D&O Litigation Risks Grow as Bankruptcies Surge

By Nan Murphy, Vice President and Underwriting Leader

As the number of businesses filing for bankruptcy rises by the week, the possibility of litigation against those businesses’ directors and officers also rises.

Battered by the impact of COVID-19 shutdowns, a who’s who of companies have filed for Chapter 11 bankruptcy protection, from retailers like Lord & Taylor, J. Crew, Neiman Marcus, and J.C. Penney, to rental car provider Hertz, oil and gas giant Whiting Petroleum, and Latin American airline Avianca Holdings. Increased bankruptcies are expected, given double digit reductions in revenues for many companies and the difficulties addressing enormous debt loads (as much as $15.5 trillion in the aggregate, according to the Brookings Institute). In conjunction, experts on D&O litigation warn directors and officers to expect an uptick in lawsuits brought by shareholders, creditors, and other parties.* Accordingly, there is no better time than the present for directors and officers to review the efficacy of their Director & Officer (“D&O”) insurance coverage and to pay particular attention to the insured versus insured policy exclusion.

Insured versus insured policy exclusion

The insured versus insured exclusion is standard in virtually all D&O policies and in several professional liability policies. At its most basic, the exclusion eliminates insurance coverage when a claim is brought by one insured against another insured also covered under the same policy. In the context of bankruptcy-related litigation, board directors (one insured) sued by an executive officer (another insured) generally would not be covered by the D&O insurance policy for potential financial losses.

Why might an executive of a bankrupt business sue their board directors? An example is a situation in which an executive believes the business owes him money, such as in the form of stock dividends, a promised bonus or a corporate contribution to the executive’s 401k plan, and files a lawsuit in an attempt to recoup this money.

Internal disputes and infighting

The origins of the exclusion date to the mid-1980s, when a large U.S.-based bank acquired a smaller bank that was not as well-managed as it had contended. The larger bank filed a negligence lawsuit against the smaller bank’s directors and officers, who were now employees of the larger bank. In an odd twist of fate, the resulting bank sued its own executives.

D&O insurers designed the insured versus insured exclusion to deter such internal disputes and infighting as well as the possibility of collusion. That is, the possibility that directors and officers could be drawn into pursuing an overly risky business strategy, knowing if the strategy failed, they could sue each other for negligence and recoup the business losses from the D&O insurance policy.

The possibility that losses for directors and officers sued in bankruptcy-related litigation may not be covered due to the exclusion is especially relevant now, given the difficult decisions companies have had to make in a once-in-a-century pandemic that has brought business to a near-standstill.

A case in point is executive compensation. Some troubled retailers, for example, paid large bonuses to high-level executives to ensure they did not flee their posts during the crisis. Assuming the retailer has filed for bankruptcy, was this decision, in retrospect, in the “best interests of the company”—the board’s fiduciary obligation? An argument may be made that the action was rash and ill advised, as it depleted cash reserves when capital was direly needed to continue operations.

The definition of an “insured” in the context of the exclusion creates other problems for directors and officers. In one D&O lawsuit, a creditor trust suing a debtor’s directors and officers was considered an insured, denying coverage for the defendants. In another D&O lawsuit, coverage was excluded for the directors and officers of a bankrupt company sued by a debtor-in-possession that had created a liquidation trust, as the court determined the debtor-in-possession was an insured.

Due diligence and carve backs

There are ways that directors and officers can ensure adequate D&O coverage to protect them in bankruptcy-related litigation. In most (but not all) D&O policies, the insured versus insured exclusion can be amended with coverage carve-backs to preserve coverage that otherwise would be precluded. In reviewing their D&O policy, directors and officers should carefully examine the contract wording of the carve-backs provided. They may want to consider that their D&O insurance policy includes carve-backs to:

• Preserve coverage when a former director or officer brings a claim against current directors or officers following the termination of that plaintiff’s service to the company. 
• Preserve coverage for shareholder derivative lawsuits.
• Maintain coverage for employment practices liability claims brought by former executives, litigation that entails cross-claims, and claims brought by a bankruptcy trustee, creditor committee or debtor-in-possession.

As each insurer words their D&O carve-back provisions differently, the devil is in the details. In the aforementioned debtor-in-possession litigation, for example, the omission of a few words in the carve-back provision left the directors and officers without insurance protection.

Other recommendations

Due to their heightened liability in this period of rising bankruptcies, directors and officers should review the organization’s risk management controls. It is advisable to consult with both the company’s general counsel and an independent attorney about the latest laws and legal nuances related to COVID-19, particularly as employees return to work. The efficacy of the controls may affect director and officer liability, especially if many employees become infected at the worksite.

Another reason directors and officers should scrutinize their D&O policy is the possibility of other coverage reductions beyond the insured versus insured exclusion, such as new exclusions or higher self-insured retentions. The D&O insurance market is hardening fast in expectation of rising claim frequency and severity. Negotiations between risk managers and insurance brokers and carriers to renew their D&O policy have been extremely challenging, given the rising number of COVID-related bankruptcies. Consequently, it is incumbent upon directors and officers to compare past years’ D&O policies to the renewal policy under discussion to ensure it preserves optimal coverage and limits of financial protection. The stakes are too high not to take that precaution.

Attorney Nan Murphy is Vice President at QBE North America and a specialist in management liability underwriting. 

*https://www.law.com/thelegalintelligencer/2020/07/31/do-insurance-renewal-trends-in-2020-covid-19-and-other-factors/?slreturn=20200907152939