Who Gets the Keys to the Safe: The Battle For Proceeds of Directors and Officers Policies

October 23, 2003

It is difficult to read the newspaper without learning about new allegations of corporate misbehavior being levied against the senior leadership of a publicly held corporation.

Correspondingly, corporations are encountering greater financial difficulties and even filing for bankruptcy as a result of the malfeasance of its most trusted leaders, the directors and officers of the corporation. Whether it is the creditors of the corporation or the directors and officers themselves, the question as to who has access to the proceeds of a directors and officers insurance policy can have far reaching consequences when the corporation has filed for bankruptcy protection.

The seminal issue is whether the proceeds of the insurance policies are considered property of the bankruptcy estate. If a court determines that the proceeds of the policies are the property of the estate, the automatic stay attendant to the bankruptcy proceedings prevents the insurer from distributing [or disputing] any of the proceeds absent a court order. Correspondingly, if the proceeds are not the property of the estate, the insurer is free to disburse the proceeds or litigate coverage issues.

A recent case from the Southern District of New York is the latest to address the question of whether the proceeds of Directors and Officers (“D&O”) insurance policies are property of the bankruptcy estate. In Re Adelphia Communications Corp, et al., 298 B.R. 49, 2003 WL 22005944 (S.D.N.Y. Aug. 25, 2003). In Adephia, the court determined that the proceeds of Adelphia’s D&O policies were not property of the bankrupt estate and that a rescission action filed by D&O insurers was not subject to the automatic stay provisions of the bankruptcy code.

Between March and June of 2002, Adelphia and its affiliate as well as its subsidiaries filed voluntary petitions for bankruptcy relief under Chapter 11 in the Southern District of New York. In July of 2002, the United States Department of Justice instituted criminal proceedings against five Adelphia directors with charges of conspiracy, securities fraud, wire fraud, and bank fraud. The same five directors were later named as defendants in a civil suit filed by the Securities and Exchange Commission and all of the directors were named as defendants in numerous fraud and shareholder suits.

In September of 2002, several of the Adelphia directors and officers filed papers in the Southern District of New York seeking relief from the automatic stay attendant to the bankruptcy proceedings to allow payment or advancement of defense costs under D&O policies issued to Adelphia.

Shortly thereafter, the D&O insurers sought to rescind the policies and brought a declaratory judgment action against certain Adelphia officers and directors. Concurrently, the insurers also sought relief from the automatic stay to name Adelphia and its affiliate as defendants in the declaratory judgment action.

The bankruptcy court determined that the automatic stay applied to the insurers’ petitions for relief in an attempt to pursue coverage litigation against Adelphia. In addition, the court ruled that the stay applied to the insurer’s coverage litigation pending against Adelphia’s directors and officers.

However, the court ruled that five directors were entitled to relief from the stay in their effort to make a claim from the insurers for up to $300,000 per insured for defense costs related to the underlying actions. Notably, the bankruptcy court ruled that the proceeds of the D&O policies were property of the bankruptcy estate. The court initially stated that the question of whether the proceeds of a D&O policy are the property of the bankruptcy estate requires an individual analysis dependent on the facts presented in each case.

The court recognized that the facts present in the Adelphia case were similar to facts in other cases where a determination had been made that the proceeds were the property of the estate (i.e. the policies provide “entity coverage” for exposure to claims of securities fraud, and the policies in question also reimburse each estate to the extent that the estate advances funds by reason of indemnification obligations in the corporate charter or by-laws).

In addition, the court determined that by giving access to the insurance proceeds themselves, the risk that the policies would be depleted was a significant consideration in determining whether the automatic stay should apply to the instant situation.

Importantly, the district court reasoned that the proceeds of the D&O policies are not property of the bankruptcy estate. The court noted that (1) it had not been suggested that any of the debtors had not made or contemplated any payments for which they would be entitled to indemnification coverage, and (2) none of the debtors had made or committed themselves to payments using their entity coverage under the D&O policies. The court analogized the argument that the debtors have a property interest in the policy proceeds to a car owner with collision coverage claiming he has the right to proceeds from the policy simply because there is a prospective possibility that his car will collide with another tomorrow.

The court also determined that the automatic stay did not apply to the coverage dispute between the D&O carriers and certain of Adelphia’s directors. However, the court remanded the case to the bankruptcy court to determine whether litigation should be stayed pursuant to the broad discretion it maintains in such matters via 11 U.S.C. Section 105. This provision has been utilized by some courts to enjoin suits by third parties if they threaten to thwart or frustrate the reorganization efforts.

Undoubtedly, each case concerning the entitlement to the proceeds of the D&O policies will be decided upon its individual facts, but the Adelphia case highlights that certain courts may find that the policy proceeds are not property of the bankruptcy estate, allowing D&O insurers an opportunity to litigate coverage issues.

Andrew S. Boris is a partner in the Chicago office of Tressler Soderstrom Maloney & Priess. His practice is focused on litigation and arbitration of insurance coverage and reinsurance matters throughout the country, including general coverage, bad faith, directors and officers liability, professional liability, environmental, and asbestos cases. Questions and responses to this article are welcome at aboris@mail.tsmp.com The Tip of the Month runs each month on claimsguides.com.

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