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ISSUES FACING OFFICERS AND

DIRECTORS IN FINANCIALY
TROUBLED COMPANIES

January 29, 2009


OUTLINE
 Zone of Insolvency  Directors and Officers Insurance

○ Defined ○ Mechanics

○ Causes of Action ○ Coverage Waterfall

○ Claimants ○ Priority of Payment Endorsement

○ Derivative Claims ○ Indemnification

○ Deepening Insolvency ○ Endorsements

○ Defenses ○ Property of the Bankruptcy Estate

○ Select Issues
ZONE OF INSOLVENCY

Definition: “Where a corporation is operating in the


vicinity of insolvency, a board of directors is not
merely the agent of the risk bearers, but owes its duty
to the corporate enterprise.” Credit Lyonnais Bank
Nederland N.V. v. Pathe Communications Corp., No.
12150, 1991 Del. Ch. LEXIS 215, at 108 (Del. Ch. Dec.
30, 1991).
SOLVENCY TESTS
▪ Balance Sheet
○ Fair Value of Assets Minus Fair Value of Liabilities
▪ Cash Flow
○ Failure to Pay Debts as They Become Due
▪ Capital Adequacy
○ Capital Level is Not Adequate to Meet Current and/or
Future Obligations
▪ “If you have to ask, or if your lender asks for an opinion
letter, you’re in the zone.”
CAUSES OF ACTION
▪ Breach of Fiduciary Duty

▪ Breach of Duty of Loyalty/Care

▪ Breach of Duty to Disclose

▪ Unlawful Dividend

▪ Fraudulent Conveyance

▪ Breach of Contract

▪ Breach of Implied Covenant of Good Faith and Fair


Dealing
CLAIMANTS
▪ Trade Creditors
▪ Unsecured Banks
▪ Mezzanine and Second Lien Lenders
▪ Chapter 11 or Chapter 7 Trustees
▪ Creditors’ Committees
▪ Assignee For the Benefit of Creditors
▪ Debtor-in-Possession
▪ Post Confirmation Trusts
DERIVATIVE CLAIMS

▪ Creditors, as Quasi Equity Investors, Only Hold Derivative


Claims Against the Corporation, and It’s Officers and Directors.

“The general rule is that [officers and] directors do not owe duties beyond
the relevant contractual terms. No direct claim for breach of fiduciary
duties may be asserted by creditors of a solvent corporation that is
operating in the zone of insolvency. When a corporation is insolvent,
however, its creditors take the place of shareholders as the residual
beneficiaries of any increase in value. Consequently, the creditors of an
insolvent corporation have standing to maintain derivative claims on
behalf of the corporation for breach of fiduciary duties.” National
American Catholic Educational Programming Foundation, inc. v.
Gheewalla, 930 A.2d 92 (Del. 2007).
DEEPENING INSOLVENCY

▪ The Board of Directors, Officers, Restructuring Advisors,


Lenders, Investment Bankers, Accountants and Attorneys
Who Prolong the Operating Life of a Financially Distressed
Company, and Thus Deplete Its Assets and Increase
Creditors’ Exposure May Be Liable to the Company.
○ Recognized as a cause of action in Florida, Louisiana,
Massachusetts, New Jersey, North Carolina and Tennessee.

○ Not recognized in Georgia and Texas.

○ Recognized as a damages theory.


DEEPENING INSOLVENCY

▪ Must prove wrongful conduct, such as fraud, as opposed to


mere negligence
▪ Incurrence of additional debt in an uncertain business is
not, in itself, a breach of a fiduciary duty. In re Global
Serv. Group LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004).
▪ Delaware imposes no absolute obligation on a board of a
company that can not pay its bills to cease operations and
liquidate. Trenwick Am. Litig. Trust v. Ernst & Young,
LLP, 906 A.2d 168, 174 (Del. Ch. 2006).
DEFENSES
▪ Business Judgment Rule
▪ Exculpatory Charter Provision
○ 8 Del. C. §102(b)(7)

○ Does Not Cover Officers

○ Does Not Cover Breach of Duty of Loyalty, Intentional


Misconduct, Knowing Violation of the Law and Personal Benefit

▪ In Pari Delecto
○ Plaintiff That Participated in Wrongdoing May Not Recover
Damages Arising From Such Wrongdoing
D&O INSURANCE
▪ Mechanics

○ Notice of Claim Filed with Carrier

○ Claims Made Policy

○ Notice of Coverage (or Denial) with Reservation of Rights

○ Engage Counsel

· Joint Defense Agreement

○ Diminishing Coverage
COVERAGE WATERFALL

▪ Side A Direct Coverage of Officers and


Directors

▪ Side B Reimbursement Coverage for the Corporation,


Based on Funds Paid to Indemnify Officers
and Directors

▪ Side C Coverage of the Corporation for Claims


Against It
ADDITIONAL COVERAGE

▪ Tail Policy Coverage for Post Policy Claims

▪ Add Ons Employee Practices, Employee Dishonesty,


Representation and Warranties

▪ Personal Coverage for Post Resignation Claims


PRIORITY OF PAYMENTS
ENDORSEMENT

▪ Express Subordination of Payments: First Side A, Next


Side B, and Finally Side C
▪ Sample Language: “In the event of a Loss from one or
more covered Claims the Insurer in all events shall (i) first
pay all Loss for coverage under Side A, (ii) then, only
after payments of all Loss covered by Side A, pay all Loss
under Side B, and (iii) then, only after payments of all
Loss covered by Side A and Side B, pay all Loss under
Side C.”
PRIORITY OF PAYMENTS
ENDORSEMENT

▪ Advance Waiver of the Automatic Stay

▪ Exclude All Requirements That Payments Must Be


Approved by Officers, Directors or the Company
INDEMINFICATION
▪ Delaware and Massachusetts Law
○ A Corporation May Indemnify Officers and Directors for Defense
Expenses. Del. Code Ann. tit. 8, §145(a); Mass. Gen. Laws ch. 156D,
§8.51(directors), §8.56 (officers). Indemnification of Expenses is
Mandatory When the Officer/Director’s Defense is Successful. Del.
Code Ann. tit. §145(c); Mass. Gen. Laws ch. 156D, §8.52 (directors),
§8.56 (officers).

▪ Indemnification in Bankruptcy
○ Seek an Order Authorizing Continuing Indemnification

○ File a Proof of Claim

○ Carrier May Require Insured to Exhaust All Indemnification


Claims Before Coverage Kicks In
ENDORSEMENTS

▪ Insured v. Insured

○ Example: Company (covered under Side C) Sues a Director


(covered under Side A)

○ Sample Language: “The Insurer shall not be liable for any Loss
in connection with any Claim brought by, or on behalf of
Insured, except and to the extent that such claim is by, or on
behalf of a debtor-in-possession, any bankruptcy trustee, litigation
trustee, examiner, creditors committee, equity committee,
administrator or liquidator, or any comparable authority (or any
assignee of the foregoing parties).”
ENDORSEMENTS

▪ Indemnification Coverage During Bankruptcy


▪ “Final Adjudication” for Personal Conduct Exclusions

▪ Pollution and Nuclear Exclusions

▪ Securities Claims and Claims by Public Debt Holders


ENDORSEMENTS

▪ Government and Regulatory Investigations


▪ “Other Insurance” Policy Claims
▪ Lengthy Trigger for Notice Provisions
▪ Severability for Innocent Officers and Directors
▪ Relation Back Start Date
PROPERTY OF THE
BANKRUPTCY ESTATE
▪ Is D&O Insurance Property of the Estate
○ The Policy -- Yes

○ The Proceeds -- It Depends

◦ If Side A exists, the proceeds are not property of the


Estate.

◦ If Side A does not exist, you must seek an order authorizing


use of proceeds to cover legal fees and costs. Any
settlement of the litigation must be approved by the Court. Use
of any proceeds to pay a judgment or settlement
must have the creditors’ consent.
SELECT ISSUES

▪ In an Assignment for the Benefit of Creditors the


Assignee Holds All Derivative Claims

▪ Derivative Claims Can Be Discharged Under a Plan of


Reorganization

▪ A D&O Policy Will be Rescinded for Application Fraud

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