Issues for Directors, Officers and their

Attorneys

Issues for Directors, Officers and their

Attorneys

By: Kitt Turner

I. Selection of Appropriate D & O Insurance and Policy Language Issues that May Affect the Availability of

Coverage

I. Selection of Appropriate D & O Insurance and Policy Language Issues that May Affect the Availability of

Coverage

August 10, 2006 3

Types of D&O Coverage Side A Coverageprovides coverage for defense costs and

liability payments to directors and officers (for both judgments and settlements) for any wrongful acts when the company cannot indemnify them

when obtaining Side A coverage, insureds may wish to negotiate for a provision whereby the insurer would pay any costs that the company is obligated to pay, but does not pay

August 10, 2006 4

It is beneficial for a company to negotiate non-rescindable Side A excess coverage. This would cover directors and officers when the underlying policy is rescinded, exhausted or does not cover a certain claim and, since none of the proceeds are paid to the company, it is not effected by the company declaring bankruptcy

Side A coverage typically does not have a deductible associated with it

August 10, 2006 5

Side B Coveragecoverage for company’s own

expenses incurred when indemnifying those covered by the policy when the company is either required or permitted to indemnify under state law and as per the company by-laws

usually a deductible/retention applies to claims made under Side B coverage

August 10, 2006 6

Side C Coverage otherwise known as entity coverage as it

protects the company itself against its wrongful acts

can either be broad or narrow to cover only certain kinds of claims, most commonly securities or employment claims

usually a deductible/retention applies to claims made under Side C coverage

August 10, 2006 7

Key Language of D&O Policies That May Affect Coverage

Prior and Pending Exclusion this language means that the policy will

exclude coverage for demands, suits etc against the insured that were begun prior to the date set forth in the declarations of the policy

this exclusion precludes coverage when a claim is made during the policy period that is either “based upon or arises from the same or any substantially similar fact, circumstance or situation underlying or alleged therein.”

August 10, 2006 8

Insured vs. Insured Exclusion this language means that coverage is not allowed on

actions brought by or on behalf of an insured this language should be narrowed so that it does not

include actions brought by a bankruptcy trustee, examiners, liquidators or receivers, creditors of the bankrupt estate or a trustee or trust that has been established for the benefit of the creditors

this language should be qualified so that defense costs coverage is preserved

this language should be narrowed so that it does not apply to suits brought after a change in control

this language should be narrowed by adding an exception to this exclusion “to the extent that an Insured Person is a member of a class alleging Loss”

this language should be narrowed so that it does not apply to claims by former directors or officers who have not served in such capacity for at least a few years

August 10, 2006 9

Deliberate Fraud Exclusion exclusion for liability arising from an insured’s

fraud or dishonesty exclusion only applies after there has been a

final judicial determination that the individual committed an intentional wrongdoing, and, therefore, the insurer must still provide defense costs until this judicial determination is made

since these cases are often settled and thus there is no final adjudication, the insurer is required to fund a reasonable settlement

Insurers are now revising language in their D&O policies so that the exclusion is not only limited to when there has been a final adjudication of wrongdoing, so insureds must read the policy language carefully to see whether this limitation is included

August 10, 2006 10

Accounting of Profits Exclusion Side A coverage typically does not apply to

claims that seek an accounting of profits from the sale of securities; however, it is preferable for the policy to still include defense costs for such claims, and this can be done by limiting this exclusion to “Loss (other than Defense Costs)”

This exclusion is typically written to apply to losses “on account of” a claim for accounting, but it is preferable, instead, to limit this exclusion “to the extent of” the accounting

August 10, 2006 11

Personal Profit Exclusion D&O policies typically will not cover losses resulting

from an insured gaining personal profit to which she is not legally entitled

it is important for insureds to read the relevant policy language carefully. If “such” or a similar word is before the phrase “directors or officers gaining in fact any personal profit, advantage or remuneration to which they were not legally entitled”, then this exclusion applies to only that individual who received the profit. However, if “such” is not included, then the exclusion may apply to all insureds, regardless of whether they profited.

Typically the personal profit exclusion will apply to settlements and a judicial determination of personal gain is not required. Therefore, to minimize theexclusion, companies should seek to include a “final adjudication” modification so that the exclusion only applies to situations where there is a final adjudication of illegal personal profit.

August 10, 2006 12

Presumptive Indemnification The Presumptive Indemnification provision

assumes that the company will indemnify the directors and officers where permitted to do so. As such, the provision prevents the company from refusing to indemnify, and therefore manipulating the deductible by forcing the insurer to pay for what would normally be within the deductible.

directors and officers should seek to exclude this provision from their policy so that the insurer would be obligated to indemnify the directors and officers if the company fails to do so, and then the insurer itself would be able to pursue a claim against the company

August 10, 2006 13

Settlement D&O policies typically provide that the insured

cannot settle a claim before first obtaining insurer’s consent

insureds should narrow this so that the insurer’s consent to a settlement cannot be “unreasonably withheld”

Some D&O policies contain a provision that if an insured does not agree to a settlement that is proposed by the insurer, then the insurer will not be liable for any amount above that proposed settlement amount

this provision is known as the “hammer clause” because it allows the insurer to force a settlement

companies should try to delete this provision from their D&O policies or at least limit the application to only when the insured was unreasonable in not consenting to the settlement

August 10, 2006 14

Defense D&O policies generally do not specifically state that the

insurer must pay the defense costs of the insureds. Instead, policies typically say that the insurer is obligated to pay all losses that the insured is obligated to pay, and this includes attorneys’ fees for defending against a legal action

Insurers generally agree to pay defense costs as they are incurred, however some include a provision in their policies whereby they will not be obligated to pay defense costs until after the underlying litigation is concluded. Therefore, insureds should read the policy carefully to ensure that defense costs will be paid in a timely manner

Some D&O policies require that the directors and officers use pre-approved counsel. Therefore, a company should seek to make sure that its preferred counsel is on the approved counsel list at the outset of the policy negotiations, so that this is not a fight down the road

August 10, 2006 15

Allocation of Loss most D&O policies have an

allocation provision whereby there is a preset allocation of benefits between covered and uncovered claims and covered and uncovered persons, the result of which is a form of co-insurance

for example, some provisions provide that the insurer will pay 75% of defense costs and the insured will pay 25% of such costs

August 10, 2006 16

Severability/Rescission to protect innocent insureds, a D&O policy should have a severability

clause applicable to representations made in the process of applying for D&O insurance process. This way, protection is preserved for those innocent insureds and the insurer cannot rescind the policy as to these insureds

there are different kinds of severability clauses Full severability clause means that the application for insurance is

deemed a separate application for each insured and that the knowledge of one insureds is not imputed to another insured

Limited severability clause means that the knowledge of the person signing the application, or the knowledge of certain officers, is imputed to all insureds and can provide cause to rescind the policy. However, knowledge of other insureds are not imputed.

A company should negotiate for express policy language that specifically details the only situations where rescission is possible

for example, some policies state that Side A coverage is not rescindable at all another possibility is stating that Side A coverage can be rescinded but only as

to those individuals who knew of the misstatements in the application yet another possibility is allowing for full severability for insureds for Side A

coverage, but no severability for the company. Under this scenario, an insured’s knowledge can be imputed to the company and rescission would be possible under Side B and C coverage

Companies must be aware of any statutes and state case law regarding rescission. Policy language that makes rescission more difficult that set forth in a statute will be enforceable; however, language that makes rescission less difficult than the statute will likely not be enforced.

August 10, 2006 17

Claim definition of “claim” is extremely important as it

defines the policy – the broader the definition of “claim” is, the broader the insurance coverage will be

most policies have a definition of “claim” that includes “written demand for money” and a “civil proceeding”

A broader definition will include the following: (1) lawsuits; (2) written or verbal demands for either monetary or non-monetary relief; and (3) administrative, arbitration, criminal or investigative proceedings

most insurers have a provision whereby the insured must notify the insurer of a claim within a certain time period, usually “as soon as practicable” or between 30-90 day post-policy period

insureds must be sure to monitor for potential claims since D&O policies typically require an insured to provide the insurer with “circumstances likely to give rise to a claim or potential claim”

August 10, 2006 18

Damages and Loss D&O policies provide coverage for losses

“Loss” is typically defined as including damages, judgments, settlements and defense costs

Some D&O policies limit covered defense costs to “reasonable” costs. Insureds should negotiate with the insurer for the inclusion of language that specifies what “reasonable” is, for example “all costs incurred pursuant to a written budget from counsel and which do not vary by more than 15 percent of these costs are deemed reasonable” or “all costs incurred consistent with the company’s litigation guidelines are deemed reasonable”

Insureds should also seek to have the definition of “defense costs” include the cost of counsel that is retained to advise an individual insured in connection with a claim

Insureds may not be a specific target of an investigation but may still wish to retain counsel, and insureds should seek to have this cost be included in the definition of “defense costs”

D&O policies generally will carve out certain damages that will not be covered under the policy. These typically include certain fines, punitive damages, multiplied damages, and damages that are uninsurable under law

August 10, 2006 19

Order of Payments a way to ensure that the policy limit

isn’t exhausted by payments to the corporation under Side C coverage is to include a provision in the policy that Side A coverage is paid before Side B and C coverage

August 10, 2006 20

Definition of “Insured” should be broad enough to include general

counsel, as well as all appropriate employees and subsidiaries or other related companies. This is important to ensure that there are no gaps in coverage when a company acquires another company or merges with another company

should be an exception for innocent insureds such that coverage will not be defeated as to these innocent insureds in cases of fraud or dishonesty

August 10, 2006 21

Definition of “wrongful acts”D&O policies cover wrongful acts,

but different policies define what a wrongful act is differently, so this language must be read very carefully

August 10, 2006 22

Criminal Indictment/Subpoena Since the typical D&O policy only covers

claims, and not costs associated with pre-claim expenses, insureds may wish to determine the cost for obtaining additional coverage that will cover such costs, including those costs incurred when responding to government subpoenas

The typical D&O policy does not cover the defense costs associated with defending a criminal case; however, some policies do include coverage for criminal matters. Insureds should read the policy language carefully to determine whether their policy does include such costs, and, if not, what such additional coverage would cost

August 10, 2006 23

Miscellaneous Coverage Issues Under a D&O Policy

when a claim is asserted against a covered person or the company during the policy period, the coverage is triggered

all claims related to one factual situation are typically (1) subject to one policy limit and (2) assigned to that policy period in which the first in the series of such claims is asserted

there typically is a single policy limit for Side A and B coverage for all insureds

August 10, 2006 24

D&O Policies usually afford the ability to lock in coverage before claims are made against the policy when circumstances that will give rise to claims arise during the policy period and the insured provides a special form of notice to the insurer during that policy period. If such notice is given, then all claims subsequently asserted will be deemed asserted during the policy period. In this case, any policy that would otherwise cover these claims exclude coverage for these claims.

Most D&O policies are “wasting policies”, which means that defenses costs reduce the amount of money available for coverage

August 10, 2006 25

If the company goes into bankruptcy, the bankruptcy trustee may treat the policy as property of the estate if the policy provides entity coverage (Side C Coverage)

D&O policies are typically a claims made policy – the policy only covers claims made against the insured during the policy period. The policy specifies a retroactive date, and all claims based on acts occurring prior to the retroactive date are excluded.

II. Fiduciary Duty of Officers and Directors

II. Fiduciary Duty of Officers and Directors

August 10, 2006 27

Typical duties Care Loyalty Good faith (application of this undefined/vague duty

questioned by the recent Delaware Supreme Court Disney decision)/fair dealing

Not owed to creditors Business Judgment Rule will typically cover acts

informed decision reasonable effort to inform itself of relevant facts D or O reasonably believed act was in the best interests Disinterestedness

August 10, 2006 28

Zone of Insolvency / Insolvency

DefinitionTests for insolvency:Balance SheetCash Flow / equity

August 10, 2006 29

Zone of Insolvency / Insolvency

Duties shift to include creditorsReasoning for shift Split between whether in “zone”

there is a shared duty to creditors and shareholders

August 10, 2006 30

Zone of Insolvency / Insolvency

D&O responsibilitiesMaximize corporations long term

wealth creating capacity (easier said than done!)

August 10, 2006 31

Zone of Insolvency / Insolvency

Business Judgment Rule (“BJR”) takes on higher scrutiny Some courts do not permit use of BJR

when corporation is in the zone.“Entire Fairness” often appliedCourts may apply hindsight viewBest to assume you will be found in

the zone of insolvency and act accordingly

Protecting Directors and Officers When Corporation is

Insolvent or in the Zone; Checklist for Directors and

Officers

Protecting Directors and Officers When Corporation is

Insolvent or in the Zone; Checklist for Directors and

Officers

August 10, 2006 33

Review corporate ratios and competition ratios. Investigate and assess the value of the

corporation’s assets (including deferred assets).

Investigate and assess the corporation’s contingent and off balance sheet liabilities.

Retain professionals to value assets. Compare the corporation’s business plan

projections and assumptions, historical performance, the expected performance of competitors, and industry trends.

Determine the Potential Insolvency of the Corporation

August 10, 2006 34

Review the business. Know the current conditions and external competitive factors that will impact its operations and financial performance.

Review current market conditions affecting the corporation’s sources of funding (including equity markets, debt markets, and interest rates).

Test the sensitivity of the corporation’s financial projections with respect to revenue variations, margin variations, and interest rate changes.

Determine the corporation’s liquidity and free cash flow levels under the projection scenarios.

August 10, 2006 35

Evaluate covenant compliance under the projection scenarios.

Evaluate the equity cushion available to the company under each of the projection scenarios.

Evaluate the safety margin of the cash flows under each projection scenario.

August 10, 2006 36

Comply with Fiduciary Duties If the corporation is in the vicinity or zone of

insolvency, evaluate whether corporate decisions benefit the corporation, its shareholders, and/or creditors. The analysis must ensure that the decision maximizes the valuation of the corporation.

Make sure that directors and officers possess all material information relating to each business decision.

Evaluate the impact of the business decision on the corporation’s stakeholders.

August 10, 2006 37

Board may wish to create or farm issues to subcommittees for review, along with the advice of qualified experts inside and outside of the corporation.

Maintain very detailed minutes of each board meeting, which describes everything that the board considered before making its decision

Maintain detailed written reports and memoranda regarding the materials reviewed and discussed in connection with a business decision.

August 10, 2006 38

Review and apply any applicable legal “safe harbor” provisions.

Limit or avoid transactions with insiders and other conflicts of interest.

Avoid preferential treatment of insiders, and do not accept personal benefits for supporting or opposing a particular transaction.

August 10, 2006 39

Minimize Liability Arising From Corporate Transactions

Ensure that any insider transactions are fair to the corporation.

Adhere to regulations concerning the payment of dividends and regarding stock redemptions.

Avoid transfers by the corporation that may be seen as an attempt to hinder, delay, or defraud creditors. View such transfers from the outside looking in.

August 10, 2006 40

Avoid transfers by the corporation where it does not receive reasonably equivalent value in exchange

Establish and document a record for the decisions underlying these transactions including the fairness of the transaction. Remember that all decisions will be reviewed in hindsight

August 10, 2006 41

Avoid Personal Liability Resulting From the

Corporation’s Violation of Law Ensure that the corporation continues to pay

all taxes as they come due. Ensure that the corporation continues to

comply with environmental laws and regulations.

Ensure that the corporation continues to comply with labor and employment statutes and regulations, including ERISA an the Fair Labor Standards Act

August 10, 2006 42

Protect D&O Insurance Coverage in the Event of the

Corporation’s Bankruptcy Review and understand the

corporation’s D&O insurance policies to ensure that directors and officers are covered if the corporation files for bankruptcy. Consult experts if necessary. Review alternatives and D&O insurance.

III. Leading Issues in D & O Litigation

III. Leading Issues in D & O Litigation

August 10, 2006 44

Deepening Insolvency

Certain courts have addressed whether deepening insolvency is a valid cause of action and/or a valid theory of damages for negligence. Courts have been tackling this issue recently, and there is currently a split in courts. A sampling of the cases is below.

August 10, 2006 45

Pennsylvania Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir.

2001) First case in which the Third Circuit recognized the independent tort of deepening

insolvency and predicted that the Pennsylvania Supreme Court would adopt this cause of action

The Third Circuit based this finding on the following: “First and foremost, the theory is essentially sound. Under federal bankruptcy law, insolvency is a financial condition in which a corporation's debts exceed the fair market value of its assets. 11 U.S.C. § 101(32). Even when a corporation is insolvent, its corporate property may have value. The fraudulent and concealed incurrence of debt can damage that value in several ways. For example, to the extent that bankruptcy is not already a certainty, the incurrence of debt can force an insolvent corporation into bankruptcy, thus inflicting legal and administrative costs on the corporation. See Richard A. Brealey & Stewart C. Myers, Principles of Corporate Finance 487 (5th ed. 1996) ("By issuing risky debt, [a corporation] gives lawyers and the court system a claim on the firm if it defaults."). . . . Aside from causing actual bankruptcy, deepening insolvency can undermine a corporation's relationships with its customers, suppliers, and employees. The very threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation, calling into question its ability to perform, thereby damaging the corporation's assets, the value of which often depends on the performance of other parties. See Michael S. Knoll, Taxing Prometheus: How the Corporate Interest Deduction Discourages Innovation and Risk-Taking, 38 Vill. L. Rev. 1461, 1479-80 (1993). In addition, prolonging an insolvent corporation's life through bad debt may simply cause the dissipation of corporate assets.” Id. at 349-50.

Third Circuit recognized that in pari delicto is a defense to a deepening insolvency claim such that the action of Lafferty in fraudulently increasing the debt of the corporation barred the Committee (in the shoes of the debtor) from seeking damages from Lafferty. Id. at 360

August 10, 2006 46

Seitz v. Detweiler, Hershey and Assocs., P.C. (In re Citx Corp.,Inc.), 448 F.3d 672 (3d Cir. 2006) Trustee brought claim against the debtor’s accounting firm for, among other things, deepening insolvency See id. at 674.

Most recent Third Circuit case on deepening insolvency District Court granted summary judgment in favor the accountants and dismissed the

claims See id. Third Circuit affirmed. See id. In so affirming, the Third Circuit addressed three issues: (1) is deepening insolvency a viable

theory of damages for negligence; (2) is negligence sufficient to support a deepening insolvency cause of action and (3) can deepening insolvency be a cause of action under 11 U.S.C. § 544, or 11 U.S.C. § 541

As to (1), the Third Circuit cited to its prior decision on deepening insolvency (Lafferty), in holding that deepening insolvency is not a viable theory of damages for negligence:

“Although we did describe deepening insolvency as a ‘type of injury,’ and a ‘theory of injury,’ we never held that it was a valid theory of damages for an independent cause of action. Those statements in Lafferty were in the context of a deepening insolvency cause of action. They should not be interpreted to create a novel theory of damages for an independent cause of action like malpractice.” Id. at 677.

As to (2), the Third Circuit noted that Lafferty “holds only that fraudulent conduct will suffice to support a deepening insolvency claim under Pennsylvania law” and ultimately held that “[w]e know no reason to extend the scope of deepening insolvency beyond Lafferty’s limited holding. To that end, we hold that a claim of negligence cannot sustain a deepening insolvency cause of action.” Id. at 681.

As to (3), the Third Circuit held that deepening insolvency cannot be brought under section 544: “Because deepening insolvency claims are brought on behalf of the debtor corporation, deepening insolvency can only be a claim under Bankruptcy Code § 541 (which deals with property of the debtor’s estate).” Id. at 676 n. 6. In so finding, the Third Circuit clarified that the cause of action of deepening insolvency does not belong to the creditors of the company.

Third Circuit is clear that its Lafferty opinion is only applicable to Pennsylvania cases . See id. at 680 n. 11

August 10, 2006 47

Delaware/New Jersey In Re: LTV Steel Co. Inc., 333 B.R. 397 (Bankr. N.D.

Ohio 2005) The Administrative Claimants Committee (ACC)

brought a motion seeking authorization to bring suit against LTV Steel Company’s officers and directors for deepening insolvency. The court granted the motion, stating that Delaware or New Jersey law would apply, and, therefore, Lafferty is controlling.

The court defined deepening insolvency to be “where the defendants conduct, either fraudulently or even negligently, prolongs the life of a corporation thereby increasing the corporation’s debt and exposure to creditors.” Id. at 421.

August 10, 2006 48

Washington DC Alberts v. Tuft (In re Greater Southeast Community

Hosp. Corp., 333 B.R. 506 (Bankr. D.D.C. 2005) Court does not recognize deepening insolvency as

an individual cause of action Court recognizing that deepening a corporation’s

insolvency is harmful; however, the Court notes that “recognizing that a condition is harmful and calling it a tort are two different things. The District of Columbia courts have not yet recognized a cause of action for deepening insolvency, and this court sees no reason why they should.” Id. at 517.

Court dismissed deepening insolvency claims on the basis that they were a mere “repackaging” of the breach of fiduciary claims with respect to D & O defendants and malpractice claims with respect to attorneys. Id. at 517.

August 10, 2006 49

Louisiana Hannover Corp. of America v. Beckner, 211 B.R. 849 (M.D. La 1997) A suit was filed by a debtor corporation’s receiver against an

attorney, who represented the corporation in a suit by the SEC, asserting malpractice and negligence claims for increasing the insolvency of the corporation. Id. at 854.

The attorney/defendant filed a motion for dismissal stating that the corporation lacked standing to bring such an action via the doctrine of in pari delicto. Id. at 852.

The court rejected the motion and found that there was standing. Id. at 860.

The court established that there was a distinct injury to the corporation resulting from the malpractice, specifically the “aggravation of insolvency and artificial extension of [the debtor corporation's] life.” Id. at 854.

The court further noted that a receiver “was not bound by the formers corporate officers’ or directors’ fraud” making any in pari delicto claim against granting standing moot. Id. at 858 n. 10 (internal citation omitted).

Although the terminology of deepening insolvency was not used in this opinion, the court noted that in pari delicto may be an affirmative defense to a deepening insolvency claim. Id. at 859.

August 10, 2006 50

Indiana Marwil v. Grubbs, 2004 U.S. Dist. Lexis 20250 (S.D. Ind. 2004) The receiver of a church corporation brought a breach of

fiduciary duty claim against the officers and directors of the corporation. Id. at 4. The directors and officers filed Fed. Rule of Civ. Proc. 12(b)(1) and 12(b)(6) motions claiming lack of subject matter jurisdiction and failure to state a motion upon which relief can be granted. Id. at 5.

The court, relying on Schaht v. Brown, 711 F.2d 1343 (7th Cir. 1983), found that Marwil’s claim for “exacerbate[ing] [the] corporations insolvency and artificially prolong[ing] its life” was “actionable.” Id.

The directors and officers asserted that the “business judgment rule” shielded them from liability. Id. at 24. However, the court noted that the business judgment rule only shields officers and directors when their decisions are informed ones. Id. The court found that the complaint properly alleged that the officers and directors were not familiar with the recommendations made to them by their accounts and attorneys and thus did not dismiss this claim. Id.

August 10, 2006 51

Arkansas Robertson v. White, 633 F. Supp. 954 (W.D. of Ark. 1986). The trustee and noteholders of a bankrupt corporation filed

suit against the former director and officers of the corporation under a variety of theories including “wrongfully prolonging operations of the [corporation] and misleading government authorities.” Id. at 969.

The officers and directors filed a Fed. Rule Civ. Proc. 12(b)(6) motion to dismiss, which a magistrate judge had dismissed, the court here heard an appeal on the motion. Id. at 958.

The court citing Schacht v. Brown, 711 F.2d 1343 (7th Cir.), allowed the claim to go forward on behalf of the noteholders because: “[t]he operation of a corporation beyond the point of its insolvency works a fraud upon creditors and investors, at least to the extent that they have been misinformed as to the true status of the corporation’s affairs.” Id. at 969. The court also allowed the trustee on behalf of the corporation to maintain this claim. Id. at 970.

August 10, 2006 52

Texas In re Vartec Telecom, Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005) Court addressed question of “whether ‘deepening insolvency’ may

be plead as a separate cause of action or whether it is treated only as a breach of a separate duty under state tort law or as a theory of damages.” Id. at 633.

After noting that other courts have recognized deepening insolvency as a separate cause of action, the Court noted that “[t]he words ‘deepening insolvency’ are neither contained in the Bankruptcy Code, nor do they arise from other federal law, so the courts that consider the theory of ‘deepening insolvency’ to be an actionable tort do so by predicting how their respective state courts would rule when adopting a new cause of action.” Id. at 638.

As such, the Court looked to Texas state law, and concluded that the Texas Supreme Court would not recognize deepening insolvency as a separate tort “because the injury caused by the deepening of a corporation’s insolvency is substantially duplicated by torts already established in Texas.” Id. at 644.

The Court further noted that “as the case law in this area has shown, for a plaintiff to assert a valid claim for damages under a theory of ‘deepening insolvency’ the plaintiff must show that the defendant has committed some other tort.” Id.

August 10, 2006 53

Tennessee In re Del-Met Corp., 322 B.R. 781 (Bankr. M.D.

Tenn. 2005) Court addressed whether Tennessee Supreme

Court would recognize a tort of deepening insolvency and concluded that “if presented with compelling facts, the Tennessee Supreme Court would recognize deepening insolvency as an actionable breach of duty to a corporation.” Id. at 815.

August 10, 2006 54

Aiding and Abetting Fraud Stanziale v. Pepper Hamilton LLP (In re

Student Finance Corp.), 335 B.R. 539 (D. Del. 2005)

Court discussed whether Pennsylvania Supreme Court would recognize tort of aiding and abetting a breach of fiduciary duty and concluded that “there is an insufficient basis to conclude that the Pennsylvania Supreme Court would decide that aiding and abetting breach of fiduciary duty is a valid cause of action under Pennsylvania law.” Id. at 551.

August 10, 2006 55

In re Del-Met Corp., 322 B.R. 781 (Bankr. M.D. Tenn. 2005)

Court noted that New York, Delaware and Tennessee all recognize the cause of action of aiding and abetting a breach of fiduciary duty

Court stated the elements of such a cause of action: “‘a showing that there (1) existed a fiduciary relationship, (2) was a breach of the fiduciary’s duty, (3) was a knowing participation [sic] in the breach by a defendant who is not a fiduciary and (4) that damages are proximately caused by the breach.’” Id. at 816.

August 10, 2006 56

In re Scott Acquisition Corp., 2006 Bankr. LEXIS 1123 (Bankr. D. Del. June 23, 2006)

Trustee brought an action against the former officers and directors of the debtor alleging, among other things, that each aided and abetted each others breach of fiduciary duties. The Court concluded that the Trustee had provided sufficient basis for its action, such that it denied the defendants’ motion to dismiss.

August 10, 2006 57

Counsel’s Exposure Courts have held that a cause of action of deepening

insolvency can be brought against counsel for the company.

Lafferty - Plaintiff asserted deepening insolvency claim against counsel to the debtor

Hannover - The court established that there was a distinct injury to the corporation resulting from the malpractice, specifically the “aggravation of insolvency and artificial extension of [the debtor corporation's] life.” that can be asserted against the attorney. Id. at 854.

Del Met - “The action [of deepening insolvency] has morphed both in form – from a breach of statutory duty claim to a form of common law tort liability – and in scope – now reaching lawyers . . .” Id. at 812.

IV: Treatment D&O Insurance in Bankruptcy

IV: Treatment D&O Insurance in Bankruptcy

August 10, 2006 59

Most courts find these to be severable concepts

Policies vs. Proceeds

August 10, 2006 60

Policies

Usually found to be property of the estate

Broad definition of section 541 includes policy interests

August 10, 2006 61

Proceeds

More complex and divided question. Typically arises in two arenas: Whether D&Os may be advanced

defense costs or other payments Are policy proceeds property of the

estate and therefore subject to the automatic stay

August 10, 2006 62

Advancement of Defense Fees/Costs to Directors and

Officers Safest route for insurer is to bring a motion

(or require that the parties wishing to be paid bring a motion) before the Bankruptcy Court before issuing any payment.

Potentially objecting parties are: bankruptcy trustees, creditors and/or creditors committees, shareholder plaintiffs. Basically arguing proceeds are property of the estate since payment of defense costs typically drain the overall recovery pool under the policy.

August 10, 2006 63

Argument for proceeds being property of the estate

Expansive view of 541 Debtor has made indemnification

claims Policy provides entity coverage

August 10, 2006 64

Argument against proceeds being property of the estate

Not property where there was no advancement of funds by the estate due to indemnification obligations in company’s charter or bylaws (the argument that it may become a reimbursement due to the estate is too premature and tenuous)

August 10, 2006 65

Other ways to get D&O defense costs paid

priority of payment provision even where entity coverage -

limited relief from stay for D&O costs where contract provided advancement of defense costs.

August 10, 2006 66

Will insurance protect D&Os and pay D&O coverage and defense

costs post-petition Insured vs. Insured problem.

Typically this exclusion from coverage exists in most D&O policies. The exclusion bars coverage for claims brought by or brought by or on behalf of one insured against another insured.

August 10, 2006 67

Does Debtor, Trustee or Committee amount to an

insured? Argued to be standing in the shoes of the pre-petition debtor, who is an insured along with the directors and officers.

Catch-22; arguably these parties are the only parties with standing and/or knowledge to bring these actions.

Trustees and Committees argue that pre-petition debtor and Trustee/Committee are legally separate entities and the insured vs. insured exclusion is not implicated.

August 10, 2006 68

Application of the Automatic Stay

Section 362 prohibits actions against the debtor or the debtor’s property, however it does not typically extend to actions against the debtor’s officers or directors. Often, actions against a debtor and its directors and officers as joint defendants will be stayed only as to the debtor itself.

August 10, 2006 69

Application of the Automatic Stay

Unusual circumstances may extend the automatic stay such as where there is an undisputed absolute indemnity provided by the company to the director or officer. However, even in that circumstance, most courts treat such an indemnity as a claim held by the director/officer against the estate, not a shield from pending actions.

August 10, 2006 70

Application of the Automatic Stay

As noted above, those courts which hold the proceeds are not property of the estate are far more apt to find that the automatic stay applies.

August 10, 2006 71

Rescission the bad acts that often lead to a company

having to file bankruptcy often times include misrepresentations that the company made to the insurer in order to procure insurance. The filing of bankruptcy shines a light on these misrepresentations. The issue then becomes, do the misrepresentations made by the company provide sufficient basis for the insurer to rescind the insurance policy, thus leaving the debtor without insurance.