It is now well-settled that a trustee of a corporation in bankruptcy may assert claims against the corporation's former officers and directors for gross mismanagement and corporate waste. These claims arise from the principle that a trustee stands in the shoes of the corporation and may assert any claims that the corporation had prior to the bankruptcy.¹ The trustee is also empowered to assert breach-of-fiduciary-duty claims by creditors against officers and directors that arise after the corporation has entered what is referred to as the "zone of insolvency."²

This case law invests the trustee with the power and the responsibility to decide whether claims against the fiduciaries are warranted. In addition to an investigation of the facts, the trustee will want to determine whether there is insurance coverage available for claims against officers and directors and take careful note of the requirements of the policy for notice to the insurance carrier and restrictions on coverage.

D&O Liability under State Law

The fiduciary duties owed by officers and directors (and the limitations on their liabilities) are defined by state law, usually the law of the state where the corporation is incorporated. As the great majority of public companies are incorporated in Delaware and that state is considered the leader in jurisprudence in this area, we will focus on Delaware law for this discussion.

Frequently, when a corporation has entered the bankruptcy arena, there are grounds for alleging negligence by the company's former officers or directors. Generally speaking, in Delaware, directors and officers are protected from claims of negligence by the business judgment rule as well as §102(b)(7) of the General Corporation Law, which permits Delaware corporations to enact provisions in their certificates of incorporation exculpating officers and directors from breach-of-fiduciary-duty claims.

The business-judgment rule and the exculpation provisions serve as a gatekeeper to bar ordinary negligence claims against fiduciaries, whether brought by the corporation, a shareholder suing derivatively or the trustee of a bankrupt. However, it is important to note that the business-judgment rule and exculpation provisions of the certificate of incorporation bar only claims of breach of the duty of care—i.e., ordinary negligence committed by fiduciaries who are fully informed and performing their jobs. These provisions do not protect the directors and officers who breach the duty of loyalty, either by dishonesty or an abdication of their responsibilities to be fully informed. Two recent decisions make the point clearly.

In In re The Walt Disney Co. Derivative Litigation, 2005 WL 2056651 (Del. Ch. 2005), the Delaware Chancery Court issued a ruling in which the court, after a lengthy trial, absolved the directors of liability in a nonbankruptcy situation. In that decision, the court explained the interplay of the business-judgment rule and the violation of the duty of loyalty as it applies in the context of a director's abdication of responsibility:

The business-judgment rule is not actually a substantive rule of law, but instead it is a presumption that "in making a business decision the directors of a corporation acted on an informed basis...and in the honest belief that the action taken was in the best interests of the company [and its shareholders]." This presumption applies when there is no evidence of "fraud, bad faith or self-dealing in the usual sense of personal profit or betterment" on the part of the directors. In the absence of this evidence, the board's decision will be upheld unless it cannot be "attributed to any rational business purpose." When a plaintiff fails to rebut the presumption of the business-judgment rule, she is not entitled to any remedy, be it legal or equitable, unless the transaction constitutes waste.
Even if the directors have exercised their business judgment, the protections of the business judgment rule will not apply if the directors have made an "unintelligent or unadvised judgment." Furthermore, in instances where directors have not exercised business judgment, that is, in the event of director inaction, the protections of the business-judgment rule do not apply. Under those circumstances, the appropriate standard for determining liability is widely believed to be gross negligence, but a single Delaware case has held that ordinary negligence would be the appropriate standard.

In re Walt Disney Co. Derivative Litigation, 2005 WL 2056651, *31-32 (Del. Ch. 2005).

Shrouded in the fog of this hazy jurisprudence, the defendants' motion to dismiss this action was denied because I concluded that the complaint, together with all reasonable inferences drawn from the well-plead allegations contained therein, could be held to state a nonexculpated breach of fiduciary duty claim, insofar as it alleged that Disney's directors "consciously and intentionally disregarded their responsibilities, adopting a 'we don't care about the risks' attitude concerning a material corporate decision." Disney II, 825 A.2d at 289 (emphasis in original); see Gagliardi, 683 A.2d at 1051 ("[I]n the absence of facts showing self-dealing or improper motive, a corporate officer or director is not legally responsible to the corporation for losses that may be suffered as a result of a decision that an officer made or that directors authorized in good faith").

Id. at *35-36.

This conclusion is reiterated by the Third Circuit's decision in In re Tower Air Inc. (Stranziale v. Nachtomi, et al.), 416 F.3d 229 (3d Cir. 2005), a case brought by the trustee in bankruptcy of Tower Air against the corporation's officers and directors for breach of fiduciary duty. The court denied a motion to dismiss the complaint, finding that the business-judgment rule would not protect the directors against allegations of indifference to their fiduciary responsibilities. Id. at 240. As the appeals court stated:

Stanziale argues on appeal that the directors' alleged rubber-stamping of major capital expenditures is consistent with bad faith. We agree. In re Caremark instructs that a "good-faith effort to be informed and exercise judgment" is the core duty of care inquiry. 698 A.2d at 967. Applying this standard, the Court of Chancery recently held that a plaintiff stated a claim by pleading that directors "consciously and intentionally" disregarded their responsibilities and adopted a "we don't care about the risks" attitude regarding a material corporate decision—hiring a new president. In re The Walt Disney Co., 825 A.2d at 289. Stanziale alleges that the directors' inattention when writing multi-million dollar checks was "intentional, willful...and malicious." The grounds of his claim are that board minutes reflect that the aircraft engine outlays were made with no discussion. That is enough to survive a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6).

In re Tower Air Inc., supra, 416 F.3d at 240.

The lesson to be drawn from the cases is that after appointment, the trustee should make a careful search of the corporation's files to determine whether the directors and officers have given full attention to their duties. Their failure to do so can give rise to a claim for damages to the estate, which will not be dismissible on business judgment or certificate of incorporation grounds.

The Insurance Contract

If the trustee's investigation reveals that such claims do exist, it is important to determine whether there is any insurance available for the officers and directors. Obviously, the company's interest in invoking the benefits of the policy is at least as great as that of the insureds. To that end, the trustee and/or its counsel should promptly review the policy and do so thoroughly. Many insurance policies have rigid time limits for notice, and it is incumbent upon the trustee to take quick action to notify the insureds and/or the carrier of a claim, even if all of the facts have not yet been determined. Failure to meet those deadlines can result in a waiver of coverage. In some jurisdictions, this defense is absolute, even if the insurance carrier cannot prove prejudice resulting from the delay in notice.³

In dealing with the directors and officers and the carrier, there are a number of defenses to coverage that the trustee should keep in mind. First, directors' and officers' insurance is traditionally geared to protect the fiduciaries against claims of negligence, not fraud. Such policies typically exclude fraud claims, and thus the notice of the claim and any subsequent litigation must be sensitive to such limitations on coverage. Second, it has become increasingly common for insurance carriers who have issued director and officer policies to seek recision of the policy on the ground of fraud. The argument that the carriers often make is that the misconduct complained of extends back to a period of time before the policy was issued, but was not revealed in the insurance application. Accordingly, argue the carriers, the policy was procured by fraud and thus there is no coverage. This argument was successful in Cutter & Buck v. Genesis Ins. Co., 306 F.Supp.2d 988 (W.D. Wash. 2004), aff'd., 2005 WL 1799397 (9th Cir. 2005). In that case, the court enforced a provision in a directors and officers (D&O) policy to the effect that an innocent misrepresentation in the insurance application will be not be imputed to the insureds who were unaware of the misstatement, but a misrepresentation made with the intent to deceive will destroy coverage for all of the insureds, innocent or not. In other cases, depending on the language of the policy and the state law applied, directors who are unaware of the fraud will not lose their coverage. See In re Healthsouth Corp. Insurance Litigation, 308 F. Supp. 1253 (N.D. Ala. 2004).

Third, there is the so-called "insured vs. insured" defense. D&O policies often exclude claims by which one of the policy's insureds sues another insured. In many policies, the term "insured" includes the corporation itself and, arguably, the trustee who stands in the corporation's shoes. Thus, carriers will argue that a trustee's suit against the directors and officers for breaches of fiduciary duty are not covered by the policy. This issue arose in an unreported decision in an adversary proceeding brought by the Genesis Insurance Co. seeking to avoid coverage. In re Telegroup Inc., 99-31527 (DHS) (Bankr. D. N.J.), Genesis Insurance Co. v. Bond, Adv. Proceeding No. 03-01534 (May 4, 2005).

In Telegroup, Bankruptcy Judge Donald H. Steckroth held that the insured vs. insured exception did not apply to suits brought by the bankruptcy estate or the assignee under a chapter 11 reorganization plan. The court first noted that the issue was controversial:

It is recognized that a split of authority exists among the federal circuits on the issue of whether a lawsuit against a company's former directors and officers brought by a trustee, creditors' committee or post-confirmation liquidating trustee triggers the "insured vs. insured" exclusion under a directors and officers' liability insurance policy. For example, the Eighth and Eleventh Circuit Courts of Appeals have concluded that the "insured vs. insured" exclusion bars coverage for lawsuits against a company's former directors and officers brought by a plan committee or a trustee. See, e.g., Reliance Ins. Co. of Ill. v. Weis, 148 B.R. 575, 581-82 (E.D. Mo. 1992), aff'd., 5 F.3d 532 (8th Cir. 1993), cert. denied sub nom., Plan Comm. of Bank Bldg. & Equip. Corp. of Am. v. Reliance Ins. Co. of Ill., 510 U.S. 1117, 114 S.Ct. 1066, 127 L.Ed.2d 385 (1994); Nat'l. Union Fire Ins. Co. v. Olympia Holding Corp., No. 1:04-CV-2081, 1996 WL 33415761 (N.D. Ga. June 4, 1996). To the contrary, courts in the Second, Third, Sixth and Ninth Circuits have held that the "insured vs. insured" exclusion was not triggered in suits by a trustee or other entity against the former directors and officers for breach of fiduciary duty. See, e.g., Cohen v. Nat'l. Union Fire Ins. Co. (In re County Seat Stores Inc.), 280 B.R. 319 (Bankr. S.D.N.Y. 2002); Alstrin v. St. Paul Mercury Ins. Co., 179 F.Supp.2d 376 (D. Del. 2002); Reiser v. Baudendistel (In re Buckeye Countrymark Inc.), 251 B.R. 835 (Bankr. S.D. Ohio 2000); Pintlar Corp. v. Fid. & Cas. Co. of N.Y. (In re Pintlar Corp.), 205 B.R. 945 (Bankr. D. Idaho 1997).

The Telegroup court went on to hold that, because the purpose of the contract provision was to prevent collusive suits, which was plainly not an issue in claims by bankruptcy estates, the provision was not applicable. (Op. at 23, citing Township of Center v. First Mercury Syndicate Inc., 117 F.3d 115, 119 (3d Cir. 1997).

The sum and substance of these cases is that claims against directors and officers that invoke insurance coverage can be very tricky. They require careful attention to the manner in which the claims are asserted as well as to the strength of the claims themselves.

Conclusion

In fulfilling his or her responsibility to obtain the assets of the estate, the trustee must be sensitive to claims against directors and officers that may not be readily apparent. He or she should also be aware of the pitfalls that are found along the path to recovery from the directors and officers and the insurance carriers.

This article is merely an overview of this area of law, which can be quite complex. A trustee would be well advised to hire experienced counsel in navigating these tricky currents.

---

Footnotes

¹ See Pereira v. Farace, 413 F.3d 330 (2d Cir. 2005) (affirming district court's decision recognizing trustee's standing to vindicate general claims by creditors for breach of fiduciary duty); Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 429 (1972); Shearson Lehman Hutton Inc. v. Wagoner, 944 F. 2d 114, 117 (2d Cir. 1991). Return to article

² In re Fleming Packaging Corp., 2005 WL 2205703 (Bankr. C.D. Ill. Aug. 26, 2005) (trustee has standing to assert claims on behalf of creditors generally); Production Resources Group L.L.C. v. NCT Group Inc., 863 A.2d 772 (Del. Ch. 2004) ("When a firm has reached a point of insolvency, it is settled that under Delaware law, the firm's directors are said to owe fiduciary duties to the company's creditors"). See, also, Smith v. Arthur Andersen LLP, 2005 WL 2077679 (9th Cir. Aug. 31, 2005). Return to article

³ See Federal Insurance Co. v. COMPUSA Inc., 239 F. Supp. 612 (N.D. Tex. 2002) (insurance company may deny coverage under a claims-made policy for late notice even in the absence of demonstrated prejudice, applying Texas law). But, see Guardian Trust Co. v. American States Ins. Co., 1996 WL 509638 (D. Kan. July 30, 1996) (under Kansas law, late notice to carrier will bar coverage only where insurer can show prejudice). Return to article