Deteriorating economic conditions threaten a massive wave of corporate defaults. Corporate borrowers’ inability to fulfill debt obligations could prompt a bankruptcy filing surge and lead to lawsuits as creditors and shareholders seek to recoup their losses. These claims could present a host of challenging directors and officers insurance coverage issues.
According to a recent Wall Street Journal article, the United States is about to experience “the most corporate-debt defaults, by dollar amount, in history.” The article estimates that “U.S. companies are poised to default on $450 billion to $500 billion in corporate bonds and bank loans over the next two years.”
The growing wave of souring debt has already resulted in rising numbers of bankruptcies. At the same time, many companies have found in the course of their year-end audits that their auditors question whether the companies can continue as “going concerns.”
A recent CFO.com article quoted the CEO of one of the Big Four accounting firms as saying that in the months ahead, “we’ll see an unprecedented number of going-concern footnote disclosures and clarifications from the auditors.”
The problem with going concern opinions is that they can become self-fulfilling prophecies. As the CFO.com article notes, “the revised status can further hinder a company on the brink of filing Chapter 11 from avoiding bankruptcy court,” because the qualification can spook “investors, lenders and suppliers.”
The prospect of surging corporate defaults and the rising numbers of companies with going concern audit opinions also raise the possibility of an increase in claims against the directors and officers of the struggling or bankrupt companies.
Among other things, the question whether a company can continue as a going concern alone can become an allegation in a shareholders’ class action complaint. Claims may arise even when companies attempt a work out to try to avoid bankruptcy. These claims can come from shareholders, who may be content that the workout resulted in a dilution of their interests, or it can even come from other bondholders, who may claim that their interests have been harmed or improperly subordinated.
A bankruptcy filing is particularly likely to be followed by claims against the bankrupt company’s directors and officers. In its recent report analyzing the 2008 securities lawsuits, the information database firm Advisen noted that the rising number of bankruptcies “almost certainly will be accompanied by an increase in securities lawsuits.”
The Advisen Report notes that since 1995, roughly 35 percent of large public companies (defined as having more than $250 million in assets, measured in 2008 dollars) that filed for bankruptcy were also named in securities class action lawsuits. During 2007 and 2008, that percentage increased to 77 percent.
These claims can come in the form of securities lawsuits brought against the individuals by the bankrupt company’s shareholders. In addition, the trustee in bankruptcy may also assert claims against the company’s directors and officers for breach of fiduciary duty or other alleged breach.
The advent of claims following bankruptcy presents a number of insurance-related challenges.
One critical issue is the amount of insurance available. The prospect for multiple simultaneous claims increases when a company files for bankruptcy. The involvement of multiple claims presents the possibility that the insurance could be entirely exhausted. Indeed, as actually happened in connection with the claims surrounding the recent Collins & Aikman bankruptcy, defense costs alone could deplete the available limits.
The interplay between the provisions of the Bankruptcy Code and the terms and conditions of the D&O policy may also present certain specific challenges. One recurring issue since so-called “entity coverage” has become a standard part of the D&O policy has been whether or not the D&O policy proceeds are property of the bankrupt estate and subject to the automatic stay in bankruptcy.
Another frequently recurring D&O insurance coverage issue arising in the bankruptcy context is whether claims asserted by the trustee or other receivers or liquidators against the company’s directors or officers runs afoul of the policy’s exclusion for claims brought by one insured against another insured. The “insured vs. insured” question arises because of the concern that the trustee or other claimant is “standing in the shoes” of a policy insured, the company itself.
A number of policy solutions to these recurring bankruptcy issues have arisen in recent years. For example, a coverage carve-back to the insured vs. insured exclusion, now standard in most policies, has developed to address concerns about coverage for claims brought by trustees and others.
In addition, many policies now contain “priority of payments” provisions to address questions surrounding the availability of the D&O policy’s proceeds for the payment of individuals’ defense expense or the resolution of claims notwithstanding the bankruptcy stay.
More importantly, the D&O industry has developed solutions to ensure that a fund of money will remain available for specified individuals so they can defend and resolve claims against them. These structures might take a number of forms, including a so-called side A/difference in conditions (DIC) policy, or even an individual director liability (IDL) policy.
The complexity of these issues underscores the need to involve a skilled insurance professional in the D&O insurance acquisition process. Financially troubled companies in particular need an informed advocate. The details of a company’s insurance program could determine whether coverage is available for individual directors and officers in the event of bankruptcy and related claims.
Finally, the economic conditions also present serious concerns for D&O underwriters. Up to this point, D&O underwriters have been able to segment risk arising from the credit crisis according to whether or not companies were financially related. However, with the growing threat of corporate defaults, risk segmentation will be more challenging. At a minimum, it will no longer be sufficient for underwriters to presume that risk is limited to the financial sector. These factors suggest that turbulent times could be ahead for both buyers and sellers in the D&O marketplace.
LaCroix is an attorney and partner in OakBridge Insurance Services’ Beachwood, Ohio, office. An earlier version of this article appeared on LaCroix’s Internet Web blog, the D&O Diary: www.dandodiary.com. E-mail: email@example.com.