Legal Briefing

Protecting a company and its directors: D&O insurance

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Insurance | 01 December 2010

The upheaval over the Past few years in the financial markets and the global economy has led to a climate of increased regulation worldwide, with greater exposures for directors and the companies by which they are employed. All of this has highlighted the importance for companies to have adequate insurance protection. Directors’ and officers’ (D&O) insurance is one such policy.

D&O cover protects a director or officer against those potentially significant personal liabilities that may arise from their negligence and breach of duty when acting in their capacity as a director or officer. It is also important to attract high-calibre personnel who may otherwise be wary of taking such positions, particularly for large multinational companies exposed to multijurisdictional regulation and legal systems. However, D&O insurance also protects the company’s balance sheet in various ways.

Structure of a D&O policy

D&O policies provide cover for directors and also companies who indemnify directors and officers to the extent permissible by law.

Traditionally, there is what is known as ‘Side A’ cover, which insures directors and officers for defence costs and liability exposures where they are not entitled to an indemnification from their company for such exposures. A typical example of where a company is not entitled to indemnify a director is where the company itself is bringing a claim against that director. There is usually no deductible attaching to Side A cover.

‘Side B’ cover exists for the benefit of a company to recoup the money it has paid by way of indemnifying the defence costs or liabilities of a director or officer. The Companies Act 2006 (the 2006 Act) sets out the extent that a director is permitted to indemnify a director or officer. There is also ‘Side C’, or entity cover, whereby cover is extended to the insured entity for claims brought against the company itself. Deductibles apply here.

While D&O insurance generally covers the liabilities of directors and officers to third parties, subject to the terms of the cover agreed, there is no legal basis why it cannot also cover directors’ and officers’ liabilities to the company itself. This is an important issue in today’s economic climate where directors may be binding their companies to liabilities where they are either acting vicariously or outside of their authority.

D&O exposures

While the US has a litigious claims culture, that in recent years has led to a significant number of claims against directors and officers, other jurisdictions, such as the UK and EU, are not as litigious and so have seen fewer D&O claims. Primarily, claims in the EU and UK against directors and officers have been brought by regulatory investigations or prosecutions, as opposed to shareholder derivative actions or third party liability claims. In several EU jurisdictions, D&O insurance is relatively novel, although as awareness of its availability grows so does the uptake. Should the level of D&O claims increase in these jurisdictions, insurers may be inclined to test the validity and scope of D&O cover in the local courts.

In the UK, exposures have recently increased for directors and officers following the enactment or implementation of legislation such as the 2006 Act, the Environmental Liability Directive (ELD) 2009, the Corporate Manslaughter and Corporate Homicide Act 2007, the Extradition Act 2003, and, more recently, the Bribery Act 2010.

Directors’ duties

On 1 October 2007, the 2006 Act codified and/or extended directors’ duties. The majority of the duties incorporated into the 2006 Act already existed at common law. The new duties included a duty to act in good faith to promote the success of the company; to act in accordance with the constitution of the company and to exercise powers for purposes conferred by the company’s memorandum and articles of association; to exercise independent judgment; and to exercise reasonable skill, care and diligence.

From 1 October 2008, certain additional directors’ duties were codified under the 2006 Act, including a duty to avoid conflicts of interest, be they direct or indirect (although there are provisions for such conflicts to be authorised); a duty not to accept benefits from third parties; and a duty to declare an interest (direct or indirect) in proposed transactions or arrangements.

Environmental exposures

One of the duties of directors under the 2006 Act represents a departure from the common law: the director’s duty to promote the success of the company. In meeting this duty, the 2006 Act identifies six factors to which a director must have regard, one of which is the effect of the company’s operations on the community and the environment. Directors face both indirect and direct risks from the impact their decisions may have on the environment. Indirect risk, for example, from shareholder derivative actions, as set out under the 2006 Act, arise not only from breaches of a director’s duty to their company, but also from their negligence in performing their job and any default.

Shareholders’ awareness is heightened by the 2006 Act’s requirement for extensive reporting. Companies are to produce an expanded business review that keeps members informed of the company’s operations and quoted companies must specifically include information on environmental matters. Direct risks are faced from statutes imposing liabilities on directors, for example the Environmental Protection Act 1990.

In a world where there is increasing global pressure on the implementation of carbon emission-reducing strategies, as well as environmental legislation aimed at reducing pollution and environmental hazards, the duty imposed by the 2006 Act increases the pressure on directors to pay due regard to environmental matters in decisions in the boardroom. Moreover, the ELD 2009 potentially introduces significant exposures to companies as it looks to reinforce the ‘polluter pays’ principle. The introduction of ELD 2009 comes on the back of legislation such as the Waste Electrical and Electronic Equipment Directive that came into force in January 2007. Directors should therefore pay more than lip service to the environmental effect their decisions and the strategies they agree on may have.

Corporate Manslaughter and Corporate Homicide Act 2007

The Corporate Manslaughter and Corporate Homicide Act 2007 (the 2007 Act) was introduced to make it easier for authorities to successfully prosecute larger organisations where a corporate management failing has fatal consequences. The new test that was brought in by the 2007 Act – that of a substantial senior management contribution to the company’s breach of duty – has focused the attention on decisions made by senior management.

Although it provides that there is no individual liability for corporate manslaughter, the investigators’ evidential focus on senior management has increased pressure for parallel health and safety charges to be brought against individual directors and managers. Directors convicted for health and safety offences will also be liable to fines and possibly disqualification as company directors.

New duties and personal liabilities of Senior Accounting Officers

The duties of senior accounting officers (SAOs) were incorporated into the Finance Act 2009 (the 2009 Act) that was enacted on 21 July 2009. In short, SAOs of qualifying companies are required to take ‘reasonable steps’ to ensure that the company establishes and maintains appropriate tax accounting arrangements, and to identify any respects in which those arrangements are not appropriate to tax accounting arrangements.

The 2009 Act envisages that the SAO will be the director or officer with overall responsibility for the company’s financial arrangements. This is likely to be the finance director. Qualifying companies are UK-incorporated companies whose results in the preceding year, either alone or aggregated with other UK companies in the same group, exceed turnover of £200m or gross balance sheet assets of £2bn.

Bribery Act 2010

Parts of the Bribery Act 2010 (the 2010 Act) came into force in the UK in April and bring English law in line with some other jurisdictions, such as the US where the Foreign Corrupt Practices Act 1977 has been in force for some time. The 2010 Act’s aim is to provide robust measures to prevent bribery in both the public and private sectors.

Penalties for individuals under the 2010 Act include imprisonment for up to ten years and an unlimited fine. Companies can incur an unlimited fine, debarment from public contracts and a confiscation order under the Proceeds of Crime Act 2002. The 2010 Act could result in clarity, where there has been some uncertainty under the laws of agency in so far as the agent exceeds or breaches its authority and the relevant knowledge of the principal in this respect.

The 2010 Act also introduces a statutory defence to bribery by showing that there were adequate anti-corruption systems in place.

Commercial organisations with an international dimension and those operating in high-risk markets need to ensure that they have effective risk management systems in place to prevent engaging in bribery. The 2010 Act could affect securing D&O policies, as well as coverage being denied under policies such as trade credit and political risk cover since, for example, paying bribes to secure contracts could be considered as moral hazard material to the risk, which in case of non-disclosure, investigation or sanctions by the authorities, might result in the policies being voided. This is, of course, in addition to the criminal sanctions imposed by the 2010 Act, which will affect the individual or the company concerned separately.

Derivative actions

The economic downturn has led to an increase in speculation of likely investor and shareholder action. While this may be true for the US, what about in England and Wales or wider Europe? There have been calls for the introduction of a class action system but what form, if any, will it take? US commentators warn of the effect their class action system has on US industry, not to mention the insurance market.

There are, however, considerable hurdles that will need to be overcome to implement a class action system, whether similar to that in the US or not. In Europe, for example, there are potentially significant changes required to legal systems that currently differ considerably. Given the importance of this to the insurance market it will be essential to monitor the debate and any action taken as a result, whether by the European Commission or the Lord Chancellor. When the provisions as to director’s duties and shareholder derivative actions set out in the 2006 Act took effect on 1 October 2007, there was a fear that the floodgates would open on claims against directors. So far, however, the safeguards in the 2006 Act for shareholder claims appear to be working, principally due to the strict approach adopted by the courts. If, as many suggest, there is to be an increase in investor and shareholder litigation it will be interesting to monitor the courts’ approach to shareholder derivative claims.

D&O insurance: protecting a company’s balance sheet

A company may also indirectly benefit from D&O cover. For example, where the company itself has suffered losses as a result of the directors acting beyond the scope of their authority or where it is vicariously liable to third parties by reason of the actions of its directors. This issue arose in Safeway Stores Ltd v Twigger & ors [2010], which is currently the subject of an appeal.

Safeway was the first instance decision of a strike-out application brought by eight former employees of Safeway Stores, including a former chairperson (the defendants). Safeway commenced proceedings against the defendants for breach of employment contracts, breach of fiduciary duties and negligence in an attempt to recover the amount of a fine/penalty levied against it by the Office of Fair Trading (OFT), following Safeway’s admitted breaches of the Competition Act 1998 (the 1998 Act). In addition, Safeway sought its costs, including the legal costs of the OFT’s investigation, that culminated in Safeway’s admission. Flaux J decided:

  1. The underlying breach by Safeway was an action to which the ex turpi causa doctrine could apply. If so held, Safeway could not rely on its own illegal or unlawful act to maintain the action against the defendants. While the penalty or fine was not a criminal penalty it had many characteristics of a fine imposed for commission of a criminal offence.
  2. Safeway had a real prospect of defeating any defence based on ex turpi causa at trial, on the basis that its liability was not primary or direct but vicarious in nature. Safeway had not approved and condoned the underlying acts of its employees.
  3. There was clear authority for the principle that a fine or penalty was recoverable against another where the claimant was not negligent or personally at fault.
  4. It also did not follow from the 1998 Act that individuals could not owe a company duties on normal common law principles to ensure that the company complied with its statutory obligations.

This judgment has serious consequences for directors and their D&O insurers. Normally such insurance would not provide cover for fines and penalties. However, in Safeway the penalty or fine was not levied against the defendants directly and so cover is likely to apply.

Comment

Insurance is an important tool for risk managers to transfer risks from the companies’ balance sheets to insurers. D&O insurance adds an important dimension as it is helps attract high-calibre directors and officers to roles in a corporate world that is the target of increased regulation. For the company, D&O insurance also provides routes for reimbursement for their indemnification of directors and officers, but also indemnity in respect of the directors’ and officers’ wrongful actions causing losses to the company itself.

By Costas Frangeskides, insurance partner, Holman Fenwick Willan.

E-mail: costas.frangeskides@hfw.com.