UK: Reform of Prohibition on Company Indemnification of Directors’s Liabilities

Last Updated: 18 August 2004
Article by Francis Kean and James Roberts

Section 310 of the Companies Act 1985 prevents a company from exempting or indemnifying any of its directors or officers against any liability for his or her negligence, default or breaches of duty or trust in relation to the company. The implications of this prohibition are significant for D&O insurance as they impact on the company’s ability to indemnify directors and to claim reimbursement from D&O insurers. The Government has been consulting on reform of this important aspect of the law affecting directors’ liabilities. That consultation period has recently ended, and publication of the submissions received together with the Government’s response is eagerly awaited, as this may have fundamental implications for the relationship between the director and his company, and, in turn, for both with their D&O insurers.

The Government’s Consultation Paper, dated December 2003 (www.dti.gov.uk/cld/ auditors_directors.pdf), canvassed a variety of options for reform, ranging from the conservative to the radical. This is intended to build on the momentum, in particular, of the Higgs Review on the role and effectiveness of non-executive directors (see D&O Liability Review, Issue 32, Spring 2003) and the work of the Company Law Review (‘CLR’) (which, although still not the subject of a draft Bill in its own right, is nevertheless exerting influence in a number of discrete areas). The issue is also being considered in tandem with the related issue of auditors’ liability. The Government has ruled out any possibility that a company might provide indemnification or exemption for a director’s fraudulent or other illegal conduct – so no surprises there. Otherwise, however, the main options are as follows:

  • Maintain the status quo: It has been said that exempting or indemnifying a director against liability effectively reduces the standards required of them. Equally, however, unrealistically high standards may reduce the willingness of the most able and well-intentioned people to act as directors. The issue is therefore whether the current law draws the right balance between these competing concerns.
  • Limited changes, without radical reform: This would involve a number of the specific changes proposed by the CLR, including:
    • restricting the s.310 prohibition to specific duties owed by the director to his or her company;
    • clarifying that the s.310 prohibition only prevents indemnification or exemption by the company itself, and not by (e.g.) a holding company, another group company, or a third party (there being some uncertainty about this at present);
    • permitting indemnification in advance against the cost of defending proceedings (at present, indemnification is permitted only after a judgment exonerating the director) - this would be subject to subsequent reimbursement by the director if found guilty, and could also include a requirement in advance to establish sufficient prospects of success;
    • permitting indemnification of a reasonable bona fide excess of loss under a D&O policy;
    • broadening the available scope of relief under section 727 of the Companies Act 1985, to enable the Court to excuse the director from liability in a wider range of situations, where the particular circumstances of the case justify that result.
  • More radical reform, based on the US model: Under US law, the honest director has much greater legal protection - although that is balanced against the significantly greater litigious nature of business life in the US. A number of particular features of US law are, however, canvassed for consideration:
    • a specific 'business judgment rule', whereby the Court looks only to whether the directors involved in a decision were disinterested in the matter, appropriately informed in advance, and acted with a good faith belief that the decision was in the best interests of the company - this needs to be balanced against the simpler and more flexible approach adopted by the English Courts, which already recognises, at least in principle, the need to respect potentially complex commercial decisions;
    • the possibility of excluding or limiting specific types of liability altogether, subject to certain procedural requirements;
    • much greater opportunity for the company to indemnify the director against liabilities to third parties, and to advance defence costs prior to any final determination.

Patricia Hewitt is on record as saying: ‘We do not want regulations that are so stringent, complex or unclear that honest, capable people are put off being directors… Equally the law must be firm and robust to deal fairly with cases where something has gone wrong.’ In an era of increasing concern about corporate governance, we will be keeping an eye on the Government’s next move in response to this consultation exercise. 

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.

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