Corporate Dissolutions: D&O Protection Considerations

Many companies rely on capital raises to grow their business and bring products and services to market—but there are times that economic and financial market conditions make it difficult for companies to secure needed capital. Since the beginning of 2022, public companies have seen their share prices drop significantly. Many other capital providers like private equity and venture capital firms are pausing on making new investments. Left with seemingly no viable path forward, some companies are making the difficult decision to dissolve—cease operations, pay creditors, and return any remaining funds to shareholders.

Delaware and other states have established a dissolution process for corporations to pay creditors and to conduct an orderly wind-up of corporate affairs. Dissolution parallels bankruptcy in that it provides companies with a clear path to resolve outstanding creditors' claims within a specified period, after which further claims are statutorily barred. However, the bar typically does not apply to creditors that did not receive notice or to claims arising after the bar date.

The dissolution process typically requires the corporation to file a dissolution petition and finish up the remaining corporate affairs, such as paying remaining liabilities like taxes and wages and distributing the remaining assets to shareholders.

An Orderly Process, But Risks Remain

The orderly nature of the dissolution process certainly limits directors’ and officers’ exposure to creditor suits by creating a process by which they are paid. Directors and officers, however, still face some potential personal liability risk from parties such as creditors not paid in full, shareholders that believe the directors and officers mismanaged the company, and regulatory authorities.

Protecting Directors and Officers from Personal Financial Exposure

Normally, these exposures would largely be backstopped by a personal indemnification agreement with the company the directors and officers serve. However, in the case of a dissolved corporation, there is no corporate balance sheet left to support the indemnification agreements.

A well-crafted Directors & Officers Liability insurance (D&O) program may be the only thing standing between the director or officer and a potential out-of-pocket payment.

D&O Insurance Program Considerations

Before undertaking a corporate dissolution, make sure you have the right D&O insurance program in place. The D&O program you have going into the dissolution process will likely be the best protection available for you. It will likely be the program you have when the dissolution process ends and through the run-off period, as discussed below. Any shortcoming in the D&O program will either persist or will be difficult and costly to remove.

Ideally the D&O program you have in place as you begin the dissolution process will not have any specific coverage limitations for claims that could arise during the dissolution process. Common examples include a creditors exclusion or a breach of contract exclusion that extends to non-indemnifiable or Side A claims against directors or officers. 

It also critical to understand the breadth of coverage for unpaid wages and taxes that could become the personal obligations of directors and officers. Is there a wage and hour exclusion (typical), and does that exclusion provide an exception for non-indemnifiable claims to cover legal costs and possibly more? Another question to consider is whether the definition of loss includes taxes that become the personal obligation of a director or officer when the company is insolvent.

Thought must also be given to the D&O program structure and limit. For example, is the current limit impaired by pre-existing claims? If so, do you want to attempt to purchase additional, unimpaired limits before sending the policy into run-off? And do you want to increase the limit, given that the run-off policy is a multi-year policy and there is no longer a corporate balance sheet that will respond if the D&O program’s limits are exhausted?

Regarding the program structure, most companies purchase traditional D&O coverage, or Side ABC coverage, that protects directors and officers from personal liability and the company’s balance sheet for indemnification paid to directors and officers and direct claims. Knowing the corporate entity will go away and not be able to indemnify any individual director or officer, the focus should be on Side A coverage and limit. 

A Run-off or Tail Policy Extends a D&O Policy

As mentioned above, the dissolution process provides a scheme that reduces but does not eliminate exposure for directors and officers. Claims can still be made during the dissolution process, wind-up period, or after. For this reason, you want the D&O insurance program to continue to respond well after the dissolution has been completed. The way to do this is to purchase Run-off or Tail Policy.

A Run-off or Tail Policy is an endorsement that goes onto the current D&O insurance policy. (The term “run-off” and “tail” are used interchangeably in this context.) The tail endorsement has the effect of extending the period during which a claim can be made against the D&O current insurance program. Note that the policy will respond for the duration of the tail period, but only if the claim relates to alleged wrongful acts that took place before the run-off or tail period began.

In this way, a normal annual D&O policy can be extended. Tail policies in the United States typically extended the claims notice period for six years. The only policy term that changes in most cases is the expiration of the time by which a claim has to be made against the policy to be covered. The fact that the tail extends the expiration date of the current D&O is why it is critical to have the right D&O insurance coverage in place before entering the dissolution process.

You want the Tail Policy to be non-cancellable so that there is no opportunity for any party to attempt to renegotiate terms after the coverage is effective.

A Trap for the Unwary

As discussed, the typical Tail Policy is designed to continue to respond to future claims so long as the alleged wrongful act took place before the date the tail policy began. To avoid picking up post-tail inception activities, the typical tail coverage endorsement also has a future acts exclusion, meaning claims for wrongful acts alleged to have occurred after the tail effective date are not covered. 

This future acts exclusion is problematic in the context of a dissolution. Per the terms of a typical D&O insurance policy, the policy will automatically go into run-off after the company sells substantially all its assets to pay creditors or when the petition for dissolution becomes effective. Unfortunately, there is often statutorily required post-dissolution activities that must be carried out by the remaining executive(s), including paying the proceeds from the sale of assets to creditors and shareholders and filing final tax returns. To address this ongoing exposure, include “wind-up/wind-down” coverage as part of the tail. Wind-up/wind-down coverage provides coverage to the remaining executive for acts related to the completion of the dissolution process that take place after the effective date of the run-off or tail coverage. 

The dissolution process varies from state to state, so that engaging a D&O broker with experience in this area is critical to ensure your directors and officers are protected. In the best case, you will begin to negotiate terms prior to starting the dissolution process, ideally as part of the proximate D&O insurance program renewal.

Woodruff Whiteboard Breakdowns: D&O Tail Policies