Insurer Beware: Payment of Defense Costs May Be Required Pending the Stay of Claims for Rescission and Determination of Exclusions
September, 2004
Introduction
A Director & Officer liability insurance policy (“D&O policy”) provides coverage for any loss that a director or officer becomes legally obligated to pay, including payment of defense costs. A D&O policy often includes indemnity coverage for the corporation, for those sums paid for the benefit of the directors and officers, as well as coverage for securities fraud claims. When a corporation files for bankruptcy, many issues arise regarding the D&O policy and whether or not the D&O policy itself or the proceeds of that policy are property of the estate. This article discusses the obligations of an insurer to advance defense costs and the recent ruling relating to the directors and officers of Adelphia Communications Corporation (“Adelphia”) in Associated Electric & Gas Insur. Services, Ltd. v. Rigas, 2004 U.S. Dist. LEXIS 4498 (E.D. Pa. 2004)(“Adelphia”).
Discussion
Adelphia Facts
Adelphia filed for bankruptcy in the Southern District of New York. All proceedings against Adelphia’s directors and officers were stayed except for the limited purpose of having the District Court in Pennsylvania decide whether the insurers were obligated to make immediate payment of $300,000 in civil defense costs for each of the directors and officers prior to adjudication of the merits of the insurers’ assertions. The Bankruptcy Court stayed the Pennsylvania action relating to the insurers’ requests for rescission, factual findings and all deposition discovery.
The insurers asserted recission of the policy as well as lack of coverage based on the Fraud and Prior Knowledge exclusions. They further argued that the D&O policies did not require the advance payment of uncovered defense costs and the policies were not ambiguous in that regard.
The insured directors and officers argued that the D&O policies require immediate payment of defense costs and that until there is a final adjudication regarding the fraud exclusion and rescission, the insurers must pay defense costs.
Adelphia Analysis
The Court first evaluated the unilateral rescission of the D&O policies by the insurers. The Court could not adjudicate the rescission issue because of the stay placed by the Bankruptcy Court. The District Court found that a D&O policy, as a contract, remained in effect until the rescission issue was resolved and that the insurers could not refuse payment of defense costs pending that adjudication.
The Court then examined the language of the D&O policies to determine whether the insurers were required to advance defense costs under the terms and conditions contained in those policies. The Court considered policy provisions relating to Indemnity, Ultimate Net Loss, Condition (T) Allocation and the Prior Knowledge and Fraud exclusions.
When the allocation provision applies, defense costs, settlements and judgments can be allocated by the insurer, which has discretion whether to advance defense costs. The insurers and insureds both made arguments supporting a reasonable interpretation of the allocation provisions. The Court found the provision ambiguous, that it must be construed in favor of the insureds and did not apply.
The insurers did not dispute that the Fraud exclusion requires a final adjudication in order to apply. The parties agreed that, pursuant to Little v. MGIC Indemnity Corp., 836 F. 2d. 789 (3d Cir. 1987), until such a determination, the insurers were obligated to advance defense costs.
The Prior Knowledge exclusion did not require a final adjudication in order to apply. Nor did it contain any language giving the insurer discretion to determine when the exclusion is applicable. Basically, the policy did not provide language defining when or how the exclusion applied. As such, it could be interpreted to require a judicial determination, or to allow the insurer to determine whether the exclusion applied. Further, the exclusion did not address whether the payment of defense costs would be required pending such a determination. The Court held that the Prior Knowledge exclusion was subject to two reasonable interpretations and was therefore ambiguous and must be construed in favor of the insureds.
In drafting D&O exclusions, insurers must make it clear whether or not a judicial determination is required. Alternatively, the language of the policy must be clear as to how the determination is made, by whom and whether the insurer is required to advance defense costs pending determination. The Court explained that an insurer issuing a D&O policy could expressly reserve “unfettered discretion” whether to advance defense costs but that a policy containing such a “draconian” power might be difficult to sell in the marketplace.
The Court then referred to the indemnity provision, which provided that the insurer shall pay all sums which the directors and officers shall become “legally obligated” to pay. Relying on Little, the court found that “legally obligated” meant that an insurer’s duty to pay defense costs arises when the insured is obligated to pay those costs.
Adelphia and Little both hold that if an exclusion is ultimately found to be applicable, any defense costs advanced are subject to reimbursement. However, this right to reimbursement does not impact the insurer’s obligation to advance defense costs, even in instances where the ability of the director or officer to repay the insurer is dubious.
When a D&O policy includes coverage for a debtor corporation, a bankruptcy court may find that the proceeds of the policy are property of the estate. Even if the automatic stay does not apply, a bankruptcy court may extend the stay to apply to those proceeds. A director or officer must then seek approval of the bankruptcy court for the payment of defense costs.
The bankruptcy court may impose certain limitations. For example, in Adelphia the court allowed adjudication of the insurers’ obligation to advance defense costs up to $300,000 for each insured. Similarly, in Executive Risk Indemnity, Inc. v. Boston Regional Med. Ctr., Inc., 285 B.R. 87 (Bankr. D. Mass. 2002), the court granted relief from the automatic stay for the purpose of making payments of expert costs not to exceed $600,000. These limitations allow the directors and officers to assert their right to payment under the policy while preventing the depletion of proceeds potentially available for the benefit of the estate.
Conclusion
An insurer may find that litigation related to its claims or defenses cannot be adjudicated because of the automatic stay. Regardless of any coverage defenses, an insurer may be required to advance defense costs. Accordingly, it would be prudent for an insurer to seek approval of the bankruptcy court or a modification of the stay, if any, prior to the payment of defense costs or proceeds. An insurer has the right to require approval of the bankruptcy court prior to any payments under the D&O policy. Because of the various issues and appropriate strategies that may required, an insurer facing such questions should consult counsel knowledgeable about the interplay of bankruptcy and insurance law. Should you have such inquiries, please contact Susan N.K. Gummow at sgummow@clausen.com.
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