UK: Insurance And Reinsurance

First published in March 2003

This edition of INSURANCE & REINSURANCE concentrates on the rapidly changing D&O landscape. A series of spectacular bankruptcies in the USA following in the wake of the collapse of Enron, and the notorious Sarbanes-Oxley Act have turned this market on its head. In the UK there has been considerable corporate governance activity, the Financial Services &Markets Act 2000 is making itself felt, a new Companies Act is in the pipeline added to which the EPL field has seen some colossal awards.

The Combined Code ("the Code ") is the key source of guidance in respect of corporate governance for UK listed companies.

There is no direct legal sanction for failure to comply with its provisions. The approach taken is "comply or explain". All quoted companies must in their annual reports give a "disclosure statement "in relation to their compliance with the Code.

The disclosure statement must include:

• An explanation of how the company has complied with the broad principles of the Code;

• Confirmation of whether the company has complied with the specific provisions of the Code, specifying which provisions have not been complied with reasons.

In this way, investors and underwriters may see the extent to which a company has effective corporate governance procedures. Institutional shareholders have a well developed understanding of governance issues and scrutinise disclosure statements in deciding where to place their funds. We now assess the changes to the Code that are proposed, together with the wider recommendations of three recent governance reports.

In January 2003,three reports were published which, when implemented, will have a major impact upon UK corporate governance.

Mr Derek Higgs has released his report on the role and effectiveness of non- executive directors ("NEDs "),whilst a group appointed by the Financial Reporting Council ("FRC")and chaired by Sir Robert Smith reported in relation to audit committees. The Smith report emanated from a recommendation in the interim report of the Coordinating Group on Audit and Accounting Issues ("CGAAI"),whose Final Report was the third governance-related report of January 2003.

The reports have been endorsed by the Government and the changes they propose to the Combined Code are scheduled for early summer, once the FRC has consulted on the precise wording, ready for implementation by companies with accounting periods beginning on 1 July 2003.

NEDs are part time employees of the company who attend board meetings and sit on board committees (audit, remuneration and nomination).They have no day-to-day role in the company, but have traditionally added variety to the board's expertise, and, since Cadbury, played an increased role in the governance and internal safeguards of the company. It is established law (and there are no proposals for change)that the same standard of care is applicable to NEDs as to their executive counterparts. Higgs talks in the introduction to is report of the "important" role of NEDs being "largely invisible and poorly understood", but he rejects the option of legislation, in favour of changes to the Code. In some areas he advocates tightening existing rules, and in others, entirely new rules are proposed.

His report has made recommendations in the following areas:

1 Board composition —at least half of the members of the board (excluding the Chairman)should be independent NEDs. This is a substantial change from the existing Code, which provides that only a third need be NEDs (with only a majority being independent).

2 Role of NEDs —a description of the role of the NED should be incorporated into the Code for the first time. Their objectives will be to:

• contribute to strategy;

• monitor the performance of the executive management;

• assess financial controls and risk management; and

• contribute to the appointment/ removal of executive management, and determine their remuneration.

In addition, the Code should provide:

• prior to appointment, NEDs should carry out due diligence on the company to ensure they have the knowledge, skills and experience necessary;

• NEDs should have a strong command of all issues affecting the business on an ongoing basis;

• the NEDs should meet at least once a year without the Chairman and executives present.

3 Independence of NEDs —a tighter definition of independence than is contained in the existing Code is proposed, as follows:

• as to how the test will be applied in practice, Higgs provides illustrations of relationships which would not meet the test of independence;

• the Code should expressly state that all directors must take decisions objectively in the interests of the company;

• not all NEDs will have to be independent but the annual report must disclose which ones are;

• a senior independent NED should be appointed who meets the test of independence and is available to shareholders where concerns have not been resolved via the usual channels of the Chairman or Chief Executive.

4 Chairman and Chief Executive —the Code already discourages the combining of these two roles in one person. Only 10%of listed companies still adopt this practice. Higgs goes further in recommending:

• these roles should always be separate, and defined in a written document approved by the board;

• the Chairman should meet the test of independence.

5 Appointment and training —steps are to be taken to broaden the pool of NEDs available and from wider walks of life.

• on appointment, NEDs should receive a letter setting out what is expected of them;

• a comprehensive induction programme should be provided;

• the performance of the whole board should be assessed and described in the annual report.

6 Tenure and time commitment —the Code currently does not provide any guidance in this controversial area. Higgs proposes new principles, as follows:

• a NED should be expected to serve two three-year terms, exceptionally longer;

• on appointment, NEDs should confirm they will have sufficient time to meet their obligations. If a NED is offered a post elsewhere the chairman should be informed before that post is accepted;

• an executive should not take on more than one NED post or chairmanship of another major company;

• except in the case of small companies, no NED should sit on all three board committees (audit, remuneration and nomination).

7 Remuneration —this is another area of concern: to attract NEDs who are prepared to devote more time to fewer companies, and accept potentially greater responsibilities (see below)they will expect more money. Higgs proposes:

• NED remuneration should be sufficient to attract high quality individuals;

• NEDs may hold shares but not share options, which would align their interests too closely with those of the executives.

8 Liability and insurance —potentially the most interesting for the D&O market are the changes proposed to the Code regarding liability and insurance. For the first time insurance will be expressly mentioned in the Code.

• the Code should refer to the need for D&O insurance, and details of the cover should be provided to prospective NEDs before they are appointed;

• There should be a greater awareness of what D&O insurance does and does not cover, and how the policy works -the ABI, BIBA, City of London Law Society and ICSA are working on guidance now;

• s310 (3)(b)(i)Companies Act 1985 prohibits the company from indemnifying the directors. However, where the directors have successfully defeated a claim the company may reimburse their costs and expenses. Higgs proposes the section is amended to allow companies to:

-advance defence costs and expenses to directors, repayable if the directors are found liable; and

-indemnify the directors for any excess payable on a D&O policy that is in existence.

• NEDs should have the same legal duties as the executives and the proposed Statutory Statement of Directors' duties in the Companies Bill (see final article)is approved;

• guidance in the Code should be taken into account by courts when assessing the knowledge, skill and experience of each NED,as required by the Statutory Statement of duties. In practice, therefore:

-it will be more difficult for NEDs to plead that the standard of care should be applied more leniently to them if they had certified on appointment that they had the relevant knowledge, skill and experience for the job and had sufficient time to meet their obligations;

-similarly, their increased role may make it more difficult for them to argue they could not reasonably have known about the problem within the company which is the subject of a claim against the directors.

• concerns about the expense and duration of court proceedings involving directors could be addressed by the Lord Chancellor's Department promoting active case management.

The Higgs changes almost double the length of the existing Code. Whilst he went further than many commentators expected, the report has generally been welcomed in the City, on the basis that many of the largest plcs already adopt best practice.

Two aspects of the Higgs Report that have elicited particular debate are whether:

1.the recommendations are too onerous for smaller listed companies. If a recommendation is considered too onerous, the company has the option "to explain", setting out the reasons why compliance is considered inappropriate.

2.there is a sufficient pool of suitable potential NEDs. Patricia Hewitt has encouraged the appointment of NEDs from the non-commercial sector (citing the example of NHS Trusts). She has appointed a group to examine ways of bringing such candidates forward, which will report to her in May 2003.

Both Higgs and the CGAAI have endorsed the Smith Report on audit committees, which recommends that the Combined Code is strengthened and expanded in the following specific ways:

1 Constitution of audit committees —the Combined Code currently provides that whilst audit committees shall comprise solely NEDs, only a majority need be independent. Recommended changes include:

• an audit committee should have at least three members, all of whom are independent NEDs;

• No one other than audit committee members shall be entitled to attend audit committee meetings;

• at least one member shall have "significant, recent and relevant" financial experience. This member will be judged according to his greater expertise under the Statutory Statement of duties.

2 Audit committee responsibilities —the Code currently provides that the duties of the audit committee include keeping under review the scope and results of the audit and its cost effectiveness, and the independence and objectivity of the auditors. Smith provides for a more explicit statement of duties, as follows:

• reviewing the company's financial controls;

• monitoring internal audit;

• primary responsibility for making recommendations to the board for the appointment of external auditors and approving remuneration and terms of engagement;

• monitoring external auditors' independence and effectiveness;

3 Non-audit services —the Code currently provides that where the auditors also supply a substantial volume of non-audit services to the company, the audit committee should keep the nature and extent of such services under review, seeking to balance the maintenance of objectivity with value for money. Smith recommends that the audit committee should be specifically responsible for implementing policy on the purchase of non-audit services from the external auditors.

4 Accountability to shareholders —in order to achieve maximum transparency in this most important of areas, Smith proposes that:

• the annual report should describe the role and responsibilities of the audit committee and actions taken to discharge those responsibilities;

• the chairman of the audit committee should attend the AGM to answer any questions.

The recommendations of Smith complement Higgs' approach of "comply or explain"but do not adopt all of the more far-reaching (and not necessarily workable)recommendations of the CGAAI's interim report.

Currently, auditors are appointed and dismissed upon the recommendation of executive management. It has recently been argued forcefully that this increases the opportunity for auditor conflicts of interest.

Smith has increased the powers and responsibilities of audit committees to oversee auditor independence from the company's standpoint.

The CGAAI has considered this area from the auditor's perspective and, in addition to the measures proposed above, has made the following recommendations regarding independence of auditors:

• auditors should disclose the nature and value of all services provided to audit clients, by category;

• the lead audit partner should be rotated every five years and other audit partners every seven years;

• there should be a two year period between an audit partner leaving his firm and taking up a post at his audit client.

An outright ban on all non-audit services is not proposed, as there may be legitimate costs reasons for the provision of certain related non-audit services.

Such recommendations largely followed the CGAAI's interim report and standards adopted by the Institute of Chartered Accountants.

The recommendations in the recent corporate governance reports are a reasonably measured response to the recent problems in the US and do not change the existing "comply or explain" framework. It remains to be seen to what extent they are adopted by the FRC and the FSA, and what the new Code will finally look like.

Annual reports after 1 July 2003 are likely to be subject to the new provisions but it will be interesting to see whether companies whose accounting periods begin before that date show signs of moving towards the new regime.

Given the quantities of additional governance related information annual reports will have to contain, there will be more for D&O underwriters to digest on placement. Whether this will really improve underwriters'(or investors') ability to assess the risk depends on whether the new rules are treated by companies as an increased box-ticking exercise, or an opportunity to bring about real internal change.

In January 2003 the Financial Services Authority ("FSA ")published Consultation Paper 164 which applies to all investment trusts, including the now notorious split capital investment trusts.CP164 proposes changes to the Listing Rules, Conduct of Business Rules and the Model Code. While the fine detail of proposed rule changes may not be of interest to D&O insurers and may be superseded by the House of Commons Treasury Committee's call for investment trusts to be classified as regulated products, in combination with the Higgs Report,CP164 raises important issues.

Investment companies usually have a slightly different structure to trading companies, because they normally appoint an investment manager to perform the executive management function traditionally associated with executive directors. Often, but not always, a director or senior employee of the investment manager will sit on the board of directors of the investment company.All of the directors are usually non-executive ("NED").If specifically named as "responsible" in listing particulars or prospectuses, NEDs could be held liable for errors in such documents and subject to fines or public censure by the FSA in its role as UK Listing Authority. They would also be vulnerable to actions for compensation for false or misleading particulars under s90 Financial Services and Markets Act 2000.

The investment manager director, as an investment professional, would almost certainly have some form of D&O cover, most probably through an outside directorship extension. However, the other directors may not have D&O cover as it is often considered that they can pass on most liabilities to the investment management company.

There are a number of reasons why this is likely to change. First, the Higgs report has recommended that D&O cover be made available to all directors (including NEDs).Second,CP164 proposes that no representative of the investment manager will be permitted to sit on the board of the investment company. While there may still be no need for executive directorships, the FSA reiterates the guidance published by the Association of Investment Trust Companies ,that boards should monitor investment performance, address persistent poor performance and, if necessary, initiate a change of investment manager. If, therefore, the investment management company performs poorly, the board could be held liable for failing to change it.

While this would not leave directors open to new actions by shareholders, it does leave them more vulnerable to actions by the investment companies themselves and makes it harder for directors to pass on those responsibilities to the investment manager. In many cases, however, such claims would fall foul of the assured versus assured exclusion in the D&O policy.

A further point to note is that if carrying on the business of an investment company is reclassified as a regulated activity, then anyone who undertakes senior management functions, including NEDs, will be brought within the Financial Services and Market Act 2000 approved person regime. Approved persons are personally subject to the FSA's disciplinary and enforcement powers, including financial penalties, so the need for D&O cover increases.

In the light of these changes, there are likely to be significant numbers of NEDs of investment companies looking for D&O cover. However, investment trust companies are currently facing substantial premium increases if they can obtain cover at all.

As a result there may be a number of new opportunities for D&O insurers who are prepared to take a certain amount of risk.

The incidence of claims in England against directors remains low with the effect that there is relatively little recent D&O case law to comment upon, although the cases discussed below could suggest that the number of claims may be set to increase in future.

The paucity of claims up to now is explained by the difficulties that claimants face in establishing liability against directors. For example, in Williams v Natural Life Health Foods ¹ the House of Lords decided that before a director could be found liable he must have assumed a personal responsibility for the acts or statements complained of, which would otherwise be regarded as being the acts or statements of his company. There have been no reported cases where this test has been satisfied, although there have been two further attempts in the past year to attach personal liability on directors, discussed below.

In Partco v Wragg &Ors ² ,the Court of Appeal considered whether a claim against two directors should be struck out before a full trial on the basis that there were no reasonable grounds for bringing the claim.

Unipart sued the directors of Partco when it became apparent that their representations concerning profitability made in the course of a "friendly take over" were false. The directors applied to strike out the claim before substantial costs were incurred on the basis that their representations were made on behalf of Partco and that they did not owe a duty of care personally to Unigate.

The Court of Appeal recognised the difficulties facing the claimants in establishing that the directors had assumed personal responsibility for those representations. However, the pleadings set up an arguable case so that it would be inappropriate to strike out the claim at least until the evidence had been tested in cross-examination.

Therefore, despite the difficulties faced by claimants alleging that directors owe them a personal duty of care, such claims should now withstand strike out applications, which leaves underwriters the unenviable choice of incurring substantial defence costs or settling the claims on an economic basis.(The case in question was subsequently settled).

In Standard Chartered Bank v Pakistan National Shipping Corporation &Others ³

the House of Lords found that the defence that a director acted as agent of the company and would only be personally liable in exceptional circumstances did not apply to cases involving fraudulent misrepresentations.

Mr Mehra was the managing director of a company called Oakprime Ltd, which was the beneficiary under a letter of credit issued to a Vietnamese bank and confirmed by the claimant, Standard Chartered Bank.

Mr Mehra fraudulently backdated certain documents in order to obtain payment under the letter of credit. Standard Chartered was unable to obtain reimbursement from the Vietnamese bank and so sued Mr Mehra for deceit.

The Court of Appeal found that Mr Mehra was not liable on the basis that these fraudulent acts were committed on behalf of Oakprime and so it was Oakprime that should be liable.

The House of Lords reversed this decision, finding that the "assumption of personal responsibility" test, enunciated in Williams v Natural Life Health Foods ,was not applicable to fraud. Put simply, a fraudster should not escape liability by asserting that he committed the frauds on behalf of is company; since all of the elements of the tort of deceit could be made out against Mr Mehra, he should be personally liable.

Obviously D&O underwriters would not be liable to indemnify Mr Mehra by virtue of the operation of the fraud exclusion. In order to avoid the advancement of defence costs, underwriters could also argue, following this House of Lords decision, that coverage under the insuring clause is not triggered because the wrongful acts complained of were not committed in the capacity of a director.⁴

Issues arising out of the collapse of a company called RGB Resources, which was a vehicle for fraud, have been before the courts on numerous occasions in the past year.

D&O policies typically offer cover for defence costs incurred in the directors' representation at "official investigations", which would be likely to include an examination ordered under s236 Insolvency Act 1986.

The Court of Appeal considered whether it would be oppressive to compel a director to attend such an examination into the affairs of RBG Resources by its liquidator who had earlier commenced civil proceedings for fraud against the same director.

The directors argued that they should not be compelled to attend the examination since this would be oppressive; itamounted to a pre-trial deposition with the objective of obtaining information on oath which would then be used in the civil claim.

The Court of Appeal conducted a balancing exercise and found that any oppression was overwhelmingly outweighed by the legitimate requirements of the liquidator. In this case, the deficiencies in the company's records meant that it was particularly important for the directors to be examined to provide the liquidators with information that was urgently required in order to recover the massive losses.

Subsequently, his Honour Justice Laddie had to consider whether a senior employee of the same company, RGB Resources, might have owed a duty to "blow the whistle" on the major fraud that was being perpetrated by its directors ⁵ .

The court found that it was arguable that the financial controller, Mr Patel, should have blown the whistle on this fraud. He could have reported the fraud internally because there was at least one director against whom no allegations of fraud were levelled and arguably he was even under a duty to report the fraud externally to the police, the Serious Fraud Office or to the company's solicitors. The failure to stop the fraud in its tracks could now lead to a substantial claim against the employee as the fraud was estimated to be $400m.

In most cases there would be little point in the liquidator suing the fraudulent directors as they would not be indemnified by any D&O policy. Following this decision, however, the liquidators could now sue senior employees who were not involved in the fraud in order to "open up" the D&O policy on the basis that these employees could be regarded as "officers" of the company and the fraud exclusion would not apply to them.

In conclusion, there remain a small number of reported cases relevant to D&O insurers. Whilst it would be inappropriate to predict future trends based upon a handful of cases, the reported cases in 2002 suggest to us that courts are adopting a more robust approach to the question of directors' responsibilities and this may have a knock on effect on the number of claims brought in the future. In this respect, the claim brought by Equitable Life against its former directors may, if it reaches court, provide an insight into how far judicial attitudes towards directors' duties have developed.

The process for proposed reform of the UK's company law began in 1998,long before the recent corporate scandals in the US. However, it has been given new impetus by the heightened interest in corporate governance. In July 2001,the final report of the Company Law Review Steering group was published by the DTI. On 16 July 2002,the government published a White Paper "Modernising Company Law", together with a draft Companies Bill, in response. The consultation period finished in January 2003 and further publications from the government on the progression of the reform are expected this year.

The White Paper contains the following recommendations for reform, that affect the governance of listed companies and directors' liability:

• The "Directors' Report" in the annual report will be replaced by an Operating and Financial Review ("OFR").This will be a broader statement of the past, present and future performance of the business and an assessment of relevant issues and risks affecting the business. It is aimed at improving the qualitative as well as purely financial nature of reporting and will enable investors to hold the directors more to account;

• In addition to existing Companies Act requirements, directors will be required to volunteer all relevant information to auditors, and a dishonest failure to do so, including deliberately or recklessly providing a false statement to an auditor, will be an offence;

• A new Statutory Statement of directors' duties is proposed, to "promote the success of the company for the benefit of its members as a whole". This duty will be applied to both executive and NEDs and will take into account a number of stated factors. In addition, the applicable standard of care for the Statutory Statement of duties is to be codified, based on the common law standard (which in turn adopted the Insolvency Act 1986 s214 standard),so that:

We are probably still over a year away from a new Companies Act.

Significantly, the government has not followed the recommendation of the DTI Steering Group with regard to a new right of action for breach of duty by directors for minority shareholders.

It remains to be seen whether this is brought into future drafts of the Companies Bill and whether further alterations to the proposed legislation will be made to reflect some of the changes to company law recommended by Higgs, particularly in relation to s310 Companies Act.

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.