In In re Palmaz Scientific Inc., the bankruptcy court for the Western District of Texas determined that a confirmed plan of reorganization would not stop a group of investors from pursuing direct (non-derivative) claims against directors and officers of the debtor companies because plan injunction language only covered claims against the debtors.  2018 WL 1036780, at *5 (Bankr. W.D. Tex. Feb. 21, 2018) (slip op. at 11).  Unfortunately for the investor plaintiffs, this proved to be a success without victory because the court went on to hold that the plan precluded the investors from using the D&O insurance proceeds to satisfy their claims.  Id. at *7 (slip op. at 14).  This case is both a cautionary tale for claimants and a potential boon for post-confirmation trustees.

When (and why) do D&O Insurance Proceeds become the coveted prize?

When D&O claims are asserted against a distressed company and/or its directors and officers, all parties look to the D&O insurance proceeds to satisfy their claims and/or fund their defenses.  If the business seeks chapter 11 bankruptcy protection, the bankruptcy court must determine which parties are entitled to access and utilize such proceeds.  Usually, the issue is framed for the court as a question of whether the D&O insurance proceeds constitute property of the bankruptcy estate, but, ultimately, the real question is whether the proceeds are available to satisfy claims against a debtor and/or its directors and officers.  Post-confirmation (after a bankruptcy plan has been approved by the court), investors and equity holders of a failed business may find themselves fighting with a post-confirmation trustee for access to D&O insurance proceeds.  In this scenario, the post-confirmation trustee will almost always claim that the policy and its proceeds belong to the post-confirmation trust because D&O insurance policies are often wasting policies (and one of the most valuable assets available to post-confirmation trusts).  Of course, D&O claimants, as well as directors and officers, will disagree.  To them, D&O insurance policies are the very source of proceeds that was purchased in order to protect and benefit directors and officers and D&O claimants.

How do courts typically determine who the prize winner is?

To resolve the “proceeds” dispute, bankruptcy courts look to the language of the confirmed plan, the confirmation order, and any trust agreement (that transfers assets from the bankruptcy estate to the post-confirmation trust).  The analysis usually consists of determining whether the D&O claims belong to the post-confirmation trustee (as opposed to investors, equity holders or any other potential plaintiffs).  Thus, depending on the types of claims asserted (for example, direct versus derivative) and the language of the governing documents, bankruptcy courts may prevent or enjoin “would be” plaintiffs from proceeding with their claims against debtors and/or former directors and officers.  Indeed, in relatively recent years, post-confirmation trustees have been losing the battle over insurance proceeds when the claims asserted are direct rather than derivative.  See, e.g., In re SemCrude, L.P., 2011 WL 4711891 (Bankr. D. Del. Oct. 7, 2011) (“Sem Crude I”) (claims were derivative, and, thus, property of the estate that had been transferred to the post-confirmation trustee, because the plaintiffs’ alleged injury was the same as the harm the debtor suffered), and subsequently aff’d, 796 F.3d 310 (3d Cir. 2015) (“Sem Crude II”); see also In re Palmaz Scientific Inc., 562 B.R. 331, 63 Bankr. Ct. Dec. (CRR) 99 (Bankr. W.D. Tex. 2016) (direct claims were not covered by the plan injunction but other claims that were common to all investors, and therefore derivative, were subject to the injunction and could only be asserted by the trustee).

Can the prize winner be the loser?

Based on Palmaz, a claimant may be entitled to pursue D&O claims but unable to access D&O insurance proceeds.  See In re Palmaz Scientific Inc., 2018 WL 1036780, at *5-*7 (Bankr. W.D. Tex. Feb. 21, 2018) (slip op. at 11-14).  Of course, this is like saying “you can have the car, but not the keys.”  So, how can this happen?  In short, the holding in Palmaz was based on a particular plan provision that was quite possibly initially understood by all parties to mean one thing but later interpreted by the court to mean another.

Before the bankruptcies were filed, a group of investors sued the debtors and two directors and officers.  The action was stayed (temporarily put on hold) when the bankruptcy petitions were filed, but came back to life after the bankruptcy court approved the debtors’ joint plan.  As is often the case, the debtors’ confirmed plan created a litigation trust and transferred certain of the debtors’ assets, including D&O claims, to the litigation trust.  The plan defined D&O Claims to include claims against Debtors but not former directors and officers, so the investor plaintiffs amended their state court complaint to drop claims against the debtors (presumably because these claims were understood to belong to the post-confirmation trust).  With their live complaint against only the directors and officers, the investor plaintiffs made a demand on their D&O claims against the debtors’ D&O insurance policy.  The insurance company sought a declaratory judgment from the bankruptcy court to determine whether the demand violated the confirmed plan’s bankruptcy injunction, and the litigation trustee joined in the motion.  None of this is unusual; however, the litigation trustee argued that the post-confirmation trust controlled all of the D&O insurance recoveries.  This argument probably came as a surprise to the investor plaintiffs.

Specifically, the litigation trustee argued that the investors’ demand for insurance coverage (i) violated the plan’s bankruptcy injunction; and (ii) interfered with the litigation trustee’s right to control D&O insurance recoveries.  In response, the investor plaintiffs relied on a line of cases that hold “even where insurance policies themselves are property of the estate, non-debtor insureds have a right equal to the debtor to the benefits provided by such policies.”  Id. at *7 (citations omitted) (slip op. at 14).  The bankruptcy court found these cases were inapplicable because “none of those cases involve[d] plan provisions similar to those [that were] before the Court,” and ultimately, ruled in favor of the post-confirmation trustee.  Id.  Ultimately, the court rejected the post-confirmation trustee’s first argument and accepted the second because the plan gave the litigation trustee the right to control D&O claims “and all D&O Insurance Recoveries.”  Id. at *6 (slip op. at 13).  The language actually used in the plan was as follows:

“The right to control the D&O Claims and all D&O Insurance Recoveries, including negotiations relating thereto and settlements thereof, shall be vested in the Litigation Trust on and after the Effective Date.”

Id. at *7 (slip op. at 13).  Significant to the court’s decision was the plan’s broad definition of D&O Insurance Recoveries, which included “the right to pursue and receive the benefits and/or proceeds of the D&O Insurance Policies.”  Id.  According to the express plan provisions, the post-confirmation trustee did not have the exclusive right to assert claims against former directors and officers but had all rights with respect to any and all D&O insurance proceeds.  Practically speaking, then, the investor plaintiffs’ legal ability to pursue their claims was of little value to them because the proceeds were not available to them.

Is there any real prospective power behind the punch in Palmaz?

Palmaz suggests that post-confirmation trustees may be able to control D&O insurance proceeds, keeping the proceeds all to themselves, by negotiating for a simple plan provision.  Of course, this would benefit all post-confirmation trustees because they are responsible for maximizing the value of trust assets in order to increase distributions to trust beneficiaries.  However, Palmaz puts potential claimants on notice that plan provisions may – intentionally or unintentionally – give post-confirmation trustees any and all rights over any and all proceeds of D&O insurance policies (regardless of the types of claims asserted).  Based on mere speculation, the parties in Palmaz likely intended for the post-confirmation trustee to have control over all D&O Insurance Recoveries with respect to D&O Claims belonging to the post-confirmation trust.  In other words, the parties probably did not expect for the post-confirmation trustee to have control over proceeds that related to direct claims against directors and officers.  Going forward, in light of Palmaz, claimants and other parties in interest will likely pay closer attention to plan provisions that relate, even tangentially, to D&O claims, policies, proceeds, and recoveries.

On top of providing a cautionary tale and a potential tool (or trick) to be used by post-confirmation trustees, does Palmaz permit post-confirmation trustees to control insurance proceeds without showing that the proceeds – as opposed to the policies – were property of the debtors’ estates (and, therefore, property of post-confirmation trusts)?  Maybe, but the clear takeaway is that in cases where debtors have D&O insurance policies, parties should carefully review all relevant plan provisions to make sure they are – or are not – similar to the one used in Palmaz.  At a minimum, Palmaz is a reminder that the pen is powerful.