Australia: Is Your D&O Coverage Up To Scratch?

While the need for directors' and officers' insurance ("D&O") is well understood, there's less understanding of some common problems in ensuring adequate coverage. In this article we'll look at recent cases which clarified liability for defence costs, and allocation of losses where a claim involves both insured and uninsured losses. In the next edition of LDR Insights we'll consider the special issue of the advance payment of defence costs.

In Vero Insurance Limited v Baycorp Advantage Limited [2004] NSWCA 390, the NSW Court of Appeal affirmed the trial judge's decision in holding that the insurer was liable for defence costs incurred in the joint representation of the company, Baycorp Advantage Limited (which was not insured for its own defence costs), and the directors in proceedings against both in the Supreme Court of Victoria ("Proceedings"). However, the Court of Appeal did find that the insurer was not liable to indemnify Baycorp in respect of the sum of $10 million which was paid to settle the Proceedings

The primary proceedings involved a claim against Baycorp and certain of its directors. The directors made a claim under a D&O policy issued by Vero in respect of the primary proceedings. The insurer denied indemnity in respect of the claim by the directors for payment of:

• the defence costs that had been incurred in the primary proceedings which benefited both the directors who were insured under the policy and Baycorp which was not insured under the policy. The defence costs were significant being in the order of $7 million; and
• the settlement sum of $10 million paid in respect of settlement of the primary proceedings.

The trial judge had found that the D&O insurer was liable for all of the defence costs and settlement sum even though it was clear that the claim involved uninsured claims against Baycorp and Baycorp had also benefited from defence costs and settlement.

Liability for defence costs

On this issue, the Court of Appeal was in agreement with the trial judge who found that the:

• The definition of "Defence Costs" under the D&O policy neither referred to costs incurred solely in defending, investigating or monitoring a claim nor did the D&O policy contain an exclusion for costs from which a party other than the insured benefited.
• The language of the D&O policy was expansive and inclusive and the insurer was required to pay "all" reasonable legal and expert fees, costs, charges and expenses.
• The Court was not warranted in importing the words "solely and exclusively" into the definition of "Defence Costs" which would have clarified that only certain costs attributable to the defence of an insured only would be recoverable from the insurer.

The Court of Appeal also supported the primary judge's finding that Claims Condition 6 of the D&O policy was unenforceable. Claims Condition 6 was an "allocation clause", which purported to allocate loss by way of a "fair and proper allocation" where a claim involved both inured and uninsured losses. The Court held that the clause was void for uncertainty as an agreement to agree. This was because there were no machinery provisions for determination of "a fair and proper allocation" or for referring the matter to a third party in the event of a disagreement between the parties as to appropriate allocation.

Liability for the settlement sum

The Court of Appeal held that the directors of Baycorp had no liability in respect of payment of the settlement moneys under clause 2.1 of the Settlement Deed. In this connection, the Deed relevantly provided:

"Baycorp Advantage on behalf of itself and each of the other defendants in the proceedings (which included the directors of Baycorp) … will pay Killorgan and Mr Price ("the plaintiffs"):

(a) $6,900,000 in respect of the claims under the Modification Agreement; (b) $300,000 in respect of the dismissal action;

(c) $600,000 in respect of the defamation action; and

(d) $2,200,000 in respect of the costs including the reserved costs and the costs orders,

in full and final settlement of the proceedings and the disputes, inclusive of costs ("payments")."

Under the Policy, the insurer's liability to indemnify an insured person was triggered by a "loss", which was defined as the "amount (whether determined by judgment or settlement) which an insured person (i.e. a director) is legally liable to pay in respect of a Claim and includes damages, interests and claimant's costs and expenses; [and] defence costs".

The trial judge considered that the Settlement Deed imposed a joint and several liability on each of the defendants to the proceedings (ie. Baycorp and the relevant directors) and as such this liability was sufficient to fall within the definition of "loss" under the Policy.

However the difficulty highlighted by the Court of Appeal was that on a strict reading of the wording of clause 2.1 of the Settlement Deed, it did not contain an express promise by the directors to pay the $10 million sum and further that the Settlement Deed, when read as a whole, did not impose joint and several liability on the directors for the $10 million, either expressly or impliedly. Accordingly, there was no "loss" as defined under the policy, and as a result the Court found that Vero was not liable to indemnify the directors for the settlement payment.

Lessons learned

Accordingly there is a fundamental message in this for insurers that they need to carefully review their allocation clauses to ensure that they provide a clear mechanism for resolution of allocation issues. In addition, this case highlights the need for a clear agreement to be reached between insurers and their insured regarding their respective liabilities prior to the settlement of a claim involving both insured losses and uninsured losses.

Payment of defence costs for commissions of inquiry

In a recent case, the Victorian Court of Appeal in the matter of Intergraph Best (Vic) Pty Ltd & Ors v QBE Insurance Limited (2005) 13 ANZ Insurance Cases 61:653 considered whether a company was entitled to indemnity under a D&O policy for defence costs expended by the company on behalf of its directors and officers who attended before a Royal Commission.

Intergraph Best (Vic) Pty Ltd was responsible for the call system for the Metropolitan Ambulance Service in the years prior to 1999. Intergraph and certain of its current and former directors and employees were the subject of an investigation at a Royal Commission or were otherwise required to attend to give evidence before the Commissioner. The Royal Commission was investigating whether or not Intergraph had engaged in illegal or improper conduct for the purposes of enabling the company to meet certain customer standards or increase the company's entitlements under its contract.

Intergraph incurred just over $5M in respect of legal costs paid by Intergraph for the legal representation of the directors and officers before the Royal Commission. The directors and officers incurred no personal liability in respect of such costs. In addition, there was no indemnity provided by Intergraph to the directors and officers pursuant to which the payment of these legal costs was made. Intergraph sought reimbursement of those legal costs under a D&O policy which was issued by QBE Insurance Limited to Intergraph.

QBE denied liability to Intergraph under the D&O policy on the basis that the legal costs paid by Intergraph were not incurred by the directors and officers of Intergraph and therefore the D&O policy did not respond. Intergraph commenced proceedings against QBE and Justice Habersberger of the Supreme Court of Victoria found that the QBE policy did respond and QBE was liable to indemnify Intergraph in respect of the $5M in legal costs incurred on behalf of the directors and officers. QBE appealed that decision.

Relevantly the Court of Appeal was confronted with the following question which related to the application of the extension for coverage of Defence Costs incurred in respect of investigations or hearings (clause 2.3 of the policy):

"Does Clause 2.3 of the D&O Policy provide an indemnity to Intergraph in circumstances where:

• Insured Persons (as defined in the D&O policy) were legally compelled to attend a Royal Commission relating to the Metropolitan Ambulance Service ("Royal Commission");
• Those Insured Persons did not incur Defence Costs (as defined in the D&O policy);
• Intergraph incurred Defence Costs arising out of the legally compellable attendance of those Insured Persons at the Royal Commission?"

Notably, clause 2.3 provided:

"2.3 QBE agrees to pay Defence Costs arising out of any legally compellable attendance by an Insured Person at any official investigation, examination or inquiry in relation to the affairs of the Corporation where such investigation, examination or inquiry may lead to a recommendation in respect of civil or criminal liability or civil or criminal proceedings and which would be the subject of a Claim under this Policy…"

QBE contended that the preamble to the part of the policy in which clause 2.3 appeared provided that each extension was subject to the insuring clause, conditions, definitions and exclusions in the policy. Accordingly, clause 2.3 was to be construed so that it conformed to the classes of a cover provided by the D&O policy. Defence Costs incurred by Intergraph, in respect of which the relevant directors and officers were not personally liable, did not fall within the classes of cover provided by the insuring clauses.

By section 1 of the policy QBE provided indemnity in respect of the directors' and officers' liability in two primary circumstances:

"1.1 QBE shall pay on behalf of each Insured Person (i.e. the directors and officers) all Loss for which the Insured Person is not indemnified by the Corporation (i.e. Intergraph) arising from any Claim first made against such Insured Person, individually or otherwise, during the Period of Cover, and which is notified to QBE during the Period of Cover.

1.2 QBE shall pay on behalf of the Corporation all Loss for which the Corporation grants indemnification to an Insured Person, as permitted or required by law, arising from any claim first made against such Insured Person, individually or otherwise, during the Period of Cover, and which is notified to QBE during the Period of Cover".

The term "Loss" included Defence Costs. QBE submitted that both of these insuring clauses required an liability on the part of the directors/officers of Intergraph for the Defence Costs. As the Defence Costs had not been paid by the directors/officers, but by Intergraph it could only recover them pursuant to clause 1.2 if it paid the legal costs pursuant to an indemnity given by Intergraph to the directors/officers. It was submitted by QBE that the construction adopted by the trial judge would have the effect that clause 2.3 provides direct cover to Intergraph and not the directors and officers of Intergraph which is at odds with the overall structure of the D&O policy. QBE asserted that the question really turned on whether the Defence Costs extension was an entirely new category of cover such that it was not restricted by having to conform to either of the insuring clauses before entitling Intergraph to payment.

In contrast, Intergraph contended that clause 2.3 did not stipulate that the Defence Costs be paid by the directors and officers or on their behalf by way of an indemnity from Intergraph. In other words, the obligation of QBE to pay Defence Costs stood alone on the terms of the clause, was not referable to the application of the insuring clauses, and it was a separate and distinct cover.

The Court of Appeal highlighted the acceptance by both parties that the relevant costs in issue did not fall within the categories of risk covered by either of the two insuring clauses and as a result it was only if extension 2.3 was sufficient to embrace the claim in its own right that Intergraph's request for indemnity could succeed.

The Court of Appeal took the view that "the object of clause 2.3 is to extend the cover provided by the two primary insuring clauses to circumstances anterior to a claim against a director and officer by covering preliminary official inquiries". It considered that this did not transform the policy into one which offers an entirely new category of cover, namely to cover Intergraph with respect to loss which does not arise out of a legal obligation owed to the directors/officers. The preamble to the extensions in the D&O policy including clause 2.3 makes it clear that the extensions are subject to the insuring clauses unless otherwise stated and clause 2.3 was an extension of the cover provided by clauses 1.1 and 1.2. The Court of Appeal concluded that the extension operated within the framework of the insuring clauses and it did not provide for an entirely new category of risk, namely a risk independent of loss founded in the legal obligations of the directors/officers.

Accordingly Intergraph was not entitled to indemnity from Vero in respect of the legal costs it had paid on behalf of its directors/officers.

Lessons learned

For corporate insureds the importance of establishing an indemnity arrangement between the company and the relevant directors and officers cannot be stressed enough. In order to activate the company reimbursement insuring clause in most D&O policies, any payment by the company on behalf of it directors or officers needs to be made pursuant to such an indemnity and there should be a clear records trail to establish that the payment is made on that basis.

The issue of allocation of legal defence costs was considered in the Baycorp case. Defence costs were expended by Baycorp on behalf of both the company and its directors in the defence of proceedings. However only the directors were insured under the D&O policy. The loose wording in the insurer's policy with respect to allocating defence costs between the insured directors and the uninsured company resulted in the NSW Court of Appeal determining that the insurer was liable for all defence costs. This case highlights the need for clear agreement to be reached between the insurers and the insured regarding their respective liabilities for defence costs.

Finally the decision in the Intergraph case simply confirms the importance of documenting indemnity arrangements between a company and its directors and officers. In order to activate the company reimbursement insuring clause an obtain recovery under most D&O policies, any payment by the company on behalf of its directors/officers needs to be made pursuant to such an indemnity.

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.