Issues Facing Officers And Directors In Financially Troubled Companies

ISSUES FACING OFFICERS AND DIRECTORS IN FINANCIALY TROUBLED COMPANIES

January 29, 2009

OUTLINE  Zone of Insolvency

 Directors and Officers Insurance

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Defined

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Mechanics

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Causes of Action

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Coverage Waterfall

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Claimants

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Priority of Payment Endorsement

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Derivative Claims

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Indemnification

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Deepening Insolvency

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Endorsements

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Defenses

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Property of the Bankruptcy Estate

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Select Issues

ZONE OF INSOLVENCY

Definition: “Where a corporation is operating in the vicinity of insolvency, a board of directors is not merely the agent of the risk bearers, but owes its duty to the corporate enterprise.” Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., No. 12150, 1991 Del. Ch. LEXIS 215, at 108 (Del. Ch. Dec. 30, 1991).

SOLVENCY TESTS ▪ Balance Sheet ○

Fair Value of Assets Minus Fair Value of Liabilities

▪ Cash Flow ○

Failure to Pay Debts as They Become Due

▪ Capital Adequacy Capital Level is Not Adequate to Meet Current and/or Future Obligations ○

▪ “If you have to ask, or if your lender asks for an opinion letter, you’re in the zone.”

CAUSES OF ACTION ▪ Breach of Fiduciary Duty ▪ Breach of Duty of Loyalty/Care ▪ Breach of Duty to Disclose ▪ Unlawful Dividend ▪ Fraudulent Conveyance ▪ Breach of Contract ▪ Breach of Implied Covenant of Good Faith and Fair Dealing

CLAIMANTS ▪ Trade Creditors ▪ Unsecured Banks ▪ Mezzanine and Second Lien Lenders ▪ Chapter 11 or Chapter 7 Trustees ▪ Creditors’ Committees ▪ Assignee For the Benefit of Creditors ▪ Debtor-in-Possession ▪ Post Confirmation Trusts

DERIVATIVE CLAIMS ▪ Creditors, as Quasi Equity Investors, Only Hold Derivative Claims Against the Corporation, and It’s Officers and Directors.

“The general rule is that [officers and] directors do not owe duties beyond the relevant contractual terms. No direct claim for breach of fiduciary duties may be asserted by creditors of a solvent corporation that is operating in the zone of insolvency. When a corporation is insolvent, however, its creditors take the place of shareholders as the residual beneficiaries of any increase in value. Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims on behalf of the corporation for breach of fiduciary duties.” National American Catholic Educational Programming Foundation, inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).

DEEPENING INSOLVENCY ▪ The Board of Directors, Officers, Restructuring Advisors, Lenders, Investment Bankers, Accountants and Attorneys Who Prolong the Operating Life of a Financially Distressed Company, and Thus Deplete Its Assets and Increase Creditors’ Exposure May Be Liable to the Company. Recognized as a cause of action in Florida, Louisiana, Massachusetts, New Jersey, North Carolina and Tennessee. ○

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Not recognized in Georgia and Texas.

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Recognized as a damages theory.

DEEPENING INSOLVENCY ▪ Must prove wrongful conduct, such as fraud, as opposed to mere negligence ▪ Incurrence of additional debt in an uncertain business is not, in itself, a breach of a fiduciary duty. In re Global Serv. Group LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004). ▪ Delaware imposes no absolute obligation on a board of a company that can not pay its bills to cease operations and liquidate. Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168, 174 (Del. Ch. 2006).

DEFENSES ▪ Business Judgment Rule ▪ Exculpatory Charter Provision ○

8 Del. C. §102(b)(7)

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Does Not Cover Officers

Does Not Cover Breach of Duty of Loyalty, Intentional Misconduct, Knowing Violation of the Law and Personal Benefit ○

▪ In Pari Delecto Plaintiff That Participated in Wrongdoing May Not Recover Damages Arising From Such Wrongdoing ○

D&O INSURANCE ▪ Mechanics ○

Notice of Claim Filed with Carrier

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Claims Made Policy

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Notice of Coverage (or Denial) with Reservation of Rights

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Engage Counsel · Joint Defense Agreement

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Diminishing Coverage

COVERAGE WATERFALL

▪ Side A

Direct Coverage of Officers and Directors

▪ Side B

Reimbursement Coverage for the Corporation, Based on Funds Paid to Indemnify Officers and Directors

▪ Side C

Coverage of the Corporation for Claims Against It

ADDITIONAL COVERAGE

▪ Tail Policy Coverage for Post Policy Claims ▪ Add Ons

Employee Practices, Employee Dishonesty, Representation and Warranties

▪ Personal

Coverage for Post Resignation Claims

PRIORITY OF PAYMENTS ENDORSEMENT ▪ Express Subordination of Payments: First Side A, Next Side B, and Finally Side C ▪ Sample Language: “In the event of a Loss from one or more covered Claims the Insurer in all events shall (i) first pay all Loss for coverage under Side A, (ii) then, only after payments of all Loss covered by Side A, pay all Loss under Side B, and (iii) then, only after payments of all Loss covered by Side A and Side B, pay all Loss under Side C.”

PRIORITY OF PAYMENTS ENDORSEMENT

▪ Advance Waiver of the Automatic Stay ▪ Exclude All Requirements That Payments Must Be Approved by Officers, Directors or the Company

INDEMINFICATION ▪ Delaware and Massachusetts Law ○ A Corporation May Indemnify Officers and Directors for Defense Expenses. Del. Code Ann. tit. 8, §145(a); Mass. Gen. Laws ch. 156D, §8.51(directors), §8.56 (officers). Indemnification of Expenses is Mandatory When the Officer/Director’s Defense is Successful. Del. Code Ann. tit. §145(c); Mass. Gen. Laws ch. 156D, §8.52 (directors), §8.56 (officers).

▪ Indemnification in Bankruptcy ○

Seek an Order Authorizing Continuing Indemnification

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File a Proof of Claim

○ Carrier May Require Insured to Exhaust All Indemnification Claims Before Coverage Kicks In

ENDORSEMENTS ▪ Insured v. Insured ○ Example: Company (covered under Side C) Sues a Director (covered under Side A) ○

Sample Language: “The Insurer shall not be liable for any Loss in connection with any Claim brought by, or on behalf of Insured, except and to the extent that such claim is by, or on behalf of a debtor-in-possession, any bankruptcy trustee, litigation trustee, examiner, creditors committee, equity committee, administrator or liquidator, or any comparable authority (or any assignee of the foregoing parties).”

ENDORSEMENTS ▪ Indemnification Coverage During Bankruptcy ▪ “Final Adjudication” for Personal Conduct Exclusions ▪ Pollution and Nuclear Exclusions ▪ Securities Claims and Claims by Public Debt Holders

ENDORSEMENTS ▪ Government and Regulatory Investigations ▪ “Other Insurance” Policy Claims ▪ Lengthy Trigger for Notice Provisions ▪ Severability for Innocent Officers and Directors ▪ Relation Back Start Date

PROPERTY OF THE BANKRUPTCY ESTATE ▪ Is D&O Insurance Property of the Estate ○

The Policy -- Yes

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The Proceeds -- It Depends ◦ If Side A exists, the proceeds are not property of the Estate.

◦ If Side A does not exist, you must seek an order authorizing use of proceeds to cover legal fees and costs. Any settlement of the litigation must be approved by the Court. Use of any proceeds to pay a judgment or settlement must have the creditors’ consent.

SELECT ISSUES ▪ In an Assignment for the Benefit of Creditors the Assignee Holds All Derivative Claims ▪ Derivative Claims Can Be Discharged Under a Plan of Reorganization ▪ A D&O Policy Will be Rescinded for Application Fraud