D&O Debate: Directors and Officers are Not Down-and-Out When it Comes to Defense Costs

Contributed by Alana Katz.
The Bankruptcy Blog previously published an extensive guide to evaluating and purchasing director and officer (”D&O”) liability insurance for individuals at the helm of troubled companies.  But what happens when a policy is in place and the directors and officers seek to obtain the proceeds of that policy to cover defense costs or related expenses?  Can the directors and officers of a bankrupt company seek such proceeds without an order from the bankruptcy court?  These questions were recently answered by the United States Bankruptcy Court for the Middle District of Pennsylvania in In re Valley Forge Composite Technologies, Inc
In Valley Forge, two of the debtor’s officers filed a motion to lift the automatic stay to allow the advancement of funds under a D&O policy for their defense costs in a class action securities lawsuit.  They alternatively sought a declaratory judgment that the automatic stay does not apply to bar such advancement of defense costs.
Two objections were filed to the officers’ motion: (1) an objection by the chapter 7 trustee, arguing that the right to defense costs is a matter of contract and the bankruptcy court should not issue a “comfort order” in the absence of a controversy capable of bankruptcy court adjudication and (2) an objection filed by the securities lawsuit plaintiff arguing that the motion should be denied because the D&O policy was a “wasting policy” and, therefore, the more proceeds paid for defense costs, the less would be available to pay claims for securities law violations.  Additionally, at the hearing on the motion to lift the automatic stay, the trustee further asserted that no relief should be granted, as the trustee had a greater interest in the proceeds of the D&O policy than the officers.
The bankruptcy court relied on precedent from the Third and Fifth Circuits, as well as the District Court for the Southern District of New York, in holding that although the debtor may own the D&O policy, it does not own the proceeds of that policy payable to non-debtors.  Due to such lack of ownership, the proceeds are not property of the estate and not subject to the automatic stay.
The Valley Forge court thus denied the officers’ motion, holding that the automatic stay does not apply to the proceeds of the D&O policy.  The court explained that the movants are not attempting to obtain “possession of property of the estate or of property from the estate or to exercise control over property of the estate” as described in section 362(a)(3) of the Bankruptcy Code and, therefore, could obtain the proceeds of the policy without court approval.
Building upon a long line of cases, the Valley Forge court reinforces that insurance proceeds payable to non-debtors, whether from D&O or other types of policies, are not considered property of the estate.  Interestingly, although the bankruptcy court held that the proceeds of the D&O policy were not property of the estate, it did recognize that the objectors may have standing to seek injunctive relief to prevent dissipation of the proceeds, but only when their rights in the proceeds had ripened.  If such a case arises, we will be sure to let you know.