Corporate directors and officers may think indemnification provisions are sufficient to protect them from claims asserted against them by shareholders or regulators.  However, if a director or officer chooses to rely solely on indemnification in bylaws or contracts, and ignores the availability of directors & officers (“D&O”) liability insurance, he or she could be making a significant mistake.  In particular, a D&O policy can offer these individuals more reliable protection in times of financial distress.  When corporations are plagued by regulatory or other legal problems, they may also suffer from financial setbacks, eventually leading to bankruptcy proceedings. The manner in which a bankrupt corporation has provided for the payment of fees and expenses for its directors and officers may be critical to the individuals affected. 

Under section 502(e) of the Bankruptcy Code, a claim for indemnification is subordinated to the class of claims in which the underlying claim is placed.  This means that, to the extent that the directors and officers are jointly liable with the corporation to a third party on an adverse claim, they will not receive any distribution on their resulting indemnification claim unless, and until, all of the claims of the class in which the underlying obligation is placed have been paid in full.  This provision is intended to provide for equality of distributions in favor of all similarly situated creditors: if the underlying claim receives payments from both the corporation and the director and officer defendants and then the defendants receive payment on account of any contributions they made on the claim, that claim will have received a higher rate of distribution at the expense of other creditors.

For example, if the underlying claim is treated as an unsecured claim in the bankruptcy case, the claim for indemnification would be subordinated to the entire class of unsecured creditors.  Since it is unlikely that claims of the unsecured creditor would be paid in full, the subordinated claims of the director and officers would receive nothing on their indemnification claims.

A decision by Judge Walsh of the Delaware Bankruptcy Court in In re Mid-American Waste Systems, Inc., 228 B.R. 816 (Bankr. D. Del. 1999), shows how this can play out in practice.  In that case, Judge Walsh decided that the director and officer claims for indemnification were not entitled to priority status as administrative expenses because the origin of the claim arose prior to the petition date.  The directors and officers in question had been terminated by the corporation prior to or very shortly after filing of the bankruptcy petition.  Shortly after the petition date, litigation was initiated against the directors and officers alleging that they had made false and misleading statements about the debtor.  The officers and directors then filed claims for indemnification, asserting that they were entitled to treatment as administrative expense claims because the underlying actions had been commenced after the petition date.  The Debtor objected to the claims on the grounds that they were not allowable as administrative expenses.

Because administrative expenses are entitled to priority over pre-petition claims, a claimant seeking allowance of an administrative claim must show that it was for “the actual, necessary costs and expenses of preserving the estate, including wages, salaries and commissions for services rendered after the commencement of the case.”  Judge Walsh found there were no post-petition dealings between the debtor and the directors and officers because all of the conduct supporting the indemnification claims occurred prior to the petition date.  Instead he concluded that the right to indemnification was merely a claim for prepetition compensation for services rendered. 

Unlike Judge Walsh, some courts have permitted the advancement of legal defense costs as administrative expenses, as opposed to indemnification after the adjudication of the claim.  For example, in In re RNI Wind Down Corporation, 369 B.R. 174 (Bankr. D. Del. 2007), Judge Sontchi of the United States Bankruptcy Court for the District of Delaware ruled that a debtor and its former directors and officers were not co-debtors with respect to the advancement of attorney fees.  Therefore, Judge Sontchi concluded that the directors and officers were entitled to have their fees advanced as administrative expenses in accordance with applicable corporate law and the governing bylaws of the organization.   Similarly, in In re Adelphia Communications, 323 B.R. 345 (Bankr. S.D.N.Y. 2005), the Bankruptcy Court for the Southern District of New York permitted the debtor entities to make indemnification payments on account of legal fees for corporate insiders, but only to the extent the entities were obligated to do so under prevailing corporate law.

In any event, proper demand for reimbursement for or advancement of legal fees is critical to the allowance of the claim.  Judge Carey, also of the Delaware Bankruptcy Court, ruled in In re Touch America Holdings Inc., 381 B.R. 95 (Bankr. D. Del. 2008), that the award of any compensation for legal fees was contingent upon an express showing that a proper demand had been made for the compensation.  Since the summary judgment record did not reflect whether a proper demand had been made for such a claim, Judge Carey denied the relief requested.

In contrast to the potential treatment of claims as administrative expenses in a Chapter 11 case, when a case is either filed under or converted to a Chapter 7 case, the expected result is even worse for the director and officers.  Since the debtor corporation would not have ongoing operations in a Chapter 7 case, there would be no basis to allow reimbursement of legal fees as administrative expenses.  Rather, any claim for reimbursement, regardless of result in the underlying litigation, would, at best, expect to receive treatment as a general unsecured claim, or, more likely, be subordinated to those claims. 

Moreover, even when a company successfully defends against third-party claims, the claims of directors and officers for the reimbursement of legal fees and expenses incurred in the dispute may be the subject of an objection in a bankruptcy.  Given the unsettled law in this area, the most secure path to provide protection from lawsuits to directors and officers is the purchase of adequate D&O insurance.  The case law is clear that when the debtor has purchased insurance policies for the benefit of its directors and officers prior to the bankruptcy petition date, the proceeds of those insurance policies may be used to cover their legal fees and expenses.  In re Downey Financial Corp., 428 B.R. 595 (Bankr. D. Del. 2010).  In my next post, I will discuss this issue in more detail, explaining the policy language that can secure a director or officer’s right to recover against a D&O policy in a bankruptcy.

In summary, because courts have differed on how to treat a request for indemnification in a bankruptcy, directors and officers should pay close attention to the corporate decisions regarding the purchase and maintenance of D&O insurance, as it can be their best line of defense in the event the corporation faces financial difficulty.