Nearly a year to the day after the Court of Appeal, in Steigrad v BFSL 2007 Ltd [2012] NZCA 604, gave insured directors a Christmas present, the Supreme Court has played Scrooge for directors and Santa for liquidators and receivers of, and investors in, failed finance companies to recover losses by pursuing directors of those companies for breaches of their directors' duties and also for breaches of the Securities Act 1978.

On 23 December 2013 the Supreme Court released its decision in BFSL 2007 Ltd (in liquidation) v Steigrad [2013] NZSC 156 where, by a three-two majority, the Court reversed the decision of the Court of Appeal. In doing so the Supreme Court has effectively 'cut-across' the terms of a large number of directors' and officers' liability policies held by directors and prevented them from accessing costs to defend claims where the amount claimed exceeds the policy limit.

What was the case about?

The decision dealt with two separate cases which were consolidated in the Court of Appeal. The first involved a claim by the liquidators of Bridgecorp and associated entities against its directors; the second was an application brought by the former directors of Felxtex Carpets Ltd in the class action suit brought against them by investors. Both cases dealt with the same issue, namely the application of section 9(1) of the Law Reform Act 1936 to directors' and officers' liability policies.

Section 9(1) of the Law Reform Act 1936 creates a "charge in favour of [a] third party over any insurance money "that is or may become payable" in respect of the insured's liability to the third party" (paragraph [15] of the Court of Appeal judgment). In simpler terms, it means where third parties suffer loss caused by an insured, and the insured has insurance to cover the loss suffered by the third party, then the third party has a 'charge' over the insurance moneys paid. The obvious example is where person A has third party car insurance and causes an accident that damages B's car. In that case, B has a charge over the money paid out under the third party policy; that means B has a claim to those proceeds ahead of any of A's other creditors.

What did the Court decide?

The question confronting the Court in the two cases dealt with in Steigrad was how section 9(1) works where directors have a policy that covers both the liability of directors to third parties for losses caused by breach of their directors' duties and by breach of the Securities Act 1978 and associated defence costs, up to a specified limit and the level of the claim exceeds that limit. In both cases there was a single cap on the directors and officers policies held by the directors; the effect of that was that any defence costs taken by the directors in defending the claims against them would reduce the amounts available from the insurance to payout for any losses suffered by the investors.

As the majority (Elias CJ and Glazebrook J in a joint judgment, concurred with by Anderson J) succinctly put it at paragraph [1]:

[t]he issue in these appeals is the nature and effect of [the section 9(1)] charge and in particular:

(a) whether the charge secures whatever is eventually held to be the full amount of the insured's liability to the third party claimant (subject to any insurance policy limit), with no payments under the policy able to be made that would deplete the insurance money available to meet the third party claim if it is established; or

(b) whether the charge secures the insurance money that remains at the time of judgment on, or settlement of, the third party claim against the insured, allowing in the meantime the payments of other sums that fall for payment under the policy, even if that depletes the sum available to meet the third party claim.

The majority, having analysed the text, legislative history and general policy arguments favoured the first option. The minority (McGrath and Gault JJ with reasons by McGrath J) having undertaken the same exercise favoured the second option. It is understandable that directors covered by similar policies might ask why, and what the consequences for them are?

The approach of the majority

The majority focused on a number of different aspects of section 9. First, the majority considered that section 9(1) operated so that the charge over the insurance proceeds arose immediately on the event giving rise to the claim between the third party and insured. They further considered that (at paragraph [34]):

[u]nder s9(1) the charge attaches not only to insurance money that is payable but also to insurance money that "may become payable in respect of that liability." It also arises "notwithstanding that the amount of such liability may not then have been determined." Section 9(1) therefore recognises that, on the happening of the event giving rise to the claim for damages or compensation, the amount of the liability to the third party may not yet be ascertained .

Second, the view of the majority was that the scheme of section 9 and, in particular, the provisions of section 9(3), provided priority to the charge generated in favour of the third party over other priorities and also over "any contractual provisions as to priority of claims" (paragraph [42]). In other words, even though the insurance policy provided for amounts to be used to meet liability to the third party or to meet other liabilities (such as defence costs) the effect of section 9(3) was to over-ride the contract and create a charge over the whole amount available under the policy in favour of the third party.

Finally, the majority placed emphasis on the effect of section 9(6). Section 9(6) sets out that payment by an insurer under the contract of insurance without notice of the existence of the charge will be a valid discharge. The majority considered that if payments under the insurance contract could be made with "impunity" then there would be no need for section 9(6); accordingly, it pointed towards an interpretation of section 9(1) that saw the charge descend over all sums available under the policy.

A number of competing rationale were offered for this result. A particular focus of the majority was on how any other result would effectively see the successful party in a proceeding – the third party – bear the costs of the unsuccessful party because the amount available to meet the claim would be reduced by the deduction of defence costs (see paragraphs [52] and paragraph [107]). Further, the majority felt that the legislative history of this section – which replaced and made of general application similar provisions in the Workers' Compensation Act 1922 and the Motor-vehicles Insurance (Third-party Risks) Act 1928 – supported this approach. That is because (at paragraph [99]):

given the link to human suffering and also the social cost of injury or death, it may be thought that the protection of the claimant with regard to insurance money was paramount. That uncharged claims such as defence costs) could diminish the money available for injured persons would, it might be thought, not fit in with this policy aim.

Further, the majority considered that the general policy considerations in this area pointed towards this outcome as desirable; they did not accept that their approach would inhibit access to justice.

The approach of the minority

In contrast, the approach of the minority was to focus on the plain wording of the section and – in particular – section 9(1). They considered the wording "a charge on all insurance money that is or may become payable in respect of that liability" as crucial and concluded that (at paragraph [168]) "[t]he charge does not attach to "all insurance money that is or may become payable" under the terms of the policy, but only to that insurance money that can be said to be payable 'in respect of' the insured's liability to pay damages or compensation."

In arriving at this conclusion, the minority analysed the text of section 9 in light of its purpose. They viewed the purpose as narrower than that favoured by the majority (at paragraph [173]):

[t]he purpose of s9 was to provide a mechanism to ensure that the money that would otherwise be paid to the insured was instead made available to claimants and not dissipated by the insured or paid to its general creditors. The legislative history gives no indication of a wider protective concern that would further intrude on the contractual rights of the insurer and insured under the policy.

Further, the minority considered that the statutory context of section 9 supported this approach. They did not consider that in order to give effect to section 9(6) – providing that payments made by an insured without notice of a charge were a valid discharge – the inverse, that all payments made with notice were not a valid discharge, needed to be true (see paragraph [177]). Further, section 9(3) which provided for priority over other charges was not read so as to encompass differing contractual entitlements which are not 'charges' (see paragraph [180]). As the minority succinctly put it, section (3) gives priority over the secured interests of creditors and prevents the insurer making payments for subsequent liabilities, but it does not "prevent the insurer from making payments to meet other obligations under the policy" (paragraph [181]).

What does this mean and what should directors do?

The effect of the decision is clear; where a claim is made against directors, and amount claimed exceeds the policy limit, then if the insurer makes payments of defence costs it will be doing so 'at its own risk'. Clearly, then, unless the claim is considered spurious or the amount claimed for inflated, directors may be left to fund their own defence costs.

What is less clear is whether the majority decision is correct. It seems a peculiar result that legislation originally designed to protect those involved in personal injury claims by giving them priority over creditors in situations of insolvency (as noted by the minority) should now be used to interrupt the allocation of risk in insurance contracts of a very different nature. Further, the majority did not adequately deal with the key words inn section 9(1) – "in respect of that liability" – adequately. Instead, the focus appeared to be on avoiding an outcome that saw the third party effectively bear the costs of the defence by a reduction in the amount available under the insurance.

That concern, however, pre-supposes that the third party was entitled to the full amount available under the insurance and the argument is somewhat circular – section 9(1) allows the third party access to all sums under the cover (even when the contract allows for the funds to be used for other purposes) because the third party is entitled to all sums under the policy. Further, it does not marry well with the clear position that a third party cannot, by virtue of section 9, be in a better position than the insured under the contract. However, that is effectively what the majority is allowing by cutting across the contract entered into. Nevertheless, directors can take comfort from the suggestion of the majority, at paragraph [111], that lawyers might be prepare to act on a contingency basis and that "an insurer may well have an incentive to fund a good defence out of its own funds as that would reduce the insurer's exposure under the policy."

Beyond relying on the good favour of lawyers and insurers, what should directors do? First, they need to reassess their cover and speak with their brokers about having two directors' and officers' policies – one for defence costs, and the other for any liability actually owed to third parties. For those with claims under way, they need to have immediate discussions with their insurers around how defence costs will be met.

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.