People Law | D&O Insurance Coverage: Business in Receivership, Insurance Provider Can Advance Defense Expenditure, However Limits Exhausted?
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D&O Insurance Coverage: Business in Receivership, Insurance Provider Can Advance Defense Expenditure, However Limits Exhausted?

D&O Insurance Coverage: Business in Receivership, Insurance Provider Can Advance Defense Expenditure, However Limits Exhausted?

An issue that frequently comes up when companies are in bankruptcy or in other forms of receivership is whether the companies’ D&O insurer can advance payment of individuals’ defense costs over the receiver’s objections. In a recent case, a Northern District of Texas judge has ruled that the individual defendants in an SEC enforcement action are entitled to have their defense expenses advanced notwithstanding the asset stay in the proceeding and despite the receiver’s objections. However the policy’s limits of liability are all but exhausted, which raises its own set of issues, as discussed below. Northern District of Texas Judge Sydney Fitzwater’s June 6, 2018 opinion in the case can be found here.

Background

Breitling Energy Company and related entities were in the oil and gas production business. In 2016, the Securities and Exchange Commission (SEC) filed an enforcement action against the companies and certain of its directors and officers alleging that the defendants had engaged in a scheme to defraud investors. The court granted the SEC’s motion for an order freezing the companies’ assets and appointing a receiver.

At relevant times, the companies’ maintained a D&O insurance policy with a $1 million limit of liability. Several of the individual defendants filed a motion with the court to lift the stay to allow the D&O insurer to advance their costs of defending the SEC action. The receiver opposed lifting the stay. While the motion was pending, the Court permitted the individuals to submit, and the D&O insurer to pay, defense costs as incurred. One of the individuals filed a separate motion seeking to have the proceeds of the D&O insurance policy distributed equitably – specifically to have the proceeds advanced to pay the moving individual’s defense expense.

The June 6, 2018 Order

In a June 6, 2018 memorandum opinion and order, Judge Fitzwater granted the defendants’ motion to lift the stay in order for the D&O insurance policy proceeds to be paid toward the individual’s defense expenses. He denied the separate motion for the proceeds to be distributed “equitably” to the individual seeking the distribution.

In agreeing to lift the stay, Judge Fitzwater noted that while the D&O policy itself is part of the receivership estate, that does not preclude the advancement of defense costs. The Court, he noted, has “broad powers and wide discretion” to determine appropriate relief within the receivership. After determining that the moving individuals are indeed “Insured Persons” under the policy and otherwise could show that the preconditions under the policy for payment of the proceeds had been met, Judge Fitzwater concluded that the defendants “have a current right to payment under the D&O Policy – a right that is superior to any potential right of the Receiver.” He noted in addition that while the motion was pending the individuals were submitting and the D&O insurer was paying the individuals’ defense expenses.

The Receiver by contrast “has demonstrated no such contractual right to the proceeds.” The Receiver contended that he is incurring expenses as part of administering the estate; however, Judge Fitzwater said, the Received “does not identify how such expenses would be covered by the policy.” Even if covered, he has not shown that payment of these expenses should supersede the payment of the individuals’ defense expenses. The Receiver also pointed out that he might file claims against the individuals in the future, entitling him to the policy proceeds. Judge Fitzwater rejected this contention as well, saying that the possibility that the proceeds might one day be paid into the receivership does not justify denying the directors’ and officers’ claims. The individuals’ “immediate need outweighs the potential harm to the Receivership Estate.”

Finally, Judge Fitzwater denied the separate motion of one of the individuals for an equitable distribution of the remaining proceeds so that his (the individual’s)defense expenses were paid. The individual (a former outside director) argued that the other company officers had withheld from him information concerning the availability of D&O insurance, delaying his ability to seek insurance for his defense expenses until the policy proceeds had been almost entirely exhausted and leaving only a small amount for payment of expense. He argued that in equity his fees should be paid as they would have and could have been if he had been told about the insurance earlier. Judge Fitzwater rejected these arguments, questioning whether his equitable powers related to the SEC enforcement action extended this far and also questioning the factual validity of the arguments on which the individual sought equitable relief.

Discussion

In many ways, there is nothing particularly noteworthy about the court’s resolution of this fee advancement issue. These kinds of disputes are more or less routine in bankruptcy proceedings and other types of receivership proceedings. While receivers in these kinds of situations typically oppose use of policy proceeds to pay individuals’ defense expenses, it is now more or less standard for courts to allow the defense expenses to be paid. In this instance the court seems to have gotten all of this more or less correct. The opinion does provide a good example for interested observers to understand how the policy should operate in this kind of context.

What makes this ruling interesting to me is not so much the court allowing the defense fees to be advanced; rather, what makes this ruling interesting to me is the second part of the order, relating to the individual’s request for equitable relief. The individual is in the unfortunate position that a significant amount of the defense fees that he has incurred in connection with the SEC enforcement action will not be paid by insurance. It isn’t clear from the record whether the insurance payments of his fees were inequitably prevented because the other defendants inappropriately withheld information from him about the insurance. The one thing that is clear is that the limits of liability of the company’s insurance policy are proving to be inadequate to provide appropriate protection.

It is not uncommon for smaller private companies to buy only minimal amounts of D&O insurance. Usually at the point where the insurance purchasing decision is being made the only consideration is cost. Understandably, most businesses try to control expenses wherever they can, and insurance is no exception. The problem, as the individuals undoubtedly are now finding out, is that spending as little as possible on insurance could create a situation where the insurance in place is inadequate for the purpose.

In this situation, the company and its executives face very serious allegations – sufficiently serious that each individual requires separate counsel. Under these circumstances, with serious allegations and multiple lawyers running up fees, costs mount quickly. A million dollars is a lot of money but as much as it is, it is not enough to provide a sufficient defense in a serious situation.

The fact is that D&O insurance is there to protect against serious claims. As we say in the insurance business, it is a low frequency high severity line of business – there aren’t frequent claims but the claims that do arise are serious, and expensive.

Cost considerations undoubtedly are important in connection with the insurance buying decision but they should not eclipse concerns relating to the adequacy of the insurance for the possible need. The kinds of circumstances in which the insurance will be called into play need to be taken into account. Multiple scenarios should be considered, including, for example, a situation where multiple individuals have been hauled into a serious claim and each has their own counsel incurring fees.

There are no absolute right answers when it comes to limits selection questions. They are always going to be competing considerations of costs and risk management. The chance that a company and its executives might find themselves in a serious situation with insufficient insurance can be reduced to the extent the worse case scenarios are considered and taken into account.

The post D&O Insurance: Company in Receivership, Insurer Can Advance Defense Expense, But Limits Exhausted? appeared first on The D&O Diary.

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