A company's bankruptcy filing affects its D&O insurers and the insured directors and officers in significant ways. One area of concern is the distribution of policy proceeds where the directors and officers continue to face costs and exposure from shareholder and derivative actions but the corporation has filed for protection under the Bankruptcy Code. Are the policy's proceeds property of the debtor's estate and therefore subject to the automatic stay of 11 U.S.C. § 362(a)? May a company's directors and officers continue to obtain benefits under a D&O policy after the company has filed for bankruptcy protection? And what impact does the company's failure to satisfy its retention have on the right of the directors and officers to seek reimbursement?

On May 7, 2010, the United States Bankruptcy Court for District of Delaware addressed these issues in In re Downey Financial Corp., Case No. 08-13041 (CSS), holding that under the terms of the insurance contract at issue, the policy's proceeds did not constitute property of the estate, or, alternatively, that the directors and officers were entitled to relief from the automatic stay to access policy proceeds. As a result, the company's directors and officers were permitted to recover their defense costs even though the retention had not been satisfied and such payments would erode the policy's overall limits.

1. FACTS OF THE CASE

A. The Policy

Downey Financial Corporation ("Downey") and its directors and officers were insured under an Executive and Organization Liability Policy issued by National Union Fire Insurance Company of Pittsburgh, PA. for the policy term July 7, 2007 to July 7, 2008 (the "policy"). The policy included "Coverage A," which insured directors and officers for losses for covered claims, "Coverage B," which insured Downey for losses for covered claims, and a "Coverage C," which insured Downey for costs it incurred in indemnifying its directors and officers. Importantly, the policy contained an "Order of Payments" provision expressly establishing a payment priority that favored the directors and officers. The clause provided that, if there was any conflict, National Union would pay a Loss under Coverage A and Coverage C first, and then pay a Loss under Coverage B. Moreover, the Order of Payments provision specifically provided that this priority would not be affected by a bankruptcy filing.

In addition, the policy had a $1 million retention, although such retention was not applicable to a "Non-Indemnifiable Loss." The policy defined that term as a "Loss for which an Organization has neither indemnified nor is permitted or required to indemnify an Insured person pursuant to law or contract."

The bankruptcy court analyzed these provisions as follows:

Prior to a bankruptcy filing, the Policy requires the officers and directors to first seek indemnification from the organization for their defense costs.... However, once the organization files for bankruptcy, the officers and directors' defense costs become "Non-Indemnifiable Loss[es]." Because the Retention does not apply to Non-Indemnifiable Losses, once the organization files for bankruptcy, the Retention ceases to apply, and the officers and directors may seek coverage for their defense costs directly from the insurer under Coverage A, without regard to whether the $1 million Retention has been satisfied.

B. The Underlying Shareholder and Derivative Actions

In May and June 2008, two shareholder class action complaints were filed against the directors and officers of Downey, a holding company whose principal operating subsidiary was Downey Savings & Loan, a failed California bank. In November 2008, Downey filed for bankruptcy. On August 21, 2009, the shareholder class actions were dismissed with prejudice, but a derivative suit alleging many of the same claims was filed against the directors and officers.

Through November 2008, Downey paid $588,000 for the defense of its directors and officers. However, once the bankruptcy petition was filed, Downey no longer was able to indemnify them for their defense costs. The directors and officers, who owed their attorneys another $880,000 in fees, sought reimbursement under Coverage A of the policy. Notwithstanding, the bankruptcy trustee disputed their right to recover under the policy. In response, the directors and officers filed a motion with the bankruptcy court seeking an order that the proceeds of the policy were not property of the estate or, if they were, a ruling lifting the automatic stay.

2. THE RULING

The bankruptcy court held that the automatic stay of bankruptcy was not a bar to the directors' and officers' recovery of their defense costs under the policy, or if it was, they were entitled to relief from the automatic stay to recover their expenses.

First, the court concluded that the proceeds of the policy were not subject to the bankruptcy stay because they did not constitute property of the estate. The court explained that although a debtor's insurance policies generally are property of the estate, whether or not the proceeds of a D&O policy likewise are property of the estate is a fact-specific inquiry:

When a debtor's liability policy only provides direct coverage to the debtor, courts generally hold that the proceeds are property of the estate. Conversely, when the liability insurance policy only provides direct coverage to the directors and officers, courts generally hold that the proceeds are not property of the estate. When the liability insurance 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 to the extent the policy actually protects the estate's other assets from diminution.

Since the policy provided both the directors and officers and the company with coverage, the issue for the court was whether payment of the directors' and officers' defense costs would adversely affect the estate because the policy was necessary to protect against the diminution of other estate assets. Answering this inquiry in the negative, the court concluded that there was no real risk of Downey's facing any further shareholder or derivative claims. Here, the securities class actions had been dismissed with prejudice and the plaintiffs in those actions had withdrawn their proof of claim from the bankruptcy court. The derivative action (in which Downey was only a nominal defendant) was also stayed due to the bankruptcy. Since there would be no further claims against Downey, there was no justification for treating the policy proceeds as estate property – as such, there was no longer any need to maintain the policy to protect other assets of the estate against these non-existent claims.

In so deciding, the court relied upon In re Allied Digital Technologies, 306 B.R. 505, 509 (Bankr. D. Del. 2004), where the court engaged in a similar analysis and concluded that the proceeds of a D&O policy were not property of that debtor's estate. In that case, the court relied on the fact that all securities claims against the debtor had been adjudicated or were barred by the statute of limitations.

Next, the court rejected the argument that the policy was property of the estate because Downey was entitled to coverage under the policy's indemnification provision (Coverage C). The trustee argued that Downey had indemnified the directors and officers and that they were demanding further indemnification for their defense costs. However, as the court explained, a D&O policy providing a company with indemnification coverage is not property of the estate where "indemnification either has not occurred, is hypothetical, or speculative." Here, the court concluded, there was no chance that the company would ever have a claim under Coverage C:

While the Debtor had, in fact, indemnified the Insureds in the amount of $588,000 prior to filing this bankruptcy proceeding, it had still not exhausted the Policy's $1 million Retention. Therefore, no indemnification for which the Debtor would be entitled to coverage under the Policy has occurred. Unless the Debtor would be entitled to coverage under the Policy, indemnification would not "adversely affect the Debtor's estate," because such indemnification would not deplete the Policy proceeds.

Since (i) the directors and officers had not sought indemnification from Downey once it had filed for bankruptcy, (ii) the Trustee had stopped indemnifying the directors and officers, and (iii) the directors and officers had not filed a proof of claim, the court concluded that it was "extraordinarily unlikely" that Downey would exhaust its retention, thereby entitling it to indemnification under Coverage C of the policy.

The court further concluded that if the policy proceeds were found to constitute the property of the estate, such a holding would turn the policy's Order of Payments provision on its head. Downey and, hence, the Trustee, only had an interest in Coverage B, the coverage afforded to the company. On the other hand, the Order of Payments provision stated that Coverage A, insurance for the directors and officers, had priority over Coverage B. Thus, withholding the payment to the directors and officers under Coverage A because of the Trustee's interest in Coverage B would impermissibly elevate Coverage B so it was equal or even superior to Coverage A. In other words, as the court explained:

Prior to bankruptcy, there was no means by which the Debtor's interests in Coverages B(i) or B(ii) could become superior to, or even equal to, the Insureds' interest in Coverage A. Were the court to hold that the Policy proceeds are property of the estate, however, there would be a means by which the trustee's interests in Coverages B(i) and B(ii) could become at least equal to the Insureds' interest in Coverage A.

In other words, the court rejected the trustee's attempt, unsupported by the Bankruptcy Code, to alter the provision of the policy under otherwise applicable non-bankruptcy law, due solely to the fact that Downey was in bankruptcy.

Finally, the court found that, even if the proceeds of the policy were the property of the Estate and, therefore, subject to the automatic stay, relief from the stay was warranted. According to the court, a determination of whether to grant relief from a stay should be made by weighing three factors:

  1. Whether any great prejudice to either the bankrupt estate or the debtor will result from a lifting of the stay;
  2. Whether the hardship to the non-bankrupt party by maintenance of the stay considerably outweighs the hardship to the debtor; and
  3. The probability of the creditor prevailing onthe merits.

The court concluded that these factors weighed in favor of lifting the stay. There was no "great prejudice" to Downey from lifting the stay since Downey no longer was facing any potential liability that might be covered by the policy. Any conceivable prejudice to Downey was also "considerably outweighed" by the hardship to the directors and officers from the failure to lift the stay. As the court found: "[s]pecifically, the Insureds would have to pay the $880,000 in defense costs, as well as any defense costs incurred subsequent to the filing of this motion, out of their own pockets." Finally, the court found that the directors and officers had shown success on the merits, as evidenced by the dismissal of the shareholder class actions and the likely defeat of the derivative actions based on the same facts.

3. CONCLUSION

In sum, the Downey Financial Corp. court explained that, whether directors and officers of a company are entitled to reimbursement of defense costs while the company is in bankruptcy will depend in large part on the terms of the particular D&O policy. The court held that, under the terms of the National Union policy, the policy proceeds were not the property of the estate. Relying on bankruptcy law, the court also held that, even if the proceeds were property of the estate, lifting the stay was warranted to ensure reimbursement of the directors and officers for their covered defense costs. Finally, the court concluded that the directors and officers were entitled to reimbursement of their defense costs even though the $1 million retention had not been satisfied, citing the policy's provision that the retention did not apply to a Non-Indemnifiable Loss—which the court concluded included a claim against an insured in bankruptcy.

The court's conclusions, while sensible, were by no means preordained. The finding that the policy proceeds were not property of the estate resulted from a backward-looking analysis of the likelihood that Downey could realistically face liability covered by the policy. Indeed, the court buttressed its conclusions in this regard by alternatively ruling that the directors and officers had met their burden for seeking relief from the automatic stay to seek the policy proceeds.

An Insurer should continue to proceed with caution when faced with coverage claims from directors and officers of a bankrupt insured. In our view, it is wise for an insurer to obtain formal guidance from the court overseeing the bankruptcy before paying policy proceeds to non-debtors. Otherwise, it faces the specter of liability for improperly dissipating property of the estate, running the risk of being sanctioned by the court, and even being forced to pay out policy proceeds twice.

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