankruptcy. Chief among those disadvantages is that the bankruptcy court may consider the D&O policy proceeds to be an asset of the bankruptcy estate, subject to the automatic stay imposed by the Bankruptcy Code and, accordingly, unavailable to individual directors and officers, who may be left self-funding any defense, settlement and/or judgment until the bankruptcy case is resolved – a process that could take years. Worse yet, the bankruptcy court could ultimately decide that the policy proceeds are assets of the company’s bankruptcy estate and, therefore, would be available to creditors to satisfy the company’s liabilities, leaving the directors and officers with little or no coverage for their losses.
Provisions That Will Facilitate Your D&O Policy’s Response to a Subprime Related Bankruptcy
1. The Definition of Insured / Change in Control
When a company files for protection from its creditors under chapter 11 of the Bankruptcy Code, the company becomes a “debtor-in-possession.” A debtor-in-possession is considered a separate legal entity from the company. To ensure continuing coverage, the definition of “insured” should include a debtor-in-possession.
In addition, the policy should not consider the act of filing for bankruptcy under chapter 11 a “change in control.” If it does, the D&O policy typically only covers wrongful acts of the directors and officers committed prior to the time of the change in control. This can be a problem in a chapter 11 because many directors and officers continue to act on behalf of the debtor-in-possession after a chapter 11 filing.
2. The Insured vs. Insured Exclusion
D&O policies typically contain an “insured vs. insured” exclusion. The purpose of the exclusion is to avoid covering collusive disputes. Although suits by a bankruptcy trustee or a creditors’ committee against directors or officers on behalf of the debtor company are obviously not collusive, many insurers take the position that the bankruptcy trustee or creditors’ committee stands in the debtor’s shoes. As such, the insured vs. insured exclusion can bar coverage for the suit. To ensure full protection against this situation, it is necessary to modify the insured vs. insured exclusion to “carve out” suits by a bankruptcy trustee, examiner, liquidator, rehabilitator, creditors’ committee or any other comparable authority.
3. The Order-of-Payments Provision
A typical “order-of-payments” provision states that the D&O policy limits should be applied first to losses due under the Side A coverage (i.e., the coverage for individual directors and officers). Then, if any limits remain, payments will be made to the company under the Side B and/or Side C coverage. Some courts have cited the order-of-payments provision as evidence that the policy proceeds are intended to benefit the individual directors and officers, not the company. Although not all courts agree with this conclusion, directors and officers should insist on an order-of-payments provision.
4. The Cancellation Clause
Many D&O policies allow the insurer to cancel its policy for any reason or no reason at all (e.g., when an underwriter fears a subprime related bankruptcy may be in the company’s future). Consequently, it is necessary to make sure that the insurer may only cancel coverage if the company fails to pay the premium when due.
5. Non-Rescindable Coverage
Rescission is the act of completely voiding a policy due to a fraud or misrepresentation in the application for insurance, thereby eliminating all coverage for all insureds back to the inception date of the policy. Insureds should request non-rescindable coverage, but must be very careful that such endorsement does not actually make it easier for insurers to deny coverage.
6. The Application Severability Provision
Absent an “application severability provision,” if any insured had knowledge of a fact that was misstated in the application, the insurer could void coverage for all insureds. By including an application severability provision, an insured can avoid this potentially unfair result by making it clear that the knowledge of one insured will not be imputed to any other insured for the purpose of determining whether coverage is available under the policy.
7. Dedicated Limit Policies
Another option for directors and officers concerned about a subprime related bankruptcy risk is to purchase a dedicated limit insurance policy such as a “Side A Only” or an “Independent Directors’ Liability” insurance policy. These policies typically sit on top of a traditional D&O program and only cover non-indemnifiable claims against directors and officers. Since the company is not insured by the policy, company losses cannot erode or exhaust the limit. For the same reason, the proceeds of a dedicated limit policy should not be treated as an asset of the bankruptcy estate. Thus, such proceeds should remain beyond the reach of the bankruptcy court and any creditors of the company.
D&O insurance is often the last line of defense for the personal assets of a director or officer. As such, directors and officers cannot leave to chance whether this multi-million dollar asset will protect them if their company files for bankruptcy due to the subprime credit crisis. Directors and officers who assume that they are protected just because their company has D&O insurance may find out too late that their protection is inadequate. In short, directors and officers need to negotiate improvements to their D&O insurance policies to be sure that their personal assets will be protected.
The authors would like to acknowledge the assistance of Eugene E. Skonicki in the preparation of this article.