It may seem churlish to complain about Section 78(6) of the Companies Bill 2008 given that it goes a long way to fixing the problems which have bedevilled the attempts to get the legislation dealing with directors and officers insurance in line with industry expectations and the recommendations on the topic in both of the King Reports.

The problem has been the convoluted wording (described as "ambiguous" in King II) of Section 247 of the existing Companies Act. The subsection renders it unlawful for a company to exempt a director or officer from liability resulting from negligence, default, breach of duty or breach of trust. It goes on to provide that the subsection is not applicable to insurance taken out and kept by the company as indemnification against such liability of any director or officer towards the company.

Of course this missed the mark altogether. The problem is not the capacity of the company to insure itself against loss. What is needed is authority to pay the premiums for a policy which would protect the director against these contingencies. Without that protection what reasonable business person would take on the risk inherent in accepting appointment as a director.

Insurers and their corporate clients have reacted to the existing legislation by ignoring it. Insurers write D&O business protecting directors and corporates pay the premiums.

The new Companies Bill recognises the right of the company to purchase insurance to protect a director against any liability or expenses for which the company is permitted to indemnify the director. The company can also purchase insurance to protect itself against any such liability. Finding out what form of indemnity will be permitted entails an analysis of the section dealing with the company's right to indemnify a director (S78(5)). That section prohibits an indemnity by the company for the consequences of wilful misconduct or wilful breach of trust by a director. The section also prohibits indemnity for the consequences of a director acting without authority despite knowing that no such authority existed; or acquiescing in the conduct of the business recklessly, with gross negligence, with intent to defraud or for any fraudulent purpose, or trading under insolvent circumstances despite knowing that the business was being conducted in this manner. The section also prohibits being party to an act or omission by the company despite knowing that this was calculated to defraud a creditor, employee or shareholder of the company or had another fraudulent purpose.

At first sight none of these limitations appears problematic. You cannot buy insurance against deliberate misconduct under a D&O policy.

The difficulty arises, however, from the definition of the term "knowing" in Section 1 of the Companies Bill. This defines the term to mean that the person either:

  • Had actual knowledge of the matter; or

  • Was in a position in which the person reasonably ought to have –

  • Actual knowledge; or

  • Investigated the matter to an extent that could have provided the person with actual knowledge; or

  • Taken other measures which, if taken, could reasonably be expected to have provided the person with actual knowledge of the matter.

The second part of the definition pulls one back immediately into the realms of negligence – i.e. if you had no actual knowledge but reasonably ought to have had knowledge you are deemed to have it. If you reasonably ought to have investigated in a manner which would have provided you with the knowledge then you are deemed to have it. If you failed to take steps which, if taken, could reasonably be expected to have provided you with knowledge then you are deemed to have it.

All of the above means that the bona fide but negligent director who makes a mistake about the extent of his authority to bind the company, or who fails to pick up on the reckless trading or does not recognise a fraudulent objective not only cannot be indemnified by the company but also cannot procure insurance against his or her negligence. Worse still, the imputed knowledge will only be determined at claims stage, perhaps in expensive litigation.

I doubt that this was the intention but the effect, once again, is to leave the director with a gap in cover.

One wonders why a relatively simple proposition needs to be complicated in this way. It is not as if there is any lack of guidance elsewhere. The English Companies Act is perfectly simple. The equivalent section prohibits the company from indemnifying a director in connection with any negligence, default, breach of duty or breach of trust in relation to the company. However the section does not prevent a company from purchasing and maintaining insurance for a director against any such liability. No complex wordings, no cross referrals, no uncertainty for the company, the director or the insurance industry.

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.