“Finding the Upside in the Downturn”

In 2007, I worked for an insurance broker that worked exclusively with private equity firms and portfolio companies. I vividly remember a meeting we had in mid-2007 to plan our marketing calendar for the next twelve months. We were planning webinar topics geared towards the private equity space and someone suggested that we host an event to explain how a D&O policy should respond to a portfolio company bankruptcy. At the time it seemed like a VERY boring topic – the type of webinar that only your mother, best of friends, or people who owed you something would attend.

Serendipitously, the random date that we chose for the event, almost one year after our planning meeting, was in the spring of 2008. This fell during a time when private equity executives were incredibly concerned about the state of the economy. Initially, we had roughly just 10 people register for the webinar, however, that figure jumped to over 50 in the days leading up to its airing. It went from being an arbitrary topic choice to a very real concern for private equity executives overseeing many portfolio companies.

In hindsight, very few of my portfolio company clients filed for bankruptcy in the subsequent years. The ones that did served industry sectors like auto and construction, which were hit especially hard by the recession. However, in the early stages of the recession, the future of many companies was unclear at best.

This blog post provides high level insight into how defense costs can be advanced in a bankruptcy situation, particularly as creditors and bankruptcy trustees seek to preserve policy proceeds while the failed company’s directors and officers are seeking to rely on the policy to defend themselves against pending claims.

After entity coverage could be added to a D&O insurance policy a couple of decades ago, a recurring problem in the bankruptcy context was whether or not the D&O policy proceeds were property of the estate under Bankruptcy Code Section 541(a) and subject to the automatic stay under Bankruptcy Code Section 362. Directors and officers of the bankrupt company wanted access to the insurance proceeds to fund defense expense or settlements, but the bankruptcy trustee wanted the proceeds preserved so they are available to satisfy the trustee’s own claims, and so the trustee sought to subject payment of the proceeds to the bankruptcy stay.

Over time, a number of standard practices have evolved to facilitate defense expense funding in the bankruptcy context. As most practitioners who regularly deal with these issues know, the practical solution to these issues that seems to have been worked out is for the insured directors and officers to approach the bankruptcy court to try to obtain an order lifting the stay to allow the insurer to advance their costs of defense – usually subject to certain terms and conditions.

These orders are often referred to as “comfort orders,” since they allow the carrier to advance the defense costs without running afoul of the bankruptcy court.  Though these procedures may be well known to those who deal with them frequently, they may be less familiar to those who are not as frequently involved in claims presenting these issues.

The following illustrates how a potential scenario could unfold whereas a D&O insurer would advance the executives defense costs, subject to certain conditions:

• The insurer could be directed to provide a report to the trustee and the trustee’s counsel no more than 45 days after the close of each calendar quarter stating:

• The order might also:

• the total amount disbursed under the policy;

• the amount disbursed during the quarter;

• the amount of fee and costs requests pending for which the insurer had not yet made disbursement; and

• the total amount of coverage remaining under the policy.

• specify that the trustee retains the right to try to seek to have the stay reinstated;

• specifically state that the order not modify the parties’ various rights and obligations under the policy; and

• place an interim cap on how much can be spent on defense costs until the next reporting event.

While there may not be anything remarkable about this now, for many years this relatively straightforward process was highly controversial and extensively litigated, as a result of disputes over the extent to which the policy and the policy proceeds were assets of the estate of the bankrupt company.

Problems Still Emerge

While the processes followed here are now better established, problems still emerge.  For instance, funding problems can occur if the priority of payments clause in the D&O policy is not worded correctly. These clauses, which are now standard in most D&O insurance policies, address how the D&O insurance policy’s limits of liability are to be paid out so that the liabilities of the individual insureds are to be given priority and paid first.

Problems can potentially be averted if a policy has the type of priority of payments provision that “unambiguously state that the corporate entity and any successor, trustee or receiver has no rights to the insurance policy proceeds until all claims asserted against the individual insureds have been resolved.”

**Conclusion **

Private equity firms with portfolio D&O programs in place in advance of the recession had a distinct advantage in this regard.  Typically, portfolio programs include insight from outside counsel and standardized wording on every policy. This means that one phone call to the insurance broker will answer the question for all portfolio companies because they were on the same policy form.  For those that didn’t take this proactive step, it became a challenge to keep track of what was in place at each of their companies. There are many coverage elements in a D&O policy, so be sure to ask whether or not the D&O policy that you are considering will provide best-in-class protection in the unfortunate, and unlikely, event of a bankruptcy.

For more information about D&O policies, contact Josh Warren or John Haskell today.