Bankruptcy Court Preserves Insurance Proceeds for the Benefit of MF Global’s Officers and Directors

A recent decision from the United States Bankruptcy Court for the Southern District of New York¹ serves as an important reminder for insurers to avoid making unauthorized payments of insurance proceeds after a policyholder files for bankruptcy. The relationship between insurer and insured is altered inasmuch as the insurer is often required to seek Bankruptcy Court approval before it releases insurance proceeds to an insured or third party claimant. Indeed, in the bankruptcy forum, a time-honored maxim is turned on its head: it is better for insurers to ask for permission before releasing insurance proceeds rather than begging for forgiveness after the fact.

The Court’s holding will also provide a certain measure of comfort to corporate officers and directors who depend on director and officer policies to fund the costs of defending shareholder lawsuits. Given the dramatic increase in litigation targeted at officers and directors of failed corporations, executives rely heavily on such policies to fund the costs of defense. The opinion represents a win for officers and directors whose ability to recover defense costs from a finite pool of insurance proceeds is often challenged by plaintiffs who depend upon those proceeds to satisfy any judgment against the officers and directors.

The opinion arises out of the MF Global Holdings bankruptcy proceeding that was filed after the well-publicized meltdown of MF Global, Inc. and related entities (collectively, “MF Global”). The critical issue² examined by the Bankruptcy Court was whether MF Global’s insurers, who had issued director and officer liability insurance policies (“D&O Policies”) and Errors and Omissions Policies (“E&O Policies”), were authorized to utilize proceeds of those policies to pay defense costs on behalf of directors, officers and employees of MF Global.

The resolution of that issue hinged upon the determination of: (i) whether such proceeds constituted property of the MF Global’s bankruptcy estate;³ and, if so (ii) whether the automatic stay that preserves property of the estate⁴ should be lifted to allow the insurers to pay the costs of defense. As discussed below, the Bankruptcy Court concluded that reasonable defense costs should be paid on behalf of the directors and officers regardless of whether the policy proceeds were property of the estate. Thus, the Court held that the automatic stay should be lifted for cause.

Facts of MF Global

Before it imploded, MF Global was an international financial derivatives broker that specialized in exchange-traded derivatives. In late October 2011, MF Global reported a material shortfall of hundreds of millions of dollars of segregated customer funds. Shortly thereafter, numerous officers, directors and high level employees of MF Global were sued in lawsuits commenced by security-holders and commodity customers. Thereafter, MF Global’s insurers began receiving requests for defense and indemnification of the claims asserted in that litigation. The two types of policies that were implicated were D&O Policies and E&O Policies. Of particular significance to the Court’s analysis, the subject policies were “wasting policies” meaning that every dollar spent of policy proceeds, including defense costs, eroded the aggregate policy limits that may be available to pay covered claims. Also of importance, the policies provided coverage for officers and directors, as well as the MF Global entities, and provided for the advancement of defense costs to the officers and directors. In other words, the policies covered two types of claims: (i) claims from the officers and directors for payment of costs of defense and judgments entered against them; and (ii) claims submitted by MF Global for any judgments or liability stemming from the actions of its officers and directors.

Following the onslaught of securities litigation, MF Global filed for bankruptcy protection with the United States Bankruptcy Court for the Southern District of New York on October 31, 2011. In the bankruptcy proceeding, the insurers requested a determination from the Bankruptcy Court that the proceeds of the insured’s policies were not property of MF Global’s bankruptcy estate. Alternatively, in the event that the Court concluded that the insurance proceeds were property of the estate, the insurers requested relief from the automatic stay, to the extent it was applicable, to permit them to advance defense costs on behalf of the officers and directors.

Among the objecting parties were the plaintiffs in the class action litigation filed against the directors and officers. Their opposition was motivated by a concern that, because the subject policies were wasting policies, the payment of defense costs would deplete the pool of insurance proceeds that would otherwise be available to pay their claims if they prevailed in the litigation. This concern was well founded given that the total amount of defense costs at issue was in excess of eight million dollars. In support of their objection, the objecting parties asserted that the policy proceeds were property of the debtor’s bankruptcy estate and therefore should not be used to pay defense costs. They also argued that cause did not exist to lift the automatic stay.

Bankruptcy Court’s Analysis and Holding

It has been consistently recognized that a debtor’s liability policies are property of the bankruptcy estate.⁵ That said, the issue of whether policy proceeds constitute property of the estate is far more complex. Indeed, courts have often disagreed over whether insurance proceeds constitute property of an insured’s bankruptcy estate.⁶ The resolution of the issue hinges on the language of the policies. Specifically, if the policy is a first party policy, which provides for direct coverage for the benefit of the debtor/insured, then courts have typically found that such proceeds constitute property of the estate.⁷ Conversely, where the coverage is provided exclusively to the officers and directors, the proceeds of such policies are not typically considered part of the bankruptcy estate. The underlying rationale for this distinction is that while proceeds from first party policies flow directly to the debtor, and hence become part of the bankruptcy estate, proceeds from those policies that indemnify only officers and directors will never flow to the debtor and should not be considered estate property.

MF Global presented a unique factual situation because the subject policies provided coverage for both the MF Global entities and its directors and officers.⁸ Accordingly, the facts did not fit cleanly into the above framework. Ultimately, the Court side-stepped the issue of whether the proceeds were property of the estate. Indeed, the Court concluded that it was unnecessary to reach the issue because, regardless of whether the proceeds were estate property, the automatic stay should be lifted to provide for the advancement of insurance proceeds.⁹

Under 11 U.S.C. § 362(d), the automatic stay can be lifted for “cause.”¹⁰ The MF Global opinion began its analysis by highlighting legal precedent supporting the advancement of defense costs even though the subject policies provided direct coverage to the debtor.¹¹ In finding that cause to lift the automatic stay, the MF Global Court observed that the primary purpose of director and officer policies was to safeguard the interests of the officers and directors.¹² The Court further observed that the securities claims had not been asserted directly against the MF Global entities and, in light of the automatic stay, MF Global did not face significant litigation exposure.¹³ Conversely, the directors and officers, who were not protected by the automatic stay because they did not file for bankruptcy, faced an immediate and significant need for reimbursement of defense costs.¹⁴ Thus, the Court concluded that the directors’ and officers’ immediate needs for payment of defense costs far outweighed MF Global’s speculative need for coverage in the event that claims were asserted directly against the entities in the future.

In sum, the Bankruptcy Court found that the plaintiffs could not have their cake and eat it too. The plaintiffs had the right to prosecute their claims against the officers and directors without interference by the automatic stay that was triggered by MF Global’s bankruptcy filing. As such, the Court found that the plaintiffs could not raise the automatic stay as a basis to thwart the advancement of defense costs arising from that litigation. In this context, the plaintiffs assume the risk that prosecution of the litigation may erode the pool of insurance proceeds.

Conclusion

As creditors’ committees and other fiduciaries of the bankruptcy estate continue to set their sights on officers and directors, opinions such as MF Global take on increasing importance. Ultimately, one’s views on the wisdom of the MF Global opinion depend in part on whose “ox is being gored.” MF Global’s investors, who contend that they were defrauded by the actions of the officers and directors, firmly believe that all of the insurance proceeds should be preserved to satisfy any judgment obtained in the class action litigation. The officers and directors, on the other hand, will tout MF Global as a just result in that the primary purpose of such policies is to protect their interests and not to serve as a vehicle for corporate protection. Absent such protections, the officers and directors would undoubtedly argue, corporations would find it increasingly difficult to secure the services of talented and experienced individuals to sit on corporate boards. While the Bankruptcy Court was sympathetic to the plight of the investors, it ultimately concluded that the accusations of misconduct were no basis to deny the officers and directors the protections afforded under the D&O policies.

Lastly, insurers would be well advised to closely examine whether any policy proceeds that will be released over the course of the insured’s bankruptcy proceeding are property of the bankruptcy estate. If so, the insurer would be well advised to consider whether court approval is necessary prior to releasing the proceeds.

For More Information

For more information on how these issues may affect your rights, contact John C. Kilgannon at 215.751.1943.

This News Alert has been prepared for informational purposes only and should not be construed as, and does not constitute, legal advice on any specific matter. For more information, please see the disclaimer.

¹ In re MF Global Holdings, Ltd., —B.R.—, 2012 WL 1191892 (Bankr. S.D.N.Y.)
² The Court also spent considerable time examining whether certain commodity customers had standing to object to the advancement of defense costs. The Court concluded that the customers were afforded standing under the broad standing provisions embodied in section 1109(b) of the Bankruptcy Code.
³ Pursuant to section 541 of the Bankruptcy Code, property of the bankruptcy estate is defined, in relevant part, as “…all legal and equitable interests of the debtor in property as of the commencement of the case.”
⁴ Under 11 U.S.C. §362(a), a stay against litigation arises immediately and automatically after a company files for bankruptcy protection.
⁵ Id. at *9.
⁶ Id. at *10.
⁷ Id.
⁸ In situations where liability insurance policies provide direct coverage for both officers and directors and debtors, courts have held that the proceeds are part of the bankruptcy estate if “depletion of the proceeds would have an adverse effect on the estate to the extent that the policy actually protects the estate’s other assets from diminution.” In re Downey Fin. Corp., 428 B.R. 595, 603 (citations omitted)
⁹ Id.
¹⁰ Although “cause” is not defined in the Bankruptcy Code, courts typically examine the issue on a case-by-case basis and take a multitude of factors into consideration in evaluating whether the automatic stay should be lifted for “cause.” In re Sonnax Indus., Inc., 907 F.2d 1280, 1286 (2d Cir. 1990).
¹¹ See e.g. In re Adelphia Commc’ns Corp., 285 B.R. 580, 598 (Bankr. S.D.N.Y. 2002)(granting stay relief to permit insurer to advance defense costs), vacated on other grounds, 298 B.R. 49 (S.D.N.Y. 2003).
¹² Id. at *12.
¹³ Id.
¹⁴ Id.