Since the passage of Sarbanes Oxley (SOX),[1] legislation written for publicly traded for profit entities in the aftermath of Enron and WorldCom, and the passage of BAPCPA, more emphasis has been placed on looking to Directors and Officers insurance policies to replace losses that occur while Corporate Boards are seated or to reimburse bankruptcy courts (which are fee generating entities) for their costs. The hallmark of this legislative reform is the automatic presumption of ‘fraudulent bankruptcy filings,’ wherein business debtors run up large debts and leave creditors and employees ‘holding the bag’ for losses only to reappear at a later date operating as another business. The reform characteristics of the Act now hold management and Boards personally financially responsible for pre-petition debts incurred prior to filings, whether or not there is actual and intended mismanagement at the expense of the creditors.
The passage of this act has made bankruptcy a very lucrative fee-generating business within the Department of Justice’s Trustee program, which operates with little independent oversight or supervision except that which is provided through the U.S. Attorney General’s Office. While federally appointed Bankruptcy Judges manage proceedings, Trustees are charged to manage cases on behalf of the unsecured creditors, and derive their financial support through priority fees charged against collections. There is no timeframe for discharging a case or converting it to another proceeding.
Whether the organization is for profit or not for profit, if the business structure of the bankrupt entity is that of a ‘corporation,’ the D&O policy is fair game for litigation no matter what the cause of the bankruptcy, unless as some courts have ruled, the agency's charter includes references to the "Prudent Man Rule," wherein some courts have found that the right to sue for breach of fiduciary responsibility is a right reserved for creditors, not the debtor in possession (DIP) or the Trustee who serves as the DIP. The only way to reach into or litigate against a D&O policy is through the failed corporation’s Board of Directors, volunteer or compensated, who are now under the Act, personally liable for the financial conditions of the corporation in the same manner as "owners," and who, where the 'prudent man rule' has been incorporated, are shielded from frivolous lawsuits filed during times of financial crisis out of their control.
Frequently, Trustees extract pre-negotiated ‘tolling agreements’ designed to limit the payout liability of claims made against the carrier. This tactic has been rarely used to address losses imposed by bankruptcy imposed by a secured lender upon a not for profit organization or church. However, it is expected that even these organizations will be fair game in the current economic climate, a fact which has very serious implications for the volunteer boards of not for profit corporations typically operated on very small margins, have little or no ability to absorb significant losses, and are subject to significant negative economic impact during times of economic downturns or natural disasters.
In this case, in order to pull cash into the financially strapped debtor reorganization, the Trustee elected to ignore the impact of the "Prudent Man Rule" and pursue a suit against the Philadelphia Life Insurance Company, issuers of the agency’s Directors & Officers policy,[2] negotiating a ‘tolling agreement’ [3] for a payout of $3,000,000 on the last day the policy was in force. He deftly minimized payout risk to the D&O carrier for “errors and omissions” by separating out the ‘inside directors’ or staff from the ‘outside directors’ or volunteers and delimiting his right to make claims against the policy as the debtor in possession.
By creating a community climate of perceived mismanagement through the development of salacious charges[4] (using the estimated $8 million in multi-year dollars transacted between ARC and the afore-mentioned companies as a basis) he knew the D&O carrier, having a ‘duty to defend’ directors under Tennessee law, would not, primarily because the claims made fell outside the scope of their D&O policy coverage. As expected, this resulted in the D&O carrier denying the “inside officers” a defense beyond that limited defense they could pay for thru a sole practitioner. Dispute of the claims made would have required contracting with an independent forensic auditing firm, and paying significant costs for depositions and court reporters, all of which were costs beyond the personal financial capability of the inside officers. When the D&O carrier, again as expected, ignored pleas to mount a defense in accordance with the terms of the Directors and Officers Policy, the Trustee filed a motion for “summary judgment” [5] to speed the route to collection on the tolling agreement.
The summary judgment was denied by the bankruptcy court Judge, Keith Lundin, and at that point, the Trustee and his legal representatives brought the litigants to the table to propose a “settlement” offer to close down the pending suit against the inside directors. During the course of the closed door discussion, they admitted that they ‘knew we were nice people, “hadn’t done anything wrong,” but they could not appear to “collude” with the inside officers to mount a suit against the D&O carrier to collect the pre-negotiated fees against the tolling agreement. By their own statement, they just needed $3 million to reimburse the court for their fees, and ‘we didn’t even need to cooperate,’ but if we interfered we would be held liable for $3 million in repayment of these fees in accordance with the allowability under the Act to hold members of corporate boards responsible for any types of losses that lead to bankruptcy filing[6] (Bankruptcy Reform Act, 2005), even those that occur in cases where the debtor organization is placed into what functionally amounts to an ‘involuntary bankruptcy’ by the secured creditor (Amsouth) and even though we were not in control of the debt incurred during the ninety day pre-petition period.
So, while we weren’t ‘technically responsible’ for the losses, which derived from a contractual dispute with the government, incomplete federal litigation and the spending of the workout group, and were no longer employed at the time of the bankruptcy filing, the 2005 revisions to the Act extended the allowability period to two years prior to the bankruptcy filing, thereby picking up the inside directors as responsible parties to the D&O litigation process. Because losses occurred during the period of allowability, one can make the claim that the Directors and Officers breached their fiduciary responsibilities, again despite the incorporation of the "Prudent Man Rule" into the agency's charter and by-laws. They proposed utilizing the $4.2 million dollar adjusting entry error in the soc account as the basis for establishing “errors and omissions and breaches of officer and management responsibility” even knowing that this error, which required a material restatement of the net inventory assets, made no impact on the financial position of the agency, and fell within the five percent (5%) statistical error of confidence protocol under which GAAP operates.
[1] Cite
[2] Philadelphia Life D&O Policy
[3] Tolling Agreement
[4] Lawsuit
[5] Summary Judgement Petition
[6] D&O Article
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