Risk managers need to prepare for attacks on D&O policies as virus bites

Directors and officers of companies that suffer losses or even bankruptcy as a result of coronavirus are likely to face legal assaults from creditors on the basis of inadequate disclosure of risks and failure to react adequately during the crisis, warned Julia Zhu, associate in the finance practice at Brattle Group. “There may be causes of actions against a company’s officers and directors for inadequate disclosure of risks relating to material contracts or events, and/or failure to fulfil their duties in addressing business issues during a pandemic. Creditors may attempt to seek recovery from directors and officers insurance claims. Auditors may also be exposed for having failed to identify material risks that are later exacerbated by the impact of Covid-19,” she wrote in a note issued late last week. “Certain types of insurance policies may be responsive to Covid-19, such as business interruption coverage, trade disruption insurance and civil authority coverage. Litigation over the interpretation of specific insurance policies may arise as stakeholders seek recovery from insurance companies,” added Ms Zhu, who works for the US-based international firm that provides consulting services and expert testimony in economics, finance and regulation to corporations, law firms and public agencies. Bankruptcies caused by the virus are already happening and are likely to rise sharply in coming months. Companies with existing operational and financial challenges are likely to be the first ones to fail, forecast Ms Zhu. On 9 February, US-based medical device maker Valeritas Holdings filed for Chapter 11, citing supply chain disruptions caused by the epidemic in China, which exacerbated existing operational issues for the company. On 2 March, Japanese cruise operator Luminous Cruise Co went bankrupt, citing cancellations due to Covid-19 and struggles with rising fuel costs and the impact of typhoons before the outbreak. Coalmining company Foresight Energy LP also filed for bankruptcy, on 10 March, stating that the economic slowdown caused by Covid-19 had pushed it over the edge, after having defaulted on its debt last year. Laura Ashley, a UK fashion and homeware retailer, fell into insolvency administration as of 17 March because it was unable to secure financing because of the “bleak” outlook caused by Covid-19. The company had been struggling with falling sales and working capital problems for some time. “One common observation from these filings is that the companies all had pre-existing operational or financial problems that were exacerbated by the impact of Covid-19, ranging from supply chain issues to overall economic slowdown. Some of the underlying conditions are company-specific; others reflect the challenging business environment for certain industries. It is more difficult for companies with higher fixed costs and/or higher leverage to flatten the curve of depressed earnings caused by Covid-19. These companies are more likely to become distressed, with Covid-19 being the last straw,” noted Ms Zhu. It is interesting to note that few lessons seem to have been learned from the credit crisis of 2008/2009. Ms Zhu pointed out that, during the past decade, businesses have enjoyed abundant credit with low interest rates. “The extended credit cycle and benign credit environment can change quickly in the face of the pandemic. US corporate bonds surged to almost $10trn by late 2019, $7.8trn of which were investment grade. Investment-grade quality has deteriorated post-financial crisis. As of December 2019, 50% of investment-grade corporate bonds were rated BBB, compared to 35% in 2007. Based solely on leverage, 50% of BBB companies have implied ratings below investment grade. In a time of volatility and recession concerns, liquidity in the credit market may dry up quickly, leaving companies with high leverage unable to refinance at low costs, thus heightening bankruptcy risks,” she wrote. For Ms Zhu, it is therefore inevitable that increased distress and bankruptcy risks in connection with Covid-19 may bring a rise of bankruptcy-related litigation. “As COVID-19-related bankruptcies increase, a wide range of litigation is likely to ensue. Stakeholders will litigate over the valuation of the debtor’s business and the allocation of value among parties with claims on the company’s assets. One area of contention may be the premise and standard of value appropriate for valuation, based on different interpretations of a company’s distress caused in part by Covid-19 and its ability to continue as a going concern, which can yield vastly different valuations,” she noted.

Risk managers need to prepare for attacks on D&O policies as virus bites

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