Chapter 14 Director and Officer Litigation

• Jurisdiction: United States

Chapter 14 Director and Officer Litigation

This chapter provides an introduction and commentary regarding the investigation, prosecution and potential recoveries by a litigation or liquidation trust in director and officer litigation.

This chapter introduces concepts involved with director and officer litigation. Recoveries from this litigation frequently constitute a major potential source of overall recoveries that is anticipated at the initial formation of litigation and liquidation trusts. This chapter provides a general introduction to potential types of litigation, insurance coverages, and relevant issues for the trustee to consider when investigating these causes of action.

A. Duties of Directors and Officers²¹⁰

One of the many tasks that the liquidation trustee must undertake is determining whether the property of the debtor's estate includes the debtor's causes of action against its directors and officers (D&Os). Deficiencies in the company's corporate governance — as well as deficiencies in the conduct and decisions of the directors and officers that contributed to the company's downfall, squandered and wasted assets, or caused other harm to the debtor's enterprise value — may offer opportunities to pursue D&O litigation. The right to pursue these actions as property of the estate held by the trust must be identified in the trust's governing documents.

There are three principal fiduciary duties owed by directors of a for-profit corporation: care, loyalty and good faith. As fiduciaries, directors hold a position of trust and conidence and are expected to fulill their duties. To the extent that they are violated, directors and officers are answerable to the corporation, its shareholders and, to an increasing degree, its creditors. Concepts of director liability for losses and damages to the corporation have long been recognized.²¹¹ In more recent years, and in addition to the traditional iduciary duties, directors are expected to meet oversight and transaction-related duties. For example, a transaction-related duty, the "Revlon duty,"²¹² requires directors to obtain the best price for the company when a corporation "initiates an active bidding process seeking to sell itself or to effect a business reorganization involving a clear break-up of the company," or "when approval of a transaction results in a sale or change in control."²¹³ Directors cannot play favorites with bidders and must take an active role in overseeing a sale process designed to secure the highest value reasonably attainable. To the extent that the directors and officers have met their obligations to make informed decisions using sound business judgment, they must also act within the scope of their authority and avoid breaching the terms of the corporate charter.²¹⁴ In some jurisdictions, they can be strictly liable, while in others their liability is limited to negligent acts or intentionally exceeding their authority.

Broader protections offered to directors and officers by the business judgment rule are no longer being applied at their fullest extent when the situation involves insolvent companies. Actions by directors and officers of these companies are coming under ever increasing levels of review, with the courts placing more stringent expectations on their performance of fiduciary obligations.²¹⁵ Where directors or officers fail to act to prevent injury to the corporation, and the failure was not a conscious decision, the business judgment rule offers no protection and ordinary negligence standards can be applied.²¹⁶

B. Bringing D&O Actions

The corporation itself, or its receiver or trustee, may bring claims for breach of fiduciary duty against the directors or officers for any injury that the corporation sustained as a result of the directors' and officers' misconduct.²¹⁷ Shareholders and creditors have standing individually to bring direct claims against the directors and officers for injuries sustained directly by the specific shareholder or creditor.²¹⁸ Shareholders may also bring derivative claims on behalf of a company, and creditors may also bring derivative claims on behalf of the company when it is insolvent; however, these derivative claims become property of the debtor's estate upon the commencement of a bankruptcy proceeding.²¹⁹ The extent to which a liquidation trustee can succeed or can preserve the right to these actions will be determined by the trust documents, including the plan, disclosure statement and trust agreement.

C. The D&O Insurance Policy²²⁰

The D&O insurance liability policy is typically an indemnity policy, which means that the insurer is obligated to indemnify or reimburse the insured for covered losses for which the insured has already paid. In bankruptcy, there is often only a limited pool of insurance proceeds available to satisfy several competing interests. A variety of entities may initiate litigation against the officers and directors of the debtor corporation, including the shareholders, the corporation itself, the trustee and creditors of the debtor. These competing interests can dilute the available policy recoveries while pursuing their separate claims against a limited pool of insurance proceeds. For instance, in February 2009 some of Stanford Financial Group's directors and officers were charged with facilitating a Ponzi scheme and fought for months with the receiver over access to the proceeds of three D&O policies that the directors and officers needed to fight the criminal charges.²²¹ In some instances, though, the proceeds can be exhausted. In Anglo-American Insurance Co. v. Molin:

Plaintiff insurers issued a D&O policy that covered the defendant insureds when they were not indemnified by the company. There was an aggregate limit of liability for all loss. After a settlement offer had been made to one defendant, the effect of which would exhaust policy limits, the insurers sought to interplead the policy limits with the court and stop funding legal expenses. Te defendants sought a preliminary injunction enjoining the insurers from ceasing to reimburse legal expenses. Denying the preliminary injunction, the court held that the insurers could exhaust the policy by disbursing the proceeds to some defendants and leave no proceeds for any remaining defendants.²²²

When creditors are litigating against former directors and officers, the trustee is immediately at a disadvantage in claiming the proceeds on behalf of the estate. "The trustee is typically one of the last parties to join the race to the courthouse and, at his appointment, lacks the information as to what potential claims and evidence exist. While the trustee gets up to speed, the creditor litigations continue unabated and the D&O policy proceeds are depleted."²²³

In an effort to safeguard the D&O policy proceeds while the trustee takes the necessary time to investigate and prosecute claims on behalf of the estate and its creditors, the trustee can seek injunctive relief through filing an adversary proceeding pursuant to § 105 of the Bankruptcy Code, which may effectively stay all pending litigation that requires the insurer to advance defense expenses.²²⁴

D. Property of the Estate

Generally, property of the estate is broadly construed and includes property in which the debtor has any property interest, including that which the debtor may own jointly. Section 541(a)(1) defines property of the estate as "all legal or equitable interest of the debtor in property as of the commencement of the case." The main issue that the courts must analyze and decide under the facts of each case is whether the debtor would have a right to receive and keep the proceeds of the D&O policy as property of the estate.

As defined under § 541(b), (c) and (d), property of the estate excludes:

1. any power that the debtor may exercise solely for the benefit of an entity other than the debtor;
2. leased assets under expired leases;
3. eligibility under certain governmental education programs;
4. certain interests in liquid or gaseous hydrocarbons; and
5. money order sale proceeds obtained within 14 days of bankruptcy petition.

D&O policies are generally single-limit policies. Terefore, every dollar paid for claims under Side A coverage would reduce the available proceeds for Side B and Side C coverage (see below). Also, D&O policies are eroding policies in which every dollar paid in defense costs is applied to the policy limit. As such, determining the order of payment, right to coverage and ultimate claim to the proceeds becomes a battle over property rights to a shared and limited amount.

Courts have attempted to fairly divide the D&O coverage between the directors and officers and the estate. For example, consider In re National Century Enterprises Inc.²²⁵ When faced with the absence of a priority of payment provision, the court allocated 70 percent of the D&O proceeds to the directors and officers and 30 percent to the entity for payment to creditors. There was $5 million in D&O coverage available, $2.6 billion in allowed claims and defense costs of nearly $4 million. The court decided that a simple proration would be inequitable because it would leave the directors and officers with "virtually nothing for their defense costs."²²⁶

An insurance policy is a contract, and as such, it is considered property of the estate; yet the proceeds of the policy are evaluated separately.²²⁷ Under § 541 of the Bankruptcy Code, insurance policies are property of the estate, so the automatic stay applies to any action to obtain control of the policies. However, the courts have not reached a consensus on whether D&O proceeds are property of the estate.²²⁸ The courts generally do agree that when the debtor has no legally cognizable claim to the insurance proceeds, they are not considered property of the estate.²²⁹ Yet "[e]ven the methods of analysis have not been uniform. The inquiries have been fact-specific and seem to turn on the issues of how immediate is the...