UK: Directors’ and Officers’ Liability Insurance: Problems and Pitfalls

This article was previously published by The In-House Lawyer.

ONE OF THE PURPOSES OF INCORPORATION is to absorb and contain liability within the corporate shell: the so-called corporate veil, behind which directors used to feel reasonably safe. However, a director can in certain circumstances be personally liable to the company, its liquidator, its shareholders, third parties and any of its regulators, such as the Financial Services Authority (FSA), Health and Safety Executive, Information Commissioner, Pensions Regulator or Office of Fair Trading. Directors may also incur considerable expense in defending claims, investigations or even extradition and, in addition to the recent potential extension of litigation by derivative action, may face claims arising out of the tougher regulation brought into force as a result of the recession.¹ Even when the director is convinced that the allegations made are completely unfounded, the costs of defending their position can be extremely high, a fact gruesomely appreciated by the departed directors of Equitable Life prior to the abandonment of all claims against them by the incoming board, apparently after £20m in defence costs are rumoured to have been incurred.² The usual methods of personal protection for a director are company indemnity and directors' and officers' liability insurance (D&O).

INDEMNITIES FROM THE COMPANY

Section 232 of the Companies Act (CA) 2006 allows companies³ to protect directors by indemnifying⁴ them in respect of actions brought by third parties,⁵ covering both legal costs and the financial cost of any adverse judgment in a civil action even where the directors are found to have committed a breach (in the absence of any morally culpable behaviour such as dishonesty). Companies are also permitted to pay directors' defence costs as they are incurred (or provide directors with the funds to do so) in other types of action, including criminal cases and even claims brought by the company against the director (although any costs advanced would have to be repaid in non-third party actions if the director were unsuccessful in their defence or their application for relief was refused by the court).⁶ This widening of the company's powers to indemnify reflects the usual D&O policy terms, although the standard 'insured v insured' exclusion of any costs or damages arising out of a claim brought by the company (however acting) against a director will probably continue not to be covered. CA 2006 does not permit the indemnity from the company to cover legal costs for the unsuccessful defence of criminal proceedings or fines imposed in criminal proceedings or penalties imposed by regulatory authorities.⁷

A director should always ensure that they have both an agreement to indemnify and access to D&O cover because the two are complementary. All D&O policies have exclusions that might otherwise be included within an indemnity. In particular the cost of cover against actions in the US is prohibitive and cover for prospectus liability is often difficult to obtain. Equally, D&O cover protects directors in the event of the insolvency of the company, when any such indemnity might have less value, and of course removes the actual costs of the indemnity and the risk that a payment to a director may be considerably higher than anticipated when the agreement to indemnify is formed. The presence of differing potential interests and differing insurable interests can give rise to problems of program structure and of content. In terms of policy wordings the definitions, exclusions and particularly the formulation of the insured v insured exclusion require considerable care. A D&O policy wording is one of the most complex and intricate on the market. Nevertheless, it would be a brave director who would choose not to have such cover, given the current and likely future climate in which directors will operate.

NATURE AND EXTENT OF D&O COVERAGE

D&O coverage is generally available to past, present, future, shadow, outside, non-executive, retired or resigned directors, and to their spouses, heirs and estates. It is also available to employees if acting in a managerial capacity or joined as co-defendant with a director. In essence D&O cover usually provides that:

• the insurer will pay all sums that a director is legally and personally obliged to pay in respect of a wrongful act, to the extent not otherwise indemnified by the company (known as 'side A' coverage, usually without a deductible); or
• the insurer will reimburse the company in respect of sums it has paid the director in respect of a wrongful act (known as 'side B' coverage, usually with a deductible).

The key elements for indemnification by insurers are:

• a wrongful act;
• a loss;
• a claim; and
• defence costs.

A wrongful act encompasses any actual or alleged error, mis-statement, misleading statement, act, omission, neglect, or breach of duty by reason of that director's actual or deemed capacity as a director. A loss will include damages, judgments, settlements and defence costs and, depending on the wording and facts, may include civil fines and penalties but will not include matters uninsurable. A claim encompasses any suit or proceeding against an insured party, a written demand evidencing an intention to hold an insured responsible for a wrongful act, a criminal prosecution, and, usually, administrative or regulatory proceedings. Defence costs encompass those reasonable and necessary fees, costs and expenses incurred as a result of an investigation, adjustment, defence or appeal of any claim, usually with the insurer's consent.

KEY AREAS TO WATCH

One Contract, Many Parts

The policy should be composite and not joint. Each director needs to have a separate interest in the insurance, which would not be tainted by the fraud or misconduct of another director, for themselves or for the company. This is the default position for D&O policies (see Arab Bank Plc v Zurich Insurance Co [1999] 1 Lloyd's Rep 262). Most policies state this fact expressly, and should do so especially where the company is also an insured under side B coverage. However, the rights of a director may arguably be affected where an agent obtaining the insurance on behalf of the director (such as the company or the company's broker) taints the insurance by breach of a contractual obligation or the duty of good faith. Most policies deal with this issue by containing a non-invalidation clause, whereby a non-fraudulent non-disclosure or misrepresentation of a material fact prior to the formation of the contract will not entitle the insurer to avoid the policy as against any director who is not responsible for the error or omission.⁸ Note, however, that the sum available under the insurance is the total sum available to cover all claims, rather than an amount per person, a fact that the policy usually makes clear. It is a fact of life that claims by one director will erode the insurance available to the others on a first-past-the-post basis. Directors therefore need to become comfortable with the limit of cover.

Irrevocable Insurance

The policy should not be capable of cancellation by any party except the insurer for the non-payment of premium, preferably with notice to the directors. Liquidators in particular may seek to cancel the policy with a view to maximising the company's assets. Such a provision will go some way to protecting the interests of those who have retired, resigned or are no longer directors. Some policies provide an additional period of cover for a retired director if the policy is not renewed.

Insured v Insured

An 'insured v insured' exclusion precludes cover for a director when sued by the company (if side B coverage exists, because the company is not an insured under side A coverage), sued by the liquidator (an officer of the company), or sued by a fellow director. In the past, insurers insisted on this exclusion to avoid family or factional disputes, or the creation or manipulation of insured losses, but now generally accept that cover should be provided when the action is commercially justified or at arm's length.⁹ The exclusion remains in force but is subject to carve-outs for liquidators or receivers acting for the company, shareholder derivative claims (provided that they are not brought with the participation or active solicitation of any director or officer), a claim by a former director, or an employment practice claim made by a director.

Contracts (Rights of Third Parties) Act 1999

Insurers are always concerned about the possibility that a third party might utilise the Contracts (Rights of Third Parties) Act 1999 (the 1999 Act) to enforce a right under the policy directly against the insurer. They therefore routinely exclude the provisions of this Act. The D&O policy is between the insurer and the company. The directors are insureds and intended beneficiaries of but not parties to the contract, unless specifically so defined. If the act is excluded, they will not be able to enforce it directly. The exclusion should always be deleted or reworded to enable directors to enforce the policy directly against the insurer.

Advancement and Repayment of Defence Costs

Some policies provide that insurers 'will' advance defence costs before resolution of the claim, while others state that they 'may' do so. Some require repayment in the event that the director is found guilty or liable in damages. In fact, the insurers could recover any monies advanced if the director has been found morally culpable, on the basis that no-one should benefit from their own wrong, and, additionally, if the wrongdoing falls within the dishonesty exclusion. Where the director has simply been negligent, they should not be obliged to return the defence costs, but it is advisable to make the position clear.

Coverage for Claims Made After Resignation or Retirement

A director who resigns or retires is vulnerable for a period of at least six years, during which claims may be made against them for wrongful acts that occurred prior to their departure. If the policy continues in force or is renewed or replaced, then such claims would usually be covered because cover is predicated on a claims-made basis. If the policy is not renewed, the director faces a period of uncertainty and will not be covered for claims made after such non-renewal. Some policies allow retired directors a happier (or less stressed) retirement by providing a period of additional cover at no extra cost.¹⁰ A policy will usually entitle the company to purchase a period of run-off cover at a proportion of the premium, often known as the 'discovery period'. This provides coverage for claims made after the date of expiry in respect of wrongful acts that occurred prior to expiry. It may also cover wrongful acts during the discovery period, provided that any claim is also made during this period. The option to purchase run-off cover during the discovery period applies only when the insurance is not renewed by the company, and one issue that then arises is whether the imposition of harder terms or an increased premium forcing non-renewal can amount to a non-renewal by the company. In one view, they do not because there is no renewal. A 'renewal' is in fact a fresh contract of insurance, unless a court were to decide that on a commercial and common sense basis the word 'renewal' is not intended to bear any technical, legal significance, but instead means substantially the same contract for the next period. A director would be well advised to pre-empt this issue by inserting a clause limiting any renewal to a maximum specified percentage increase of premium and on substantially the same terms as expiring, to prevent an insurer imposing additional obligations and then alleging that it is the insured who has elected not to renew.

Whoever Pays the Piper Calls the Tune

The policy usually authorises the company to act on behalf of all directors in respect of giving notice, claims or termination of the policy, the acceptance of policy amendments and the exercise of any discovery period. While such a clause makes life considerably easier for the insurer, this devolution of power is not necessarily in the interests of each director. As a working compromise, each director should have the right to separate legal representation in the event of any possible conflict, noting that the amount of coverage available will reduce exponentially should the clause be activated.

Allegations of Dishonesty

A director would not be entitled to an indemnity in respect of any fraud, dishonesty or similar morally culpable behaviour, both as a matter of common law and under s55(2)(a) of the Marine Insurance Act 1906. Usually a D&O policy will expressly state as much, requiring a judicial or arbitral finding to this effect before the exclusion will apply. Problems arise when allegations involving dishonesty are settled, because there is then no adjudication enabling insurers not to indemnify, although if an insurer were to feel sufficiently strongly it could simply refuse to pay and then try to prove that the director had been dishonest in any proceedings brought by the director against the insurer for the indemnity. The director should insist upon a clause requiring a firm finding that they had been dishonest (or reckless) and particularly that costs should be advanced until such a finding, at which point they would be repayable.

Extradition

The UK Extradition Act 2003 (and the UK-US Treaty 2003) enables a UK citizen to be extradited on request to category 2 countries where the offence in question could carry a 12-month sentence, either in the UK or the requesting state.¹¹ The US is currently the highest user of this facility, which does not require the UK court to ascertain the existence of a prima facie case but instead to verify that the process has been correctly effected.¹² The conduct on which the extradition request is based need only have affected a party in the US or taken place in the US, resulting in potential extradition to a country where the individual is not familiar with the legal system, potentially faces imprisonment in a foreign prison and will often have no automatic right to bail because they are deemed a high-risk defendant. A UK company without obvious US or foreign exposure may be able to benefit from reduced premiums by obtaining cover that excludes the US, but the far-reaching nature of the extradition treaty with the US requires a company to be very confident that it has no exposure to the US at all. Where it may have such exposure, it should not only ensure that its internal controls are robust but also that any agreement by the company or under the policy in respect of defence costs should also include defence costs relating to the extradition proceedings and any subsequent proceedings. Such coverage may also be enhanced by including the fees of a public relations firm, psychological counselling, tax advice and the premium for any bail bond. Bail costs can be substantial owing to the potential delay between extradition and any substantive trial.

Corporate Manslaughter

The Company Manslaughter and Corporate Homicide Act 2007 (the 2007 Act) now enables a company to be held fully accountable for manslaughter. The 2007 Act looks at systemic risk and any related carelessness of senior management (rather than any 'manager'), which means anyone who plays a significant role in the making of decisions about how the whole or a substantial part of the company's activities are to be managed or organised, or the actual managing or organising of the whole or a substantial part of those activities.¹³ The standard of care is objective. The 2007 Act makes the company liable and, on the face of it, would hold no implications for D&O liability insurance. However, an individual could still be prosecuted contemporaneously,¹⁴ or held liable in a civil claim,¹⁵ and may therefore wish to utilise any costs or substantive coverage available, and there may also be costs allocation implications if the company holds entity coverage. Claims for bodily injury are usually specifically excluded from cover but a director would wish to be advanced defence costs in this regard.

Pensions Trustee Liability

Parties to a breach of trust are jointly and severally liable. Under the Pensions Act 2009, the Pensions Regulator can issue a contribution notice against a company, a corporate shareholder owning one-third of the voting rights and any director where an act or failure to act has detrimentally affected, in a material way, the likelihood of benefits being paid in full in respect of a defined-benefit pension scheme.

It is rare for pension scheme trustees to be held personally liable for breach of their obligations but the risk is clearly there. In 2009 the High Court and the Pensions Ombudsman ruled that scheme trustees (including member-nominated trustees) had committed a breach of trust in authorising an unsecured loan to the sponsoring employer, rejecting the trustees' submission that the decision to advance the loan to the employer was in the best interests of the members, and in their belief that it would help to maintain the employer's status as a going concern. In circumstances involving dishonesty, matters can go beyond the Pensions Regulator to investigations by the FSA (who could take action for inadequate internal controls) or the Serious Fraud Office (SFO). D&O insurance may extend coverage to include pensions-related liability, particularly in relation to costs. If not, it may have to be insured elsewhere.

Outside Boards

A director of one company who sits on the board of another company to monitor its activities will wish to be covered for any liability arising therefrom. The director should initially ensure that their actions (or inaction) as a director of that other company are covered by its own D&O insurance, and could also extend their 'main' D&O insurance, which will usually be expressed to sit on top of the 'subsidiary' insurance. This may also be beneficial to the directors of the main company because the policy limit affecting them all will not be eroded by claims relating to the subsidiary.

Presumptive Indemnification

Some policies contain a 'presumptive indemnification' clause (in side B cover) in which the company is deemed to have indemnified its directors 'to the fullest extent permitted by law'. The director should insert a clause specifying that the insurer will indemnify them if the company should have indemnified them but has not, and that insurance payment should not be subject to any deductible.

CONCLUSION

The above discussion highlights just some of the main areas in which careful judgment should be exercised by a director, or, more usually, the company secretary overseeing cover for the board. It should be remembered that D&O policy wordings are complex and the smallest error could result in a large gap in coverage.

Footnotes

1. For example, in March 2009 Hector Sants, the chief executive of the FSA, made it clear that 'people should be very frightened of the FSA', a view endorsed on 27 April by Margaret Cole, its director of enforcement.

2. Although some costs were recovered.

3. Without obtaining shareholder approval. An 'agreement' as to any indemnity contained in the articles of association is not enforceable by the director. It must be express, and is often contained in directors' service contracts and stated to survive the contracts' expiry or termination.

4. But not exempting them from liability. Although the company can choose to indemnify its directors at any given time, it cannot agree in advance to indemnify them for negligence, breach of duty, etc.

5. Employees, investors, shareholders, creditors and regulators, but never the company.

6. Section 234(3). The risk of non-repayment of the loan will remain but, following the Higgs Review, that is the price to pay to enable a director to defend themselves adequately.

7. Section 234(3). Section 232 renders void any indemnity wider that that specifically permitted and not just the element in excess of that permitted.

8. It is thought that a principal can exclude a liability or other impact of a fraud perpetrated by their agent if clearly expressed. See HIH Casualty and General Insurance Ltd & ors v Chase Manhattan Bank & ors [2003] UKHL 6.

9. For example, a company sued for an uninsured loss could conceivably sue the director for breach of duty and thereby obtain the benefit of their D&O cover.

10. Although rarely do they define what is meant by retirement.

11. And the European arrest warrant in Europe.

12. Most famously, perhaps, of the post-Enron NatWest Three in 2006.

13. Section 1(4)(c).

14. The first prosecution under the Company Manslaughter and Corporate Homicide Act 2007 commenced on 23 April 2009. The company, Cotswold Geotechnical Holdings, is accused of corporate manslaughter following the death of an employee killed in September 2008. The company's director has also been charged with manslaughter and could face life imprisonment if convicted, and both the company and the director have been charged with breaching ss33 and 37 of the Health and Safety at Work Act 1974.

15. In the event of an successful criminal prosecution, it is easier for an injured party to sue for damages because the burden of proof in the civil case is reversed and the onus placed on the convicted defendant.

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.