Australia: D&O: Severability & Non-Avoidance

Last Updated: 20 October 2008
Article by Peter Tredinnick

The case, Martin John Green in his capacity as liquidator of Arimco Mining Pty Limited (in liquidation) v CGU Insurance Limited & Ors [2008] NSWSC 825, has a little something for everyone interested in Australian D&O. It perhaps highlights how more recent coverage enhancements such as severability and non-avoidance may have a real significance in future cases.

On 18 August 2008, a judgment was handed down by the New South Wales Supreme Court on significant issues surrounding:

  • The liability of directors for insolvent trading by an insured company.
  • The settlement by the directors with the insured company's liquidator of those claims, on terms which meant the consent judgments against the directors would not be enforced against them. The issue remained whether the settlement nevertheless founded a right of recovery from the insurer.
  • The right of the liquidator, as a claimant, to rely upon section 6 of the Law Reform (Miscellaneous Provisions) Act 1946 (NSW) (Law Reform Act) to directly access the D&O Policy.
  • The pre-contractual obligations of directors and officers to give full disclosure to the D&O insurer of the financial condition of the insured company.
  • The significance of the evidence of the actual underwriters and underwriting manuals and written records of the assessment of the risk.
  • The juxtaposition of insolvent trading claims, particularly to the extent it is based on the directors' knowledge of financial issues, and the duty of disclosure to the D&O Insurer.

The facts

The insured company, Arimco was a mining company. Its 30 June 1998 annual accounts showed the entity to have a positive financial condition. This deteriorated in the period prior to the inception of the D&O policy on 31 December 1998. The reasons were varied but included diminished mining reserves and financial liabilities to the principal lender. In March 1999, the directors voted to place Arimco in voluntary administration. The administrator shortly thereafter became the liquidator and pursued the directors for insolvent trading.

Ultimately, the directors resolved the liquidator's claims against them under terms which, effectively, were intended to create a liability in the directors which would sound under the D&O policy but without the payment to the liquidator of the monies the subject of the judgments. The liquidator agreed to discharge the consent judgments against the directors if:

  • The proceedings against CGU terminated in favour of the liquidator;
  • The liquidator reached a compromise with CGU; or
  • The proceedings terminated in favour of CGU.

After detailed evidence of the deteriorating financial condition of Arimco in the period leading up to policy inception, the Court found that the directors 'knew' certain matters within the meaning of the statutory duty of disclosure in the Insurance Contracts Act 1984 (Cth) and that they knew, or alternatively a reasonable person would have known, that those matters were in fact relevant to CGU's decision to write the D&O policy and, if so, on what terms. The Court agreed with CGU that the financial deterioration of Arimco could not have been caused solely by events after inception of the policy and before the administrator was appointed.

The Court also gave close attention to the evidence of the CGU underwriters, including as to their assessment of the risk, their internal systems, underwriting manuals and file notes. The evidence led the Court to the conclusion that, if there was proper disclosure, an insolvency exclusion would have been imposed thereby avoiding liability in CGU for the insolvent trading claims against the directors. CGU was therefore entitled to reduce its liability for the claims to nil under section 28 (3) of the Insurance Contracts Act 1984. The Court accepted that the financial condition of the insured company was fundamental to the assessment of the risk under a D&O policy.

Given that finding, it was strictly unnecessary for the Court to make any findings on the availability to the liquidator of the section 6 Law Reform Act action. It was defeated because CGU was not liable in any event. It does raise whether a liquidator in those circumstances might simultaneously seek indemnity for the company under Side C of the Policy if there are such claim.

Further, the effect of the terms entered between the liquidator and the directors was that the directors had no 'legal liability' and therefore there was no 'loss'.

Finally, and again without making any final determination on the point, the Court did not disagree with CGU's contention that there was an inconsistency in the liquidator's assertions of insolvent trading (which necessarily incorporate a suspicion of actual or potential insolvency) and a denial of knowledge in the directors of relevant matters that should be disclosed to an insurer.

Lesons for D&O practitioners

For D&O insurers, the policy in this case is likely to be significantly different to the current landscape of severability and non-avoidance promises in D&O policies. There is no evidence in the judgment of such provisions existing in the CGU policy in question, or of any examination of the different states of knowledge or conduct of individual 'innocent' directors (if any). No doubt, in the coming years, there will be similar cases on non-disclosure defences viewed through the prism of severability and non-avoidance extensions in D&O policies.

For individual underwriters of D&O policies, clearly the making and retention of good records to support evidence in Court is critical. The underwriting manuals and guidelines, in this case particularly around the imposition of an insolvency exclusion, were vital. Of course, this also bears upon the 'similar fact' evidence in other later cases. If an underwriter is known in some cases to have waived an insolvency exclusion on one risk, it is likely to weaken the credit of the underwriting witness in a different case if it is said such an exclusion would have been imposed.

Further, these disclosure issues highlight the importance of the proposal and questions in it, at a time when many D&O insurers are increasingly agreeing to do away with, or minimise questions in, proposals.

For liquidators and their supporting litigation funders, careful consideration needs to be given to the insurance implications for directors in making insolvent trading claims against them (and therefore the recoverability on the claim). Further, settlement agreements between the directors and the liquidator cannot create an artificial liability merely for the purpose of an insurance policy recovery. Insurers remain entitled to challenge any such agreements.

For claims handlers, this case confirms the sometimes difficult tensions between coverage issues and the defence of the directors, particularly where indemnity has been reserved and a director's position on the claim may impact on an entitlement to indemnity. Here the early resolution of the claim by the directors seems to have at least in part founded the position of the insurer on coverage.

For the directors' lawyers in any such proceedings, obviously care needs to be taken in negotiating any terms. No issues of good faith or other obligations of the directors to the insurer were evident in the judgment, given the apparent disposal of the matter, but the may have surfaced at a later point in time.

Phillips Fox has changed its name to DLA Phillips Fox because the firm entered into an exclusive alliance with DLA Piper, one of the largest legal services organisations in the world. We will retain our offices in every major commercial centre in Australia and New Zealand, with no operational change to your relationship with the firm. DLA Phillips Fox can now take your business one step further − by connecting you to a global network of legal experience, talent and knowledge.

This publication is intended as a first point of reference and should not be relied on as a substitute for professional advice. Specialist legal advice should always be sought in relation to any particular circumstances and no liability will be accepted for any losses incurred by those relying solely on this publication.

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