How to Defend Officers and Directors in a Management-Hostile Environment

Recently, in the Kmart bankruptcy cases, the debtors did request court authority to use estate funds to retain and pay separate counsel to represent their independent directors, which Kmart contended was necessary to preserve the estate and reorganize. Initially, Kmart sought such retention under Section 327(e) of the Bankruptcy Code. This request was objected to by several parties-in-interest for various reasons, and rejected by the Court, primarily because Section 327(e) only authorizes the retention of special counsel for the debtor. Subsequently, however, the debtors moved for similar relief under Section 363 of the Bankruptcy Code (although the debtors did not concede that the proposed use of its funds to retain counsel for the independent directors was outside the ordinary course of its business). This time, with the agreement of the cases' several official committees, Kmart's request was granted, subject to certain restrictions, including, among other things, a $750,000 monetary cap (which could be increased by agreement or court order), and the inability to use the funds to represent the independent directors in matters brought by the committees or debtor or in matters adverse to the debtor.

In the Kmart cases, the use of estate funds to retain counsel for the independent directors was blessed by the bankruptcy court. In Adelphia, when certain former D&Os moved to modify the automatic stay to seek access to the applicable D&O policies' proceeds, the court modified the automatic stay to allow each of the moving D&Os to utilize up to $300,000 in insurance proceeds for their defense (although, not surprisingly, the insurers are contesting their obligations under the policies and at least initially, the court refused to modify the automatic stay to allow lawsuits over coverage obligations to continue and be resolved, in large part due to pending criminal investigations). In each of those instances, the existence of a court order should protect the payments from later attack However, in instances where payments on account of D&O defense and indemnification were made either made pre-petition or post-petition without court approval, the protection provided by a court order does not exist. Therefore, in light of the current hostile environment, it is likely that such payments can, and will increasingly be subject to attack.

The two most obvious methods of attacks under the Bankruptcy Code in response to pre-petitions transfers on account of D&O defense and indemnification are those for the avoidance of preferential or fraudulent transfers. As to the former, brought under Section 547 of the Bankruptcy Code, as noted earlier, some courts have expressed the view that indemnification obligations to D&Os arise at the time of employment or when the applicable corporate by-law or charter is enacted. Therefore, at least one court has held that a pre-petition retainer paid to counsel for D&Os on the eve of bankruptcy is an avoidable preferential transfer because it was paid on account of an antecedent debt owed to the D&O, even though the retainer itself was a prepayment for legal services paid in anticipation of future claims. (See O'Neil v. Shipman (In re Pratt and Whitney Company, Inc.), 143 B.R. 19 (Bankr. D. Conn. 1992).

The same pre-petition obligation view has also been used to oppose D&Os' assertions that their indemnification claims are entitled to administrative priority because the costs for which they seek indemnification were incurred post-petition. This issue is significant with regards to a preference attack because if a claim that was paid by the alleged preference would ultimately be paid in full as an administrative claim, the pre-petition payment of it should not be considered a preference. It should also be noted, however, that despite the antecedent indemnification argument, and undoubtedly in response to the need for Chapter 11 debtors to retain top-level management, courts and parties-in-interest are often sympathetic to D&Os that continue to serve a debtor post-petition and assert such claims are entitled to administrative priority, and utilize such facts as their continued post-petition employment as a basis to grant the claim administrative priority.

At the opposite end of the priority spectrum, however, is the fact that many D&O indemnification claims arise out of security fraud claims ' and courts have held that such claims are subordinated under Section 510(b) of the Bankruptcy Code ' thus almost insuring that the pre-petition payment in full of such a claim would satisfy the 'more than would receive in Chapter 7 liquidation prong' of Section 547's preference analysis because it is unlikely subordinated claims would ever be paid in full under the Bankruptcy Code's priority scheme.

If a court accepts the argument that a debtor's indemnification obligation to a D&O arises upon employment or the creation of the applicable by-law or charter, than it is also possible that the same is true with regard to the payment of D&O insurance premiums. As is the case with a retainer to counsel, premiums are almost always paid in advance. However, again, the antecedent debt at issue is that debt owed to the D&O, rather than the insurer. Thus payments in the 90 days (or 1-year Insider period) preceding the bankruptcy filing could be susceptible to attack as preferential. On the other hand, such payments, which are usually regular in nature, often paid through financing facilities and usually paid on account of debt incurred in the ordinary course of the debtor's business, should be less susceptible to attack. In addition, in a Chapter 11 reorganization case, most creditors and debtors should be uncomfortable taking any action that would cause their existing D&O's insurer to attempt to cancel the policy.

Finally, one interesting aspect of the preference analysis is the question of from whom the preference can be recovered. The payments discussed above would have been made on account D&Os, who, under Section 101(31) of the Bankruptcy Code are Insiders ' thus invoking the extended, 1-year preference reach-back period. However, under the DePrizio amendment, a preferential payment can only be recovered from a non-Insider (such as the insurers or law firm in the examples, above) if the payment was received in the shorter, 90-day period regardless of whether the payment was made for the benefit of an Insider. On the other hand, such a transfer (or the value thereof) made during the entire 1-year reach-back period would be recoverable from the D&O for whose benefit the transfer was made.

A less obvious attack on account of D&O defense or indemnification obligations that a preference attack is a fraudulent conveyance attack under state law (through application of Section 544 of the Bankruptcy Code) or Section 548 of the Bankruptcy Code. Admittedly, this is because on its face, the supporting arguments for such an attach are more far reaching. However, with the increased disgust over the behavior of, and compensation being paid to D&Os, it may only be a matter of time before such an attack is both made and succeeds. There are two types that may be subject to avoidance under the bankruptcy code ' transfers that are constructively fraudulent and/or actually fraudulent. The former type focuses on the economic circumstances of the transfer rather than intent with which it was made, ie, was the debtor insolvent at the time of, or rendered insolvent because of the transfer and did the debtor receive reasonably equivalent value for the transfer. With the recent developments and animosity towards D&Os, it is conceivable that allegations will arise in light of the mismanagement provided by a debtor's D&Os and/or the massive compensation packages that D&Os for failing companies receive, that reasonably equivalent value was not given by a D&O for a debtor's payment of D&O insurance or D&O indemnification claims.

In contrast to constructive fraud, actual fraud focuses on the intent surrounding the transfer, and requires actual intent to defraud creditors by transferring the debtor's assets out of the creditors' reach. While it may be harder to fathom this scenario in the context of attacking transfers made on account of D&O defense and indemnification, an actual fraud claim could be viable if D&O premiums, especially excessive D&O premiums, were being paid to an insurer with a relationship to the debtor or one of the debtors' insiders. And again, in the current environment, with the level of scrutiny being applied to corporate management's behavior ' one never knows what will happen.

What is set forth above just touches on the issues that are becoming increasingly commonplace in this environment of hostility toward corporate management and economic distress. As a result of the reprehensible acts of a few high profile corporate officers and directors, corporate management now finds itself subject to a higher lever of scrutiny and accountability. Nowhere is this fact more evident that in the bankruptcy forum, where creditors, equity holders and the judiciary all have a very public forum with which to conduct their inquiries and some very unique laws with which to attempt to rectify perceived wrongs. And at the same time that all of this is occurring, standing in the face of this onslaught is the long standing, and much needed, corporate policy of protecting and indemnifying corporate management in order to induce the best possible officers and directors to manage.

While this author is certain that the current management-hostile environment will ultimately subside, it may not do so for some time. In the meanwhile, more and more litigation and case law will further develop the issues discussed above, as well as other, related ones. And during that time period, the most interesting aspect may be the manner in which debtors, attorneys, and quite possibly the courts, acknowledge the need to, and balance, the legitimate rights of creditors and equity holders with the very important economic need to continue to allow corporations to protect their management.

Brian L. Shaw is with Chicago's Shaw Gussis Fishman Glantz & Wolfson, LLC.

As noted last month in part one of this article, it is less common, but not unheard of, for the debtor itself to directly provide funds to defend and indemnify its D&Os, in addition to, or in lieu of, maintaining D&O insurance or to address a situation where the D&O has refused coverage (which is not that uncommon of an development).

In light of the current atmosphere, it is understandable that any such payment would be subjected to serious scrutiny. However, it is the same hostile atmosphere that threatens D&Os which explains why companies find it necessary to make such payments itself in order maintain necessary, competent management. In fact, one would be naive to believe that as part of pre-bankruptcy preparation, companies never discuss whether prior to the bankruptcy filing, they should tender a retainer to independent counsel who will independently represent the D&Os during the pendency of that company's bankruptcy case. The need to have this discussion pre-petition is that because a company's bankruptcy petition is filed, creditor scrutiny is magnified, and creditors, as well the bankruptcy court and the United States' Trustee may raise questions about the proposed transfer and/or oppose it.

Moreover, while such a payment is generally approved by corporate by-laws and charters and state law (ignoring, for the moment when D&Os authorize such payment in anticipation for the inevitable lawsuits that will arise as a result of their willful wrongdoing, there may be a self dealing question), most bankruptcy practitioners will advise their clients to seek court approval of any payment proposed to be made post-petition.

Recently, in the Kmart bankruptcy cases, the debtors did request court authority to use estate funds to retain and pay separate counsel to represent their independent directors, which Kmart contended was necessary to preserve the estate and reorganize. Initially, Kmart sought such retention under Section 327(e) of the Bankruptcy Code. This request was objected to by several parties-in-interest for various reasons, and rejected by the Court, primarily because Section 327(e) only authorizes the retention of special counsel for the debtor. Subsequently, however, the debtors moved for similar relief under Section 363 of the Bankruptcy Code (although the debtors did not concede that the proposed use of its funds to retain counsel for the independent directors was outside the ordinary course of its business). This time, with the agreement of the cases' several official committees, Kmart's request was granted, subject to certain restrictions, including, among other things, a $750,000 monetary cap (which could be increased by agreement or court order), and the inability to use the funds to represent the independent directors in matters brought by the committees or debtor or in matters adverse to the debtor.

In the Kmart cases, the use of estate funds to retain counsel for the independent directors was blessed by the bankruptcy court. In Adelphia, when certain former D&Os moved to modify the automatic stay to seek access to the applicable D&O policies' proceeds, the court modified the automatic stay to allow each of the moving D&Os to utilize up to $300,000 in insurance proceeds for their defense (although, not surprisingly, the insurers are contesting their obligations under the policies and at least initially, the court refused to modify the automatic stay to allow lawsuits over coverage obligations to continue and be resolved, in large part due to pending criminal investigations). In each of those instances, the existence of a court order should protect the payments from later attack However, in instances where payments on account of D&O defense and indemnification were made either made pre-petition or post-petition without court approval, the protection provided by a court order does not exist. Therefore, in light of the current hostile environment, it is likely that such payments can, and will increasingly be subject to attack.

The two most obvious methods of attacks under the Bankruptcy Code in response to pre-petitions transfers on account of D&O defense and indemnification are those for the avoidance of preferential or fraudulent transfers. As to the former, brought under Section 547 of the Bankruptcy Code, as noted earlier, some courts have expressed the view that indemnification obligations to D&Os arise at the time of employment or when the applicable corporate by-law or charter is enacted. Therefore, at least one court has held that a pre-petition retainer paid to counsel for D&Os on the eve of bankruptcy is an avoidable preferential transfer because it was paid on account of an antecedent debt owed to the D&O, even though the retainer itself was a prepayment for legal services paid in anticipation of future claims. (See O'Neil v. Shipman (In re Pratt and Whitney Company, Inc.), 143 B.R. 19 (Bankr. D. Conn. 1992).

The same pre-petition obligation view has also been used to oppose D&Os' assertions that their indemnification claims are entitled to administrative priority because the costs for which they seek indemnification were incurred post-petition. This issue is significant with regards to a preference attack because if a claim that was paid by the alleged preference would ultimately be paid in full as an administrative claim, the pre-petition payment of it should not be considered a preference. It should also be noted, however, that despite the antecedent indemnification argument, and undoubtedly in response to the need for Chapter 11 debtors to retain top-level management, courts and parties-in-interest are often sympathetic to D&Os that continue to serve a debtor post-petition and assert such claims are entitled to administrative priority, and utilize such facts as their continued post-petition employment as a basis to grant the claim administrative priority.

At the opposite end of the priority spectrum, however, is the fact that many D&O indemnification claims arise out of security fraud claims ' and courts have held that such claims are subordinated under Section 510(b) of the Bankruptcy Code ' thus almost insuring that the pre-petition payment in full of such a claim would satisfy the 'more than would receive in Chapter 7 liquidation prong' of Section 547's preference analysis because it is unlikely subordinated claims would ever be paid in full under the Bankruptcy Code's priority scheme.

If a court accepts the argument that a debtor's indemnification obligation to a D&O arises upon employment or the creation of the applicable by-law or charter, than it is also possible that the same is true with regard to the payment of D&O insurance premiums. As is the case with a retainer to counsel, premiums are almost always paid in advance. However, again, the antecedent debt at issue is that debt owed to the D&O, rather than the insurer. Thus payments in the 90 days (or 1-year Insider period) preceding the bankruptcy filing could be susceptible to attack as preferential. On the other hand, such payments, which are usually regular in nature, often paid through financing facilities and usually paid on account of debt incurred in the ordinary course of the debtor's business, should be less susceptible to attack. In addition, in a Chapter 11 reorganization case, most creditors and debtors should be uncomfortable taking any action that would cause their existing D&O's insurer to attempt to cancel the policy.

Finally, one interesting aspect of the preference analysis is the question of from whom the preference can be recovered. The payments discussed above would have been made on account D&Os, who, under Section 101(31) of the Bankruptcy Code are Insiders ' thus invoking the extended, 1-year preference reach-back period. However, under the DePrizio amendment, a preferential payment can only be recovered from a non-Insider (such as the insurers or law firm in the examples, above) if the payment was received in the shorter, 90-day period regardless of whether the payment was made for the benefit of an Insider. On the other hand, such a transfer (or the value thereof) made during the entire 1-year reach-back period would be recoverable from the D&O for whose benefit the transfer was made.

A less obvious attack on account of D&O defense or indemnification obligations that a preference attack is a fraudulent conveyance attack under state law (through application of Section 544 of the Bankruptcy Code) or Section 548 of the Bankruptcy Code. Admittedly, this is because on its face, the supporting arguments for such an attach are more far reaching. However, with the increased disgust over the behavior of, and compensation being paid to D&Os, it may only be a matter of time before such an attack is both made and succeeds. There are two types that may be subject to avoidance under the bankruptcy code ' transfers that are constructively fraudulent and/or actually fraudulent. The former type focuses on the economic circumstances of the transfer rather than intent with which it was made, ie, was the debtor insolvent at the time of, or rendered insolvent because of the transfer and did the debtor receive reasonably equivalent value for the transfer. With the recent developments and animosity towards D&Os, it is conceivable that allegations will arise in light of the mismanagement provided by a debtor's D&Os and/or the massive compensation packages that D&Os for failing companies receive, that reasonably equivalent value was not given by a D&O for a debtor's payment of D&O insurance or D&O indemnification claims.

In contrast to constructive fraud, actual fraud focuses on the intent surrounding the transfer, and requires actual intent to defraud creditors by transferring the debtor's assets out of the creditors' reach. While it may be harder to fathom this scenario in the context of attacking transfers made on account of D&O defense and indemnification, an actual fraud claim could be viable if D&O premiums, especially excessive D&O premiums, were being paid to an insurer with a relationship to the debtor or one of the debtors' insiders. And again, in the current environment, with the level of scrutiny being applied to corporate management's behavior ' one never knows what will happen.

What is set forth above just touches on the issues that are becoming increasingly commonplace in this environment of hostility toward corporate management and economic distress. As a result of the reprehensible acts of a few high profile corporate officers and directors, corporate management now finds itself subject to a higher lever of scrutiny and accountability. Nowhere is this fact more evident that in the bankruptcy forum, where creditors, equity holders and the judiciary all have a very public forum with which to conduct their inquiries and some very unique laws with which to attempt to rectify perceived wrongs. And at the same time that all of this is occurring, standing in the face of this onslaught is the long standing, and much needed, corporate policy of protecting and indemnifying corporate management in order to induce the best possible officers and directors to manage.

While this author is certain that the current management-hostile environment will ultimately subside, it may not do so for some time. In the meanwhile, more and more litigation and case law will further develop the issues discussed above, as well as other, related ones. And during that time period, the most interesting aspect may be the manner in which debtors, attorneys, and quite possibly the courts, acknowledge the need to, and balance, the legitimate rights of creditors and equity holders with the very important economic need to continue to allow corporations to protect their management.

Brian L. Shaw is with Chicago's Shaw Gussis Fishman Glantz & Wolfson, LLC.