Skip to main content
Article

Evolving directors’ and officers’ risk for distressed organizations: Part I

Financial, Executive and Professional Risks (FINEX)
N/A

By John M. Orr | July 30, 2020

Due to economic conditions, many companies are filing for bankruptcy or selecting an alternative to bankruptcy. We examine the impact to directors and officers liability and insurance as a result.

In the current economic downturn, corporate insolvency and restructuring are becoming more than just the subject of what-if internal strategic discussions. They are driving many companies to take immediate measures, whether in the form of a bankruptcy filing or the election of any one of several alternatives to bankruptcy. For companies of all sizes and across industries, reduced revenues, diminished customer demand, supply chain disruptions and other macro-economic forces have led to the onset of distress, impacting organizations within months, even weeks, of public health restrictions brought on by the coronavirus outbreak.

On 26 June 2020, a new act came into force in the UK bringing major changes to insolvency procedures in the jurisdiction (the Corporate Insolvency and Governance Act 2020). The UK has introduced a new moratorium procedure with similarities to the US Chapter 11 debtor-in-possession process, whereby the directors of a company remain in control with a view to implementing a rescue plan. The act also introduced a new Restructuring Plan process whereby the directors can seek to compromise the claims of creditors and/or members with court approval even where there are dissenting creditors. Finally, the new act also provides temporary reliefs for directors and companies where there is potential insolvency as a result of the COVID-19 pandemic.”

Angus Duncan, Executive Director, Coverage Specialist, Global FINEX

We explore the subject of bankruptcy risk and its impact on directors and officers (“D&O”) liability and insurance in a two-part series. Below, in Part I, we provide a high level overview of bankruptcy, alternatives to bankruptcy and how D&O duties of care and loyalty transform as a company’s financial health deteriorates. In Part II, we will describe the nature of claims against directors and officers in bankruptcy, as well as issues surrounding the responsiveness of D&O insurance to bankruptcy claims.

Overview of bankruptcy processes

The most common forms of business bankruptcies in the United States are Chapter 7 and Chapter 11 filings. If a firm is filing under Chapter 7 of the Bankruptcy Code, it is folding its tent. Chapter 7 is “liquidation.” In a Chapter 7 filing, the bankruptcy court appoints a trustee, who then identifies, collects and liquidates the debtor’s assets to pay off creditors to the extent possible. In doing this, the trustee may look to where liabilities to the company may lie. They may then commence litigation to collect on those liabilities and, in some instances, bring suit against directors and officers.

In contrast, Chapter 11 is most often “reorganization.” In a Chapter 11 filing, the firm may not be liquidating or winding down. Instead, it is seeking protection from creditors as it restructures its debt. Chapter 11 provides the debtor with a fresh start, with the company typically remaining open and operating as a debtor-in-possession, or “DIP.” It does so subject to fulfilling obligations under a reorganization plan negotiated and approved in the bankruptcy process.

In the typical Chapter 11 filing, or “free fall” bankruptcy, the debtor is forced to file bankruptcy with no precise game plan or certainty as to how the company and capital structure will look upon exit. In contrast, in a “pre-arranged” bankruptcy, there is a general consensus among creditors that a Chapter 11 case should be filed, but an agreement on restructuring of debt cannot be achieved prior to filing. A “pre-packaged” filing, or “pre-pack,” involves a reorganization plan that the debtor prepares with its creditors in advance of its filing. Thus, with a pre-arranged or pre-pack filing, a filing is ultimately required, but the process can be cleaner and less protracted. In fact, more than half of Chapter 11 filings are pre-packaged, upwards of almost two-thirds of all Chapter 11 filings in recent years.1

Companies most often file under Chapter 11 believing they can rehabilitate their affairs under a reorganization plan. Nevertheless, after filing, it may become apparent that rehabilitation is not likely to be successful. In this instance, the organization may convert its filing into a Chapter 7 liquidation.

Likewise, bankruptcy filings can be “voluntary,” as described in the examples above, or they can be “involuntary.” In an involuntary bankruptcy, creditors may commence a proceeding against the debtor, attempting to force it into a Chapter 7 or 11 bankruptcy. As a general matter, courts may grant the involuntary bankruptcy to the extent the company maintains some level of ability to pay its debts, yet it refuses to do so.

The Automatic Stay

An important component to any bankruptcy is the Automatic Stay, a provision contained at section 362 of the Bankruptcy Code, that temporarily prevents creditors and others from taking action to pursue claims against debtors. The Automatic Stay takes effect immediately upon the debtor’s filing for bankruptcy and applies to both Chapter 7 and Chapter 11 filings.

The Automatic Stay can be understood as a means of preserving corporate assets. In this regard, and subject to numerous exceptions, it will not just prevent creditors from pursuing claims against debtors, it may also preclude debtors from disposing of corporate assets without court approval. For purposes of D&O liability and insurance, the Automatic Stay may prevent the debtor from indemnifying directors and officers in claims brought against them in the bankruptcy proceeding. Therefore, and in the absence of court approval, coverage under the D&O policy for claims against directors and officers may potentially be afforded under the policy’s Side A coverage for non-indemnifiable losses.

We discuss the effectiveness of D&O insurance to pay claims against directors and officers in corporate bankruptcy proceedings in Part II of our series.

Alternatives to bankruptcy

Bankruptcy proceedings can be factually and legally complicated. Creditor claims may be costly and contentious. Claims asserted by trustees or DIPs against third parties or directors and officers may need to be pursued, and assets might not be easily identified. In these situations, a court-supervised process may be the most advantageous path forward. Other cases might not be as complicated. Creditor agreements may come more quickly, and perhaps a prolonged process isn’t desired or needed. Organizations in this situation may elect to explore alternatives to bankruptcy filings, including:

  • Out-of-court restructuring, or "workout": A nonjudicial process through which a distressed organization and its creditors reach an agreement for modifying the company's obligations
  • Recapitalization: A process of restructuring a company’s debt and equity mixture, in many cases to make a company’s capital structure more stable.
  • Foreclosure: A legal process by which a lender attempts to recover the amount owed on defaulted loans by taking ownership of and selling mortgaged property. Business foreclosures can be judicial or non-judicial.
  • Assignment for the Benefit of Creditors: A process under state law wherein a company transfers its assets to an assignee, who then becomes a fiduciary for the benefit of creditors. The process may require approval by a majority of shareholders, but it generally allows the company to operate and remain open without court supervision.
  • Mergers and acquisitions (M&A): A path ahead for a distressed organization may involve the sale of all or part of the company, such as a stock sale or divestiture. If M&A is in the company’s strategy, consideration to transactional insurance, such as Representations and Warranties, and Tax Opinion liability insurance products, is imperative.

Director and officer duties of care and loyalty

A corporation’s journey from solvency to bankruptcy can be understood as a process along a spectrum. As the company’s financial condition changes along the spectrum, so do director and officer duties of care and loyalty.

For the solvent organization, directors and officers generally owe fiduciary duties of care and loyalty to the organization itself and its shareholders. As the firm’s condition deteriorates, at some point it enters the “zone of insolvency.” As one source has described it, a firm may be operating in the zone of insolvency if “the failure of a proposed transaction is reasonably likely to cause a company to become insolvent, or if it is reasonably foreseeable that the corporation will have ongoing trouble paying its creditors as a class.”2 Upon entering the zone of insolvency, duties of directors and officers change in the sense that they begin to owe duties, not just to the firm and its shareholders, but also indirectly to creditors.

The importance of transforming duties to creditors is best understood in the changing relationship directors and officers have with creditors as insolvency and bankruptcy become more likely. While a company is solvent, relationships with creditors are contractual. Corporate obligations owed to creditors are encompassed in contractual provisions. Thus, creditors retain direct rights of action and may assert claims against companies for breach of contract, fraud or other contract-based torts; however, as the company approaches the zone of insolvency and drifts further into deepening insolvency, creditors, like shareholders, become constituencies who hold a risk of damages emerging from breaches of fiduciary duty.

Conclusion

Understanding the basics of corporate insolvency and bankruptcy will help risk professionals to anticipate questions internally and to seek guidance from their D&O and M&A insurance brokers, and outside counsel, in a more focused manner.

In Part II, we will assess the types of claims that can be brought against directors and officers in bankruptcy and the extent to which the company’s D&O policy may be responsive to those claims.

Footnotes

1 See John Yozzo and Samuel Star, “For Better or Worse, Prepackaged and Prenegotiated Filings Now Account for Most Reorganizations,” ABI Journal, November 2018, available at abi.org/abi-journal.

2 Barbra R. Parlin and Sandra E. Mayerson, “The Zone Of Insolvency: A Trap for the Unwary,” MEALEY’S Emerging Insurance Disputes, December 2007.

Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal or professional advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In the United States, Willis Towers Watson offers insurance products through licensed subsidiaries of Willis North America Inc., including Willis Towers Watson Northeast, Inc.

Author

D&O Liability Coverage Leader, FINEX

Contact Us
Related content tags, list of links Article Financial, Executive and Professional Risks (FINEX)