On June 8, 2007, Delaware Bankruptcy Judge Kevin Gross issued a decision in the World Health Alternatives, Inc. bankruptcy case that corporate directors, officers, attorneys, and bankruptcy professionals alike will find of interest. A copy of the Court’s 13-page decision and short order is available here.
The Three-Sided D&O Policy. The issue in the case was whether a Chapter 7 bankruptcy trustee could get an injunction to prevent directors and officers from using the proceeds of a Director and Officer (D&O) liability policy to settle a shareholder lawsuit pending in another court (known as the Consolidated Action). The underlying question centered on who owns the proceeds of a D&O policy when the policy provides:
- Side A coverage for directors and officers;
- Side B coverage for the corporation’s expenses in indemnifying directors and officers; and
- Side C coverage for the corporation’s own exposure for securities litigation claims.
As is true with many D&O policies, the policy involved in this case also had a "Priority of Payments" endorsement that gave payments under the Side A coverage for the directors and officers priority over both the Side B and Side C coverages.
Does The Automatic Stay Stop Use Of A D&O Policy’s Proceeds? The Chapter 7 trustee sought to block the use of the D&O policy’s limited proceeds to settle the shareholder lawsuit, arguing that they were property of the bankruptcy estate and that the effort to use them to settle this Consolidated Action violated the automatic stay of bankruptcy. The Chapter 7 trustee had his own lawsuit pending against the directors and officers and he wanted to keep the "wasting" D&O policy (called "wasting" because the policy proceeds also had to cover defense costs) available to cover his claims. The debtor corporation had been dismissed from the shareholder litigation so no Side C coverage was implicated, and because no indemnification had been or was likely to be paid, the Side B coverage had not been triggered.
In denying the Chapter 7 trustee an injunction, the Delaware Bankruptcy Court held that although the policy was property of the bankruptcy estate since the debtor corporation had purchased it, the policy’s proceeds were not. Although acknowledging that some other courts had ruled differently, Judge Gross followed an earlier Delaware Bankruptcy Court decision in In re Allied Digital Technologies Corp., 306 B.R. 505 (Bankr. D.Del. 2004), and held as follows:
Applying the rulings in the cases cited above to the case at hand, it appears that the proceeds of the Debtor’s insurance policy are not property of the estate. The Court arrives at this conclusion from its review of the ‘language and scope of the [P]olicy at issue.’ Allied Digital, 306 B.R. at 509. The Policy proceeds which are being used to fund the Settlement and are being held in escrow by Lead Counsel are from the Policy’s Coverage A. World Health, and now the Trustee as successor, has no right to any Coverage A proceeds, which insures only World Health’s officers and directors. World Health must look to Coverage B which insures it for indemnification claims. There are no such claims against World Health. If the Trustee is seeking to recover for the wrongs of the defendants in the Trustee’s Action pending in this Court, it is not entitled to preference over the settlement of the Consolidated Action. As the Court held in Allied Digital:
The Trustee’s real concern is that payment of defense costs may affect his rights as a plaintiff seeking to recover from The D&O Policy rather than as a potential defendant seeking to be protected by the D&O Policy. In this way, Trustee is no different than any third party plaintiff suing defendants covered by a wasting Policy.
Id. at 512.
Judge Gross ruled that the automatic stay did not apply to the policy proceeds at issue and, as a result, the Chapter 7 trustee was not entitled to an injunction to stop them from being used to settle the other litigation.
The Take-Aways. When D&O policy proceeds are being used by insured directors and officers to fund a defense or settlement of a covered claim, a bankruptcy trustee generally will not be able to interfere if none of the other coverages — specifically the Side B and C coverages — has been invoked.
If claims have been made against the Side B or Side C coverages, the outcome could very well be different.
A Priority of Payments endorsement, which gives priority to the Side A coverage for directors and officers, is one tool to consider to help ensure that the D&O policy is available for directors and officers first. However, the law is not clear whether that endorsement would trump the automatic stay if the other coverages were invoked.
These issues are complicated and those with a stake in these questions should be sure to get legal advice on both the bankruptcy and insurance coverage issues involved.
For more discussion of the decision and the insurance issues raised, be sure to read Kevin M. LaCroix’s excellent post at The D&O Diary. Special thanks to Francis G.X. Pileggi of the Delaware Corporate and Commercial Litigation Blog for highlighting Kevin’s post.