A D&O liability policy protects key individuals in a corporate structure.  These individuals are likely targets for shareholder frustration if an entity is underperforming or suffering from other troubles.  In addition, they may be exposed to personal scrutiny from regulators if the corporation is investigated for any wrongdoing.  As previously discussed in this space, an insurance policy can provide more reliable protection for the indemnification rights of the officers and directors in times of financial distress because corporations plagued by regulatory or other legal problems frequently suffer financial setbacks.  However, when a bankruptcy results from the financial troubles, not all insurance policies offer the same protection for the payment of fees and expenses for its directors and officers. 

Under section 541 of the Bankruptcy Code, a debtor’s liability insurance policy is the property of a bankruptcy estate and is subject to the jurisdiction of the Bankruptcy Court, including the automatic stay.  There is considerable disagreement among the courts over whether the proceeds of the policy are also property of the estate.  The actual determination of whether the proceeds are property of the estate is made on a case by case basis and is controlled by the express language and scope of the policy. 

When the D&O policy only provides direct coverage to the debtor, there is little doubt that the proceeds are part of the debtor’s estate and are to be administered by the Bankruptcy Court for the benefit of all creditors.  Similarly, when the policies only provide direct coverage to the individuals for their indemnification claims courts generally hold that the bankruptcy estate has no interest in the proceeds.  However, when the policy provides direct coverage to both the debtor and the directors and officers, the proceeds will be property of the estate if depletion of the proceeds would have an adverse effect on the estate.  Depletion of the proceeds will be construed to have an adverse effect on the estate if the policy proceeds actually protect the estate’s other assets from diminution. 

This scheme, while appearing clear and equitable, can impact individual officers and directors if the corporate D&O Policy falls into the third category.  Because the proceeds of the policy could be used for the benefit of either the individual insureds or the debtor company, the courts uniformly hold that the proceeds are assets of the estate and subject to the automatic stay requirements of section 362 of the Bankruptcy Code.  The individual insureds must then seek relief from the automatic stay in order for the insurance proceeds to be available to pay defense costs.  When the debtor may also have claims against the policy an inherent tension exists between the parties which the Bankruptcy Court must balance using the language of the insurance policy as its guide.   

For example, in In re Downey Financial Corp., 428 B.R. 595 (Bankr. D. Del. 2010), the Bankruptcy Court for the District of Delaware was faced with an insurance policy that provided coverage to both individuals and the debtor entity.  Because the underlying claims against the debtor had been dismissed the debtor required no direct coverage for the claims.  Only claims for indemnification from the individual insureds remained against the policy.  Since the trustee was unlikely to provide indemnification to the individuals, the debtor’s claims against policy were, at best, speculative.  Importantly, the Bankruptcy Court found the policy contained an express priority scheme which required that the individuals be indemnified prior to any distributions being made to the debtor.  Therefore, the court concluded that if it determined that the proceeds were property of the bankruptcy estate and subject to the automatic stay, the trustee would have greater rights in the policy proceeds than the debtor had prior to the filing of the bankruptcy. 

Even if a bankruptcy court makes an initial determination that the policy proceeds are property of the estate, it may be appropriate for the court to grant relief from the automatic stay for the purpose of protecting the interests of the individuals.  For example, in In re CyberMedica, Inc., 280 B.R. 12 (Bankr. D. Mass. 2002), the company had a liability insurance policy which provided direct coverage for the directors and officers as well as indemnification and entity coverage for the debtor.  After concluding that the proceeds from the policy were assets of the estate, the court nevertheless found cause to lift the automatic stay and allow ongoing indemnification of the individuals.  This finding was based upon a balance between the interests of the individuals, who were in immediate need of their contractual rights to indemnification and could suffer harm if their defense was not properly funded, as opposed to the interests of the debtor, whose claim for coverage was purely speculative because it had no present claims for coverage. 

Finally, even if the proceeds of the policy are initially determined to be assets of the estate and subject to the automatic stay, events in the case could change that determination.  For example, in In re MF Global Holdings Ltd., Case No. 11-15059 (MG), slip op. (Bankr. S.D.N.Y. 2014), the Bankruptcy Court for the Southern District of New York the individual insureds repeatedly requested relief from the automatic for the purpose of funding defense costs from the proceeds of various insurance policies which the debtor had purchased for that purpose.  Initially the court granted relief from the automatic stay to allow the insurers to advance up to $30 Million for fees and expenses against the policies.  Later this “Soft Cap” was increased to $43.8 Million.  During the case and after confirmation of a plan of liquidation, the individuals’ legal expenses continued to mount.  Since no new direct claims could be brought against the debtors for which coverage could apply, the individual insureds sought to have the policies excluded from the estate’s assets. 

 The policies contained a priority of payment provision similar to the one contained in the Downey case.  Noting that the trustee should not gain greater rights in the policy by virtue of the filing, the court concluded that, with a very limited exception, the proceeds of the policy were no longer property of the estate and the proceeds should be made available to the individuals for their defense costs. 

Therefore, when purchasing D&O insurance, care should be given to the language of the policy to make sure it is available to the key employees in times of need.  While proceeds from a policy providing only direct coverage to the individuals will most likely be excluded from the assets of the estate and available to the individuals, it does not provide the corporation with the flexibility it may need to elect between paying indemnification costs directly for matters which appear small at first blush.  Therefore, if the corporation elects to purchase a D&O policy with benefits for both the individuals and the corporation it should include a priority of payment provision to protect the interests of the individuals.