Directors and officers of Australian corporations face ever-increasing exposure to claims. As well as the liability for any wrongdoing, the increasing use of investigative powers by the Australian Securities and Investments Commission, the Australian Competition and Consumer Commission and the Australian Prudential Regulation Authority demonstrate the potential additional liability for the cost of defending such investigations. Such inquiries gain considerable media attention and can run a lengthy course which means the cost of arranging representation or responding to an inquiry can be very high.
This article reflects on the risks and pitfalls for directors and officers in performing their duties, and the two main methods of protection - indemnity and insurance. We specifically consider directors' and officers' (D&O) insurance, and the potential gap between the directors' perception of the scope of the indemnities given to them and the actual scope of indemnities provided by corporations and insurers.
Where are the risks?
Directors owe duties to the company in which they are a director :
- to act honestly and in good faith
- to not to make improper use of their position or information they receive
- to act for a proper and legitimate purpose
- to act with reasonable skill and care in the best interests of the company (and to the shareholders collectively)
- to disclose all material personal interests to the company.
Obviously each company is different and directors need to be aware of the specific risks relevant to the business and the industry in which it operates. Some of the more obvious areas of risk for directors are:
- trade practice issues including consumer protection, product liability and proper disclosure of information
- occupational health and safety
- industrial relations
- environmental liability
- ensuring disclosure of accurate financial information
Transferring the risk
Risk transfer acts as a protection against liability for directors who act in the best interests of the company. Company officers can transfer risk by:
- seeking an indemnity from the company; and/or
- obtaining some form of insurance.
Risk transfer is not an encouragement of reckless or illegal behaviour. The fact that company officers can transfer their risk of liability to another party does not mean that they are entitled to engage in misconduct. Any activity by a director which is reckless, dishonest or illegal will undoubtedly void any D&O insurance policy, and the company is in any event prevented by statute from taking on the liability associated with such an activity.
To counter the exposure of individual directors and officers, a company's constitution may include indemnities in favour of directors and officers. These indemnities may also be conferred by the corporation by means of a deed of indemnity. However there are important restrictions imposed by statute on the liabilities that may be indemnified by a corporation.
The Corporations Act 2001 (the Act) provides that a company may provide an indemnity to its officers subject to the limitations set out in section 199A and the company's constitution. Most company officers request a full indemnity from the company to ensure the company reimburses them for any liability and associated expenses incurred if they are sued as a result of carrying out their duties on behalf of the company.
However, in practice, no matter how broadly a corporate indemnity is drafted, the Act and other legislation will limit the extent to which companies can indemnify their officers. Additionally, the effectiveness of any corporate indemnity will very much depend upon the solvency of the company. If the company is insolvent or does not have sufficient funds to back the indemnity, the right is virtually worthless.
A typical Australian D&O insurance policy contains two separate insurance components. The first consists of a direct cover component which provides indemnification to directors and officers where the company itself is unable or unwilling to do so. The second consists of a company reimbursement component which provides for the company to seek reimbursement for those amounts for which it is obliged under its constitution to indemnify its directors and officers. These are the principal insuring clauses in D&O insurance policies in Australia although D&O policies commonly offer a number of extensions of cover, such as cover for defence costs relating to prosecutions under environmental or occupational health and safety laws.
There are a number of exclusions from D&O policies which can restrict the extent of cover including:
- prospectus liability exclusion - important to directors of companies who undertake public offerings;
- professional indemnity exclusion - excludes cover for claims of a breach of duty other than the duties owed by a director in that capacity;
- major shareholder exclusion - prevents parties with significant equity in the company from benefitting by bringing a claim against the directors and officers for a wrongful act which they themselves were party to or had the opportunity to prevent; and
- insured vs. insured exclusion - excludes claims brought by one party covered by the insurance against another, including by the company against a director. This is a significant exclusion because a director's duties are owed to the company itself and actions brought by the company are a significant potential source of liability.
Checklist For Implementing D&O insurance
1. When selecting a broker, ensure that they are knowledgeable and experienced in D&O insurance.
2. Directors should meet with the board and discuss the primary purpose of the D&O insurance policy. What is it that the board wants from the policy? Ask the company's insurance broker to assist with this process.
3. Select a quality D&O insurer who can provide broad protection with a solid financial backing and track record.
4. Carefully examine the quotations provided by each insurer including the scope of cover. Consider which option best suits the needs of the company.
5. Who is responsible for paying D&O insurance premiums? Do directors have to pay a portion of the insurance premiums?
6. Ensure that the board understands the options and that it is given adequate time to make this important decision.
7. Check the policy wording carefully to ensure that it reflects the requirements as set out by the board.
8. Make sure any material changes to risks such as change in control of the company are notified to the insurer and there is adequate insurance for directors who have retired or resigned as a result of this change in control.
9. Ensure that internal protocols are in place for compliance with the duty of disclosure.
Potential gaps in cover will inevitably continue to arise and it is important for directors to be aware of the extent to which the liabilities they may incur are matched by the indemnities and insurance provided to them. Likewise, companies themselves need to be aware of any indemnities that they have provided to their directors and officers, perhaps unwittingly, which are not backed up by their own corporate reimbursement insurance.
Risk protection is only one component of the overall governance structure of a company.
Swaab was recently named a 2009 Winner in the ALB Employer of Choice awards, and was winner 'Best Law Firm in Australia (Revenue < $20m)' and 'Attribute Award for Exceptional Service (Australia Wide)' in the 2008 BRW- Client Choice Awards.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.