RISKVUE ARCHIVE | INDUSTRY WATCH >DIRECTORS & OFFICERS LIABILITY (D&O)

D&O Liability Insurance Companies Must Advance Defense Costs

By William G. Passannante, Esq.

You, Ms. Big, are a director of BigCorp, Inc., a New York Stock Exchange listed company. On account of an acquisition of a major subsidiary (now gone sour), the plaintiff’s class-action bar is circling like a school of hungry piranhas. The 50% drop in BigCorp’s stock price is the blood-in-the-water. You get sued. Personally.

On account of allegations of bad faith self-dealing, BigCorp refuses to indemnify you. Thank goodness you have the protection of the D&O liability insurance policy sold to you by the Really Big Insurance Group (“RIG”). You send them the civil and criminal complaints against you and ask them to pay for your lawyer. They refuse to advance defense costs pending the final outcome of the matter.

Most Courts Require Advancement of Defense Costs

A recent case, Brown v. AIG, Inc., et al., (Oct. 19, 2004) has reiterated the rule that D&O liability insurance companies should be required to advance defense costs during the defense of a D&O claim. In Brown, the insurance companies attempted to avoid advancing defense costs by relying upon an exclusion for “related acts.” The Brown court concluded that the insurance company failed to prove the applicability of the exclusion. The court thus required advancement of defense costs. This is a story oft-repeated.

If the insurance company arguments were legitimate, the D&O policy itself would be “rendered a nullity,” and the coverage it supposedly provided would be completely illusory. See United States v. Weissman, (S.D.N.Y. 1997).

Furthermore, a policyholder may seek a ruling on the duty of an insurance company to provide defense costs even though the total amount of the liability for those defense costs may not yet be ascertainable. General Accident Insurance Co. of America v. Allen (1997). Directors and officers should receive the fair protection and compensation bargained for under the D&O policies. See In re Adelphia Communications Corp. (Bankr. S.D.N.Y. 2002):

In many cases, officer or director insureds might be severely prejudiced by a refusal to grant relief from the stay to recover defense costs….D&O policies are obtained for the protection of individual directors and officers…

Defense Costs Must Be Advanced Despite Rescission Claims

Simply declaring “rescission” does not end the obligation under the D&O liability insurance policy to advance defense costs. one case seeking rescission of an errors and omissions policy, the Court held that the insurance company’s “attempt to unilaterally rescind the policy was ineffective, absent resolution by the court through either a declaratory judgment proceeding or equity action.” Colonial Valley Abstract Co. v. Homestead Ins. Co. (1993). The Court also cited to a prior decision, Prudential Ins. Co. of America v. Ptohides, which held:

Repudiation is…an act too uncertain…to be accepted as the equivalent of ordered battle in the courts….A [valid] contest [of liability] begins when the insurer avoids, or seeks to avoid, the obligation of the contract by action or defense. [emphasis added]

Every Court Which Has Considered the Issue Has Concluded That Defense Costs Must Be Advanced Pending a Resolution of the Rescission Claim

Every court which has considered the issue of advancement of defense costs in the context of a rescission claim has concluded unequivocally that defense costs must be advanced until there is a final judicial determination of rescission. Though they continue to make the same arguments, D&O liability insurance companies do not offer any persuasive arguments against them.

Advancement of Defense Costs Is Consistent with the Purpose and Language of the D&O Policy

In In re Adelphia Communications Corp., 285 B.R. 580 (Bankr. S.D.N.Y. 2002), the court considered the directors and officers requests for advancement of defense costs from a D&O policy. The court found that:

[W]here the debtor has had a material interest in the proceeds of the D & O policy for its own economic exposure—e.g., by way of reimbursement for any indemnification payments it might make, or for “entity coverage,” satisfying issuer obligations on account of securities fraud liability—courts have recognized the interest of the debtor in the policy proceeds as well as the policy itself, with the result that the proceeds are property of the estate.

Id. at 591. The Adelphia Creditors’ Committee argued that defense costs constituted property of the estate because: (1) the Adelphia policies reimburse the estate to the extent that the estate advances defense costs to directors and officers; and (2) the Adelphia policies contain entity coverage protecting the estate from securities claims. Id. The Creditors’ Committee also argued that unfettered resort to the Adelphia policies would deprive a debtor trying to reorganize of an asset that it needs to secure independent directors who will not serve without insurance coverage. Id. at 592-93. The court agreed with the Creditors’ Committee and held that:

[A]n important factor is whether the estate is worth more with the D & O policy than without it. Here the [Adelphia] estate is worth more with the D & O Policy than without it by reason of the entity coverage, and the [Adelphia] estate is worth more with the D & O Policy by reason of the amalgam of the entity coverage and the need for the policy itself to secure independent directors. Under the facts of these cases, then, the proceeds of the D & O Policies are, like the policies themselves, property of the estate, and requests by insureds to draw down on policy proceeds do indeed require motions for relief from the stay.

Id. at 593. In light of the court’s discussion earlier in its opinion, as discussed above, it appears that the reference to “entity coverage” may include the reimbursement coverage provided by the Adelphia policies.

After deciding that the Adelphia policies and the proceeds were subject to the automatic stay, the court considered whether to grant relief from the stay under Bankruptcy Code section 362(d)(1), based on the factors set forth in Sonnax Industries, Inc. v. Tri Component Products Corp., 907 F.2d 1280 (2d Cir. 1990). After considering the competing claims to the Adelphia policies and applying the Sonnax factors, the court decided to allow the directors and officers to seek a limited amount of defense costs and to stay the insurers’ rescission action in its entirety. In re Adelphia Communications Corp. 285 B.R. at 593-600.

Resolution

Now, armed with proper interpretation of provisions regarding defense costs advancement, Ms. Big forcefully insists upon a current advancement of the defense costs from RIG. RIG hems and haws, but ultimately relents and agrees to advance defense costs. Perhaps the dispute is over, and all of Ms. Big’s defense costs regarding the BigCorp share-price drop will be covered. When last seen, Ms. Big’s attorney and RIG’s claims unit were discussing RIG’s “litigation guidelines.”

ABOUT THE AUTHOR

William G. Passannante is a senior shareholder in the New York Office of Anderson Kill & Olick, P.C., Co-Chair of the firm’s Insurance Recovery Group, and a member of the firm’s Executive Committee. Mr. Passannante regularly represents policyholders in insurance coverage disputes. He can be reached at wpassannante@andersonkill.com.

riskVue | The webzine for risk management professionals
January 2006