Making Sense of the D&O Policy Proceeds Puzzle in Bankruptcy

The increasing size and complexity of modern corporations has contributed to a growing necessity for directors’ and officers’ (D&O) liability insurance policies.[1] It is well-settled that when a corporation goes into bankruptcy, D&O insurance policies themselves are property of the bankruptcy estate and thus subject to the automatic stay.[2] However, there is disagreement among the courts on whether the proceeds of these insurance policies should be classified as property of the estate.[3] Despite the split among the courts on whether D&O insurance proceeds are property of the bankruptcy estate, three shared concerns animate the courts’ analyses: (1) what the language of the policy says about who is covered (i.e. A-side, B-side, or C-side); (2) the potential depletion of the estate as compared to the harm to directors and officers; and (3) whether the coverage is merely speculative or actual.

In In re Louisiana World Exposition Inc., a pivotal early case addressing the issue of how to properly classify D&O insurance proceeds in a bankruptcy proceeding, the Fifth Circuit ground its analysis in the nature of the insurance policy.[4] There are three basic types of D&O insurance policies: A-side, which covers directors and officers when the corporation does not indemnify them; B-side, which reimburses a corporation for indemnifying directors and officers; and C-side, which covers the corporation itself in the event it must defend against claims or satisfy judgments.[5] While the debtor in Louisiana World possessed A-side and B-side coverage, it did not have C-side coverage that protected the corporation itself.[6] Because the insurance proceeds would thus be payable to the directors and officers, the court reasoned that they had the property interest in the proceeds, not the debtor corporation.[7] Furthermore, since the payment of any liability proceeds would reduce by the same amount the sum available for indemnification, there was no potential for increased exposure to the estate.[8] The court in In re First Cent. Financial Corp. followed the reasoning of Louisiana World, holding that the fundamental purpose of D&O insurance policies is to protect D&Os.[9] The debtor corporation in this case was not entitled to direct coverage, and the court concluded that the mere existence of indemnification coverage for the corporation did not alter the purpose the D&O policy.[10] Building on the framework of Louisiana World and First Cent., the court held in In re Allied Digital Techs. that D&O insurance policy proceeds are not a part of the bankruptcy estate under A-side and B-side policies.[11] Importantly, the Allied Digital court noted that the proceeds from insurance policies covering both the debtor corporation and its directors and officers would 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.”[12] Moreover, if indemnification is only hypothetical, speculative, or has yet to occur, the proceeds are not considered property of the estate.[13]

Although Louisiana World was met with considerable acceptance in other jurisdictions addressing the same issue, several courts have disagreed with the reasoning employed in this case. In In re Sacred Heart Hosp. of Norristown, the court rejected Louisiana World’s distinction between indemnification and liability proceeds.[14] Since payment under either type of coverage would ultimately reduce the amount available in the estate’s “pot,” an indemnification interest is sufficient to establish the debtor’s property interest in the proceeds.[15] The court in In re Jasmine Ltd. followed Sacred Heart in concluding that the debtor’s indemnification interest in the D&O insurance proceeds rendered them property of the estate.[16] Crucial to the court’s determination was the definitive nature of the debtor’s duty to provide indemnification, which was clearly established by the language of the policy itself and not at all speculative.[17] In re Cybermedica represents another case wherein the court homed in on whether the debtor’s estate would be worth more with or without the proceeds for D&O insurance policies.[18] As the policy in question insured the debtor against indemnity and entity claims, the court held that the insurance proceeds were indeed property of the estate.[19] Immediately after reaching this conclusion, however, the Cybermedica court found that there was cause to lift the automatic stay to permit two directors and/or officers to access the defense funds to which they were entitled under the policy.[20] The court thus utilized its broad powers under § 362(d)(1) to grant relief from the automatic stay.[21]

After CyberMedica, courts have continued to employ their authority under § 362(d)(1) to lift the automatic stay and thereby dodge or minimize the issue of whether D&O insurance proceeds are property of the estate. In In re Mila Inc., the Bankruptcy Appellate Panel (BAP) declined the Trustee’s request that it declare the D&O insurance proceeds as property of the estate.[22] The BAP explained that a decision on this much debated issue was not essential to the disposition of the case.[23] Rather, the BAP engaged in a balancing of the harm to the debtor if the automatic stay is modified, as compared to the harm that would befall the directors and officers if they couldn’t access the proceeds for defense costs.[24] It held that the bankruptcy court appropriately undertook this balancing of harms and granted relief from the automatic stay due to the director’s immediate need for funds to pay defense costs.[25] Id. at 545. Another refinement this modified approach offers is the ability for the court to specify a certain amount that may be freed up under § 362(d)(1) relief. In In re MF Global Holdings Ltd., the court held that the policy proceeds from the D&O insurance were not property of the estate.[26] The court utilized the same approach as the BAP in Mila, holding that the balance of harms to the estate and the insured directors and officers weighs in favor of lifting the automatic stay and permitting the directors and officers to access the proceeds.[27] Id. at 203. However, the court put in place a soft cap on the amount of proceeds that may be received by the directors and officers in order to prevent inequitable depletion of the estate.[28]

The trend in the courts has been towards not classifying D&O insurance policy proceeds as property of the bankruptcy estate. With the increasing number of cases employing the modified approach, however, it is clear the concerns expressed by the minority of courts about potential harm to the estate continue to influence the analysis. Regardless of the approach adopted, questions over what the policy says about coverage, the difference between the potential harm to the estate and the harm to the directors and officers, and whether the coverage in question is merely speculative or actual will continue to be the driving force behind the courts’ determination of whether D&O insurance policy proceeds are property of the bankruptcy estate.