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Thomas H. Bentz, Jr.
Shannon A Graving
Holland & Knight

Editor's note: Each month, we ask a Directors & Boards reader to comment on critical issues facing directors today. If you'd like to participate in this section in the future, please email Scott Chase.

HOW TO PREPARE YOUR D&O INSURANCE POLICY FOR THE SUBPRIME CREDIT CRISIS

How can directors gauge and perhaps improve the effectiveness of existing D&O policies as the subprime credit crisis plays out?

As companies try to sort out the impact of the subprime credit crisis, many directors and officers are asking whether their D&O insurance will protect their personal assets if their company files for bankruptcy. The short answer is that it depends on how well the D&O policy was negotiated.

Most standard D&O policies do not offer optimal protection to directors and officers for subprime related bankruptcy claims – however, if you know what to ask for, most insurers will offer enhancements to their standard policies to provide additional protection. The following outlines why some D&O policies may not cover subprime related bankruptcy claims and provides some examples of provisions that need to be negotiated in a typical D&O insurance policy.

Why don’t some D&O policies cover subprime related bankruptcy claims?

A typical D&O insurance policy offers three main types of protection:

(1)     Side A coverage, which protects directors and officers when the company may not indemnify them by law or for public policy reasons or cannot indemnify them due to financial insolvency;

(2)     Side B coverage, which protects the company by reimbursing the company for amounts it pays to its directors and officers as indemnification; and

(3)     Side C coverage, which protects the company for its own wrongful acts (typically limited to securities actions in public company D&O policies but may provide broader protection in private company and non-profit company policies).

Although most claims are paid under either the Side B or Side C coverage of the D&O policy, Side B and Side C coverage can have real disadvantages from the perspective of directors and officers in the context of a bankruptcy. The bankruptcy court may consider the D&O policy proceeds to be subject to the automatic stay imposed by the Bankruptcy Code and unavailable to directors and officers, who may be left self-funding any defense, settlement and/or judgment until the bankruptcy case is resolved (a process that could take years). Worse yet, the bankruptcy court could decide that the policy proceeds are assets of the company’s bankruptcy estate and therefore available to creditors to satisfy the company’s liabilities, leaving the directors and officers with little or no coverage for their losses.

What provisions need to be negotiated so my D&O policy will respond to a subprime related bankruptcy?

1.    The Definition of Insured / Change in Control

When a company files for protection from its creditors under Chapter 11 of the Bankruptcy Code, the company becomes a “debtor-in-possession.” To ensure continuing coverage, the definition of “insured” should include a debtor-in-possession and the definition of a "change in control" should not include the filing for bankruptcy under Chapter 11 of the Bankruptcy Code.

2.    The Insured vs. Insured Exclusion

D&O policies typically contain an “insured vs. insured” exclusion to avoid covering collusive disputes. Although suits by a bankruptcy trustee or a creditors’ committee against directors or officers on behalf of the debtor company are obviously not collusive, this exclusion can bar coverage for the suit. To ensure protection in this situation, the insured vs. insured exclusion should “carve out” suits by a bankruptcy trustee, examiner, receiver, liquidator, rehabilitator, creditors’ committee or any comparable authority.

3.    The Order-of-Payments Provision

A typical “order-of-payments” provision states that the D&O policy limits should be applied first to losses due under the Side A coverage. Then, if any limits remain, payments will be made to the company under the Side B and/or Side C coverage. Some courts have cited the order-of-payments provision as evidence that the policy proceeds are intended to benefit directors and officers, not the company. Although not all courts agree with this conclusion, directors and officers should insist on an order-of-payments provision.

4.    The Cancellation Clause

Many D&O policies allow the insurer to cancel its policy for any reason or no reason at all (e.g., when an underwriter fears a subprime related bankruptcy filing may be in the company’s future)! Consequently, it is necessary to make sure that the insurer may only cancel coverage if the company fails to pay the premium when due.

5.    Non-Rescindable Coverage

Rescission is the act of completely voiding a policy due to a fraud or misrepresentation in the application for insurance, thereby eliminating all coverage for all insureds back to the inception date of the policy. Insureds should request non-rescindable coverage, but must be very careful that such endorsement does not actually make it easier for insurers to deny coverage.

6.    The Application Severability Provision

Absent an “application severability provision,” if any insured had knowledge of a fact that was misstated in the application, the insurer could void coverage for all insureds. By including an application severability provision you can avoid this potentially unfair result by making it clear that the knowledge of one insured will not be imputed to any other insured for the purpose of determining whether coverage is available under the policy.

7.    Dedicated Limit Policies

Another option for directors and officers concerned about a subprime related bankruptcy risk is to purchase a dedicated limit insurance policy such as a “Side A Only” or an “Independent Directors' Liability” insurance policy. These policies typically sit on top of a traditional D&O program and only cover non-indemnifiable claims against directors and officers. Since the company is not insured by the policy, company losses cannot erode or exhaust the limit. For the same reason, the proceeds of a dedicated limit policy should not be treated as an asset of the bankruptcy estate. Thus, it will remain beyond the reach of a bankruptcy court and any creditors of the company.

Is time of the essence?

D&O insurance is often the last line of defense for the personal assets of a director or officer. As such, directors and officers cannot leave to chance whether this multi-million dollar asset will protect them if their company files for bankruptcy due to the subprime credit crisis. Directors and officers who assume that they are protected just because their company has D&O insurance may find out too late that their protection is inadequate. In short, directors and officers need to negotiate improvements to their D&O insurance policies now to be sure that their personal assets will be protected.

Thomas H. Bentz, Jr. is a Partner in the law firm of Holland & Knight and leads the firm’s D&O and Management Liability Insurance Team. Shannon A. Graving is an Associate at the firm and also practices insurance law with a focus on D&O policy negotiation. Together, the authors are among the nation’s leading authorities on D&O and employment practices liability insurance. For more information, email Thomas H. Bentz, Jr. at thomas.bentz@hklaw.com or call toll free, 1-888-688-8500.

The authors would like to thank Eugene E. Skonicki for his help with this article.