For numerous reasons, bankruptcy can promise significant relief, and even new opportunities, for companies beset by financial hardship. With news of tightening credit markets, soft employment numbers, and decreases in capital expenditures, an increase in commercial bankruptcy filings may be on the horizon. As a corollary, litigation personally targeting the directors and officers of debtor firms may also increase.
When a bankruptcy is filed and litigation starts, some of the primary protections against personal director and officer liability can be called into question, and potentially undermined. Before finding oneself on the receiving end of unpleasant surprises, directors and officers should carefully consider the facts leading to the need for bankruptcy protection, assess the likelihood that they may be personally subjected to litigation, and achieve clarity on the nature and extent of any insurance they should have in place in the event that the worst case scenario materializes.
The Attorney Client Privilege
Bankruptcy is expensive, and creditors frequently become uncooperative in the process. The longer a company remains under bankruptcy court supervision, the more likely it becomes that the company may be forced to liquidate, or that creditors will demand a change in management
whether through the appointment of a trustee or some other officer responsible to turn around the ailing firm. No matter which course the change in control takes, the effect can be troubling.
Outside of bankruptcy, the power to control and to waive the attorney-client privilege rests with company management. The filing of a bankruptcy petition creates an entity, a bankruptcy estate, which controls virtually all claims and rights of the pre-bankruptcy debtor. Included among the rights the estate enjoys is the right to assert or waive the attorney-client privilege.
Just as the pre-petition debtor could have demanded that all files, emails, correspondences, memos, and other documents in the possession of their counsel be turned over to them, a bankruptcy trustee also can make such a demand. Because the trustee controls the privilege, he or she can and may assert or waive the privilege if doing so may ultimately result in additional funds coming into the bankruptcy estate for the benefit of creditors. This includes the potential waiver of the privilege if doing so would bolster claims that former directors and officers breached duties they owed to the company or, as discussed below, its creditors. In other words, emails, memos, and other items that may have been generated in the normal course of seeking legal counsel before the commencement of a bankruptcy case, including strategy discussions as to how to thwart or mollify one creditor or another, or detailed information concerning various decisions that were made pre-petition, can be made available for examination by a trustee and possibly others desirous of identifying new assets to be liquidated for the benefit of creditors. Included among the potential assets are claims against former management for breach of duty and, by extension, the personal assets of directors and officers.
Fiduciary duties owed to creditors
Once a company actually becomes insolvent, duties owed by the directors and officers begin to run in favor of the companys creditors. Directors and officers of insolvent companies must therefore maintain acute awareness of, and sensitivity to, creditor needs. Prudent managers will assess, from the creditors perspective, whether decisions they make and options they reject serve the general interest creditors share, i.e., that their claims will be paid. Riskier strategies promising the potential of higher payouts may appear to serve the interests of the ownership hoping for a return on investment as well. Such strategies may, however, also fail, in which event creditors may predictably complain that had a safer path been chosen, they would have been made whole, or more nearly so. One can also predict that a trustee may seek to rectify any resulting shortfall by seeking necessary recoveries from directors and officers, or the insurance policies that cover them.
Denial of insurance coverage
Compounding the foregoing concerns is the prospect that director and officer insurance carriers may take the position that D&O insurance policies exclude coverage in the context of litigation brought on behalf of a bankruptcy estate. If they provide a defense, they almost always do so under a reservation of rights pursuant to which they may determine at a later date that coverage should not have been made available. In this event, carriers may later add to a defendant directors or officers troubles by seeking to recoup from them amounts spent on their behalf during litigation.
A basis frequently cited for the denial of coverage is the insured vs. insured coverage exclusion, which most director and officer liability policies contain. The language describing the exclusion varies from policy to policy, but the general thrust of the exclusion is by and large the same. The insured vs. insured exclusion provides, in one form or another, that an insurer is not required to provide coverage where one insured sues another. The reason for the exclusion is a valid one. It protects carriers from being forced to cover collusive suits brought by company insiders. The rationale for denying coverage in the bankruptcy context is based on a variation on this theme.
Specifically, in bankruptcy, there is a generally well-known concept that the bankruptcy estate steps into the shoes of the pre-petition entity. A bankruptcy estate is said to have no greater rights than did the pre-petition entity. Consequently, carriers contend that the bankruptcy estate is subject to the same coverage limitations and defenses to coverage that were applicable to the pre-petition entity. Carriers therefore have been known to argue that, because the insured vs. insured coverage exclusion would have applied outside of bankruptcy, i.e., in the context of a claim brought by the company against directors and officers, that it should apply in bankruptcy as well including when the bankruptcy trustee or estate representative is seeking recoveries from directors and officers personally.
The rationale forwarded by carriers has some support in case law, although recent decisional law makes it less clear. Ultimately, the analysis will bear on the verbiage contained in the insurance policy(ies), and how such language has been construed under state law. In advance of a bankruptcy filing, directors and officers should therefore review their policies and, if appropriate, negotiate for policy language that makes clear that a bankruptcy trustee or other court-appointed officer is not an insured for purposes of triggering the coverage exclusion.
Although bankruptcy promises significant relief, helping a troubled company maximize the return creditors realize on their claims, directors and officers are wise to engage separate counsel for advice while under the increased pressures of running a company approaching insolvency, and potentially a voluntary or involuntary bankruptcy filing. Company counsel should not be the primary source for directors and officers seeking advice on enhancing the value of their personal interests, or diminishing their exposure to liabilities. Directors and officers should employ extra care in making decisions, remaining mindful of creditor interests and potential creditor claims that may arise against them as they navigate the choppy waters of financial strain.
At a minimum, before one is surprised by claims or unintended consequences of decisions made at perhaps the most troubled period of a companys life, they should seek input and achieve clarity on the nature and extent of any claims that may accrue against them, and take care to maximize their immunity from personal claims.
Eric Peterson is a partner practicing in the bankruptcy litigation group. In 2005, 2006 and 2007, Eric was named by Law & Politics Magazine and the publishers of Los Angeles Magazine as one of the top young attorneys in Southern California. Eric can be reached at (310) 286-1700 or email@example.com.