D&O Insurance Policies in Bankruptcy Proceedings

Author: Adnan Arain

Executives may not typically consider bankruptcy proceedings when purchasing Directors & Officers (D&O) insurance. Yet in bankruptcy, D&O insurance policies may prove valuable by covering adversary proceedings and other litigation against the directors, officers and employees of the entity entering bankruptcy (the Insured Individuals). The first in a series addressing insolvency, this paper addresses the importance of D&O insurance policy provisions covering litigation against Insured Individuals during the pendency of the Insured Entity’s bankruptcy proceedings, while also providing basic overview of Chapter 7 and Chapter 11 bankruptcy proceedings. 

Consider the following scenario: 
A director serves on the board of a company that suffers a severe cash shortage and ultimately files for bankruptcy. One of the parties in interest¹ in the bankruptcy case alleges that the board of directors committed acts, errors or omissions that caused the company to enter into insolvency proceedings. 

Notably, the director may face the allegations without any indemnification by the insolvent company. Without a robust D&O insurance policy in place, the director will have to self-fund any defense along with any verdict or settlement. Where a properly worded D&O insurance policy is in place with limits intact, however, the director should receive defense and indemnification for any covered claims, and should not have to pay a dime from her own assets.

The effect of bankruptcy proceedings on existing D&O insurance coverage 

At the outset, one should consider how filing for bankruptcy affects D&O insurance coverage that is already in place at the time of the bankruptcy filings. Bankruptcy courts have generally considered existing D&O insurance coverage for the entity property of the bankruptcy estate,² and this includes reimbursement for the indemnification of directors, officers or employees.³ Bankruptcy courts have not traditionally allowed for D&O coverage to continue as a matter of right (either entity coverage or reimbursement to the entity for indemnification of directors, officers or employees).⁴ Instead, any deploying of limits would typically be ruled upon by the bankruptcy judge.⁵

In their rulings, however, bankruptcy courts have been more accommodating of insurance defense payments or reimbursements directly to Insured Individuals, where there is no aspect of insurance coverage or reimbursement directly to the entity.⁶ Insured individuals (directors, officers or employees) must specifically petition for the bankruptcy court to lift the stay in order to receive insurance reimbursement payments.⁷

One formulation of a general rule is that the D&O insurance policy is an asset of the estate, but proceeds for the protection of Insured Individuals may not be.⁸ Some courts have taken it a step further in recognizing the need to preserve separate insurance proceeds to be set aside specifically for the defense of individual directors and officers.⁹ Yet another approach by bankruptcy courts is that the debtor entity has no property interest in the D&O insurance policy until it indemnifies the Insured Individuals.¹⁰ Ultimately, the debtor entity may be subject to how much creditors will want to support the ongoing operation of the D&O policy, as opposed to having it stayed during the course of the bankruptcy.

Bankruptcy basics: Chapter 7 and Chapter 11 

How litigation proceeds against individuals associated with the entity will depend upon the type of bankruptcy proceeding, Chapter 7 vs. Chapter 11. Chapter 7 focuses on dissolution, a complete liquidation and winding down of the company in order to pay off creditors, whereas Chapter 11 focuses on restructuring the organization. 

At the start of Chapter 7 proceedings, a case trustee is appointed by the judge to manage the affairs of the entity as it winds down. The bankruptcy court and the trustee together take steps aimed at achieving one end: the orderly valuation and sale of assets in order to pay the creditors in order of priority. Secured creditors are paid first, followed by unsecured creditors, such as lenders, suppliers and bondholders. Equity holders are last in the order of priority, often meaning that the shares effectively have no value upon the entity’s filing for Chapter 7 bankruptcy.¹¹

Chapter 11 proceedings often have a similar ultimate effect on equity holders, albeit via a different route. In the context of Chapter 11, most reorganization plans cancel existing shares, and issue “new” shares that become effective upon the approval of the reorganization plan.¹² Additionally, during the course of the reorganization, the Chapter 11 court uses the prospect of equity in the newly restructured entity (the “new company”) as an incentive for financiers.¹³

Management of the “old company” (the company entering into bankruptcy proceedings) remains intimately involved in the entire bankruptcy process, however. The old company is in theory replaced by a new legal entity known as the “debtor in possession” moving forward within the bankruptcy proceedings, but in practice this amounts to essentially the same personnel in terms of makeup, including management. The company and its management will still adhere to the original business model and strategy, with the same operations, in the same locations and with the same existing workforce; generally speaking, it will do so with the full blessing of the creditors.¹⁴ The main difference, however, is that the overall mission of the entity is no longer to maximize value to shareholders—the overall mission of the entity is to serve the interests of the creditors by working with them to create a reorganization plan.¹⁵ 

While the debtor in possession and creditors are in the process of creating and approving this reorganization plan, there are a number of operational steps the bankruptcy court oversees. We list the operational steps below—the debtor in possession participates in each. 

• The bankruptcy court schedules an initial meeting between the debtor in possession and the creditors. This conference presents creditors the opportunity to ask specific questions about the debt, outgoing management’s plan to repay it, assets and sources of revenue of the entity at the time of its filing for bankruptcy.¹⁶ 
• The court enforces an automatic stay, suspending all debt payments and contracts whose performance has not yet begun. The court also possesses the ability to recover preferential transfers or fraudulent transfers. 
• Key operations of the debtor in possession will be monitored by the creditors, under the supervision of the U.S. Trustee, ¹⁷ during this Chapter 11 case. The debtor in possession must report to the Trustee monthly regarding the following: income, operating expenses, the establishing of new bank accounts and taxes, including with regard to current employee withholding. 
• The debtor in possession retains the ability to hire outside attorneys, accountants and other professionals. The professional must, however, apply for fees to the bankruptcy court for payment of these professionals in intervals of 120 days.¹⁸ 

The reorganization plan must be approved by certain percentages of various parties in interest.¹⁹ If the parties cannot agree on a plan, a party may motion for other means to conclude the case, including motioning for the case to enter into Chapter 7 bankruptcy proceedings instead. 

Of note for the purposes of this paper, Chapter 11 proceedings include a U.S. trustee, but unlike a Chapter 7 case trustee, the U.S. trustee in a Chapter 11 proceeding monitors the debtor in possession’s compliance in reporting procedures. Chapter 11 proceedings may also include a case trustee, but only if a party in interest makes a motion for cause. The party making the motion may cite fraud, incompetence or gross mismanagement, or may claim that a case trustee would generally serve creditors’ interests.²⁰

Litigation against the filing entity, or its directors, officers or employees 

Now having introduced an overview of Chapter 7 bankruptcy and Chapter 11 bankruptcy, we can address how litigation proceeds under either chapter. Plaintiffs fall into two broad categories for the purposes of our discussion: parties in interest in the bankruptcy proceeding and all others. 

Litigation by parties not related to the bankruptcy proceeding

Outside of the parties in interest, litigation proceeds according to the following principles. We have covered the fact that prior-to-bankruptcy litigation is stayed, and will not proceed until the bankruptcy court grants relief from the stay or the bankruptcy proceeding is concluded. All new litigation by outside parties not related to the bankruptcy can be brought in any jurisdiction if based upon post-petition acts of the entity or the entity’s Insured Individuals. To the extent that the plaintiffs seek insurance proceeds of the entity, the plaintiffs may seek to bring litigation by filing a complaint within the bankruptcy proceeding, in what is known as an “adversary proceeding.”²¹

Litigation by parties in interest 

The parties in interest in the bankruptcy may bring motions within the bankruptcy proceeding itself, and therefore have no need to litigate against the entity in another forum. The parties in interest (the trustee, debtor in possession or creditor’s committee) may, however, sue the entity’s individual directors, officers or employees. 

As with litigation by parties unrelated to the bankruptcy, litigation by parties in interest may be brought in any court. For example, if pursuing a breach of fiduciary duty claim against a member of the board of directors, a plaintiff may choose to sue a Delaware corporation in Delaware Chancery Court, where judges have much more experience with such claims. Or the party in interest may opt to file a complaint within the bankruptcy proceeding itself, which falls under the category of adversary proceeding.

Adversary proceeding within bankruptcy vs. suing in another court 

While a lawsuit may be brought either within the bankruptcy proceeding or outside of the bankruptcy proceeding, the final adjudication may or may not take place in the forum selected by the plaintiff. In a landmark case from 2010, the U.S. Supreme Court held²² that the findings of bankruptcy courts only count as “final judgment” on issues that are considered “core”²³ to the bankruptcy proceeding.

For any “non-core” issues, a ruling by the bankruptcy court would be considered a non-binding, “proposed finding of fact and conclusion of law”²⁴ to be considered by the federal district court of proper jurisdiction for its final adjudication.²⁵ Federal statute specifically provides for the removal of matters from district court to bankruptcy court²⁶ and vice versa²⁷ according to these principles.²⁸

D&O insurance coverage during the pendency of bankruptcy proceedings 

Regardless of where the suit is brought and where it is ultimately decided, there would remain only one source of insurance proceeds to protect the directors, officers and employees of the entity if they are sued—the D&O insurance policy. Because the bankruptcy court typically considers proceeds under the D&O insurance policy to be part of the bankruptcy estate, claims are not generally paid to indemnify Insured Individuals unless the bankruptcy court consents. Notably, the consent of the bankruptcy court is typically required for the deployment of limits, regardless of where the lawsuit is brought.²⁹ 

Returning to the opening scenario, the D&O policy serves as an effective lifeline to millions of dollars of defense or loss. In a Chapter 11 proceeding, the debtor in possession might have the availability of cash to indemnify the Insured individuals, after which the entity could petition the bankruptcy court for indemnification by the D&O policy. In the event that the entity would lack the availability of cash to indemnify the individual due to insolvency (under either Chapter 7 or 11), Side A coverage would apply. The policy limits would deploy to cover the first dollar of defense or loss incurred by the individuals. Without a D&O policy in place prior to filing for bankruptcy, the directors, officers and employees are left without a lifeline—they must rely upon their own individual assets to cover the cost of litigation along with any verdicts or settlements.