Australian insurance law association geoff masel memorial lectures

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Directors’ and Officers’ Insurance and

the Global Financial Crisis

Robert Merkin

Professor of Law, University of Southampton

Consultant, Barlow, Lyde & Gilbert LLP

An economic downturn may be thought of as a situation in which the customers have stopped ordering. An economic crisis may be thought of as a situation in which the customers who never intended to pay have stopped ordering.1

The Global Financial Crisis of 2008-2009 has led to a mass of claims against directors, officers, auditors and others in a number of jurisdictions, most importantly in the United States. Claims are being brought by shareholders alleging negligence in bank lending policies, and also against companies who have bought up bank loans which have proved to be toxic. Less plausibly, but equally true, claims are being brought by debtors against creditors on the basis that, without negligence, loans would not have been made to them and they would not have incurred unaffordable liabilities. For these reasons, Directors’ & Officers’ policies have been dusted off and scrutinised. However, the present writer believes that – as with the Y2K fiasco – the insurance market is not going to find itself facing a mass of successful claims. This is so for two reasons. First, the US apart, the law is unlikely to impose liability upon directors in their personal capacities, because duties are not owed to shareholders individually or third parties dealing with the company, but only to the company itself. Secondly, even where liability is established, it is most unlikely to be covered by a D&O policy. So the substantive coverage of a D&O policy is in most cases going to prove illusory.

Underwriters are likely to face successful claims of only two types. The first is in respect of the costs of defending proceedings. D&O policies contain a variety of different provisions for defence costs: some will respond and some will not. It is interesting to note that online advertisements for D&O cover on broker and insurer sites all say how significant D&O cover is, but the examples given of coverage provided in the cases on those websites almost exclusively relate to defence costs or the costs of defending regulatory proceedings. It is also interesting to note that the cases on D&O policies (and there are many from Australia, New Zealand, Canada and England) are concerned almost exclusively with defence costs cover, and there are very few, if any, on substantive coverage. The second is an issue mainly for the London market, namely, claims against reinsurers by D&O carriers in other jurisdictions, particularly the US market. Reinsurance claims raise issues of allocation of losses between policy years, aggregation and – the last resort of the scoundrel – compliance with claims conditions.

This paper examines some of the more common problems which arise in respect of D&O claims at both the direct and the reinsurance levels.

Directors face an array of common law, equitable and statutory liabilities: many of these duties are codified or otherwise contained in the Corporations Act 2001 (Cth). The statutory duties, which give rise to civil penalties of up to $200,000 per breach as well as liability at common law or in equity (see s 185, which makes the remedies cumulative and not alternative), are as follows.
(a) Discharging duties with the degree of care and diligence that would be exercised by a director in the company’s circumstances (s 180(1))2 – a business judgment satisfies this provision if: it is made in good faith and for a proper purpose; the director does not have a personal interest in the subject matter; the director informs himself appropriately; and the director rationally believes that the judgment is in the company’s best interests (s 180(2)).

(b) Exercising powers and discharging duties in good faith in the company’s best interests and for a proper purpose (s 181). There is a criminal sanction for a dishonest or reckless director (s 184(1)).

(c) Not using his position to gain an advantage for himself or to cause detriment to the company (s 182). There is a criminal sanction for a dishonest or reckless director (s 184(2)).

(d) Not using information to gain an advantage for himself or to cause detriment to the company (s 183). There is a criminal sanction for a dishonest or reckless director (s 184(3)).

Directors also face strict criminal liability for regulatory infringements relating to the registered office, the issue of shares, making returns and complying with ASIC requirements.3 In the last decade ASIC has been particularly active in bringing regulatory proceedings – criminal, civil and disqualification – against directors for their conduct in office. A director also faces strict criminal liability for failing to disclose other directors of any material conflict of interest. Finally, there is a civil penalty under s 588G where a director permits the company to incur a debt when it is insolvent and he knows or ought to know of that insolvency.

Apart from the Corporations Act, directors may face strict criminal liability where their company has committed an offence under one or more of a battery of regulatory provisions.4 In addition, a director owes common law duties of care and skill and equitable duties: these mirror those codified in the legislation. The proper claimant in respect of these duties is the company itself (or its subsidiaries – s 187), and not, other than in exceptional circumstances, individual shareholders. That means that a harm done to the company must be remedied by an action on behalf of the company, which means that if the wrongdoers control the company a class action on behalf of the shareholders (a “derivative” action) will be necessary. The number of class actions has been increasing, and the approval of litigation funding for such actions5 is likely to see a further rise in that number.

That said, directors do not owe common law duties to creditors, employees or indeed third parties, although statutory liabilities may be incurred for infringement of regulatory or trading legislation. The common law set its face against personal liability to third parties in Williams v Natural Life Health Foods Ltd.6 Here, a director of a company negotiated with a potential franchisee and presented a very favourable view of the business and of likely future income. The franchisee was persuaded and proceeded to suffer significant losses. A claim against the director for negligence was dismissed, their Lordships holding that the director was acting on behalf of the company and had not undertaken any personal responsibility towards the franchisee – the claim was against the (insolvent) company only. The interesting point about this case, which will be referred to again later, is that the only situation in which a company director can incur personal liability to a third party is where he is acting outside his capacity as director and on his own behalf, a finding which would arguably take him outside the scope of any D&O cover that he might hold.

In this context, note should also be taken of the House of Lords’ final decision before being pensioned off as a court on 30 July 2009, Stone & Rolls Ltd v Moore Stephens.7 Here, a one-man company embezzled several millions from banks who financed fictional trading deals and paid against false bills of lading. The banks sought to recover their money, but the company and its controller were hopelessly insolvent. The liquidator, in an audacious move, commenced proceedings against the company’s auditors, alleging that they owed a duty of care to make sure that the company was not defrauding its creditors. By a 3:2 majority the House of Lords dismissed the claim, which they recognised as in effect an indirect attempt by the banks to obtain funds from the auditors’ professional indemnity insurers, a claim which could not have been brought directly because auditors do not owe duties of care to third parties. The outcome turned on the fact that the company was a one-man company, and his acts were those of the company – had there been any independent directors or shareholders, the outcome might have been different. Lord Mance, dissenting, was outraged that auditors who had allowed a “Ponzi Scheme” to flourish ought not to be able to walk away. For those who have not checked, the eponymous inspiration was one Charles Ponzi, who flourished in the US in the first half of the twentieth century and who impressively clocked up several hundred fraudulent schemes. But, as he said of his victims in mitigation, “Even if they never got anything for it, it was cheap at that price”.

The ability of a company to indemnify its directors against liability incurred by them is set out in the Corporations Act 2001, Part 2D.2

Section 199A(1) does not permit a company to exempt a director from liability to the company. Any exemption has to be by the court, under s 1318, but only where the director has acted honestly and the court considers that the director should fairly be exempted from liability.

A company may indemnify a director against liability, including liability for legal costs. However restrictions are imposed upon each possibility.

As far as general liability is concerned, s 199A(2) states that a company must not provide an indemnity in respect of :

(a) a liability owed to the company or a related body corporate;

(b) a liability for a pecuniary penalty order under s 1317G or a compensation order under ss 1317H or 1317HA;

(c)  a liability that is owed to someone other than the company or a related body corporate and did not arise out of conduct in good faith.
As far as legal costs are concerned, s 199A(3) denies the right of indemnity where the costs are incurred:
(a)  in defending or resisting proceedings in which the person is found to have a liability for which they could not be indemnified under s 199A(2);

(b) in defending or resisting criminal proceedings in which the director is found guilty; or

(c) in defending or resisting proceedings brought by ASIC or a liquidator for a court order (disqualification, oppression, civil penalties or injunction) the grounds for making the order are found by the court to have been established, although the company can provide an indemnity to cover the director’s costs incurred if the director is represented in any investigation leading up to proceedings; or

(d)  in connection with proceedings for relief to the person under this Act in which the Court denies the relief.

The prohibition applies to the proceedings themselves and any appeal (s 199A(4)).

Section 212(2) permits a company to advance a loan to a director to pay for defence costs unless the proceedings fall within 199A, and if the outcome falls within s 199A then the loan has to be repaid. Any loan must, under s 212(2), be reasonable

These provisions apply also to civil and other liabilities incurred under the Trade Practices Act 1974 (Cth) (see s 77A of that Act).

Insurance against liability is governed by s 199B of the Corporations Act. It is lawful for a company to take out insurance to indemnify a director. However, under s 199B(1), a company must not pay, or agree to pay, a premium for a contract insuring a person who is or has been an officer or auditor of the company against a liability (other than one for legal costs) arising out of:

(a) conduct involving a wilful breach of duty in relation to the company; or

(b) a contravention of section 182 or 183.

Breach of the section is a strict liability criminal offence (s 199B(2)). Any agreement which contravenes ss 199A or 199B is void to that extent (s 199C).

And so to the nature of D&O policies. This form of insurance has its origins in Australia in 1975, and now represents some 20% of total professional indemnity insurance.9 Three types of cover are found in the market.

Side A Cover: the insurers agree to pay any loss suffered by a director where the director has not been indemnified by the company. Some clauses go on to exclude liability the company is permitted to indemnify the director. The latter exclusion is of some significance. Section 199A impliedly authorises the company to indemnify its directors other than in the situations set out in s 199A(2) (a claim by the company, liability for a pecuniary or compensation order or a claim by a third party where conduct was in bad faith) and 199A(3) (defence costs arising out of s 199A(2) liability, criminal liability, ASIC claims and a liability under the Act for which relief is denied ). The proviso thus defeats a claim under Side A in the vast majority of cases, and the director must look to the company.10 It is of no assistance to the director for him to argue that the company has refused to indemnify him or does not have the funds to do so. The proviso does not say that Side A cover attaches if the company has not provided an indemnity, or that it is unable to provide an indemnity, only that it is not permitted to provide an indemnity. If the company is not permitted by law to indemnify the director, there are relatively few (and possibly no) other cases in which the Side A can respond either as a matter of general law or accordingly to its terms.

Side B Cover: the policy covers any sums paid by the company to the director by way of indemnification for the director’s own liability. A director may not himself sue under Side B cover: the only insured person in respect of that cover is the company.11 The company is not insured by Side B against any personal liability faced by the company itself. Thus if a claim is made against the company, and the directors are not named as co-defendants, Side B does not respond.12 It was similarly held in Intergraph Best (Vic) Pty Ltd v QBE Insurance Ltd13 that if a company takes upon itself the liability for meeting the legal costs incurred by directors in proceedings covered by the policy, as opposed to indemnifying the directors for costs incurred by them in those proceedings, the policy does not respond to a claim by the company. In such a case the company is seeking to recover its own legal costs, not those of the directors. The distinction is a technical one, in that the policy would have responded had the company required the directors to incur the costs for themselves and then indemnified the directors. That, however, did not happen. Care thus has to be taken in drafting a settlement where the potential liability of the directors is at stake. In Vero Insurance v Baycorp Advantage14 a claim was made against a company and its directors, and the company entered into a settlement “on behalf of itself and each of the” directors for a sum which exceeded the amount claimed from the directors themselves. The New South Wales Court of Appeal held that the company, by entering into that settlement, had not thereby rendered the directors personally liable for the agreed amount.

Side C Cover: the company insures against its own personal liability. This may be found in Australian D&O policies, and there is stand-alone Side C Cover now on offer. There is an increasing trend in shareholder actions against the company itself. That trend was given a significant boost by the majority of the High Court in Sons of Gwalia Ltd v Margaretic.15 This case concerned a provision of English company law going back to the nineteenth century and re-enacted in Australia as s 563A of the Corporations Act 2001. This provides that “Payment of a debt owed by a company to a person in the person's capacity as a member of the company, whether by way of dividends, profits or otherwise, is to be postponed until all debts owed to, or claims made by, persons otherwise than as members of the company have been satisfied.” The majority of the High Court ruled that this section did not operate to postpone a claim by shareholders against the company for loss sustained by the purchase of shares in the company as the result of misleading selling: the Court reasoned that a debt of this type was not owed to the shareholders in their capacities as members so that the claim ranked equally with, and was not subordinated to, the claims of other unsecured creditors. The danger of this ruling for directors is that a major claim against the company will erode whatever personal cover is open to directors under Side A.16 For that reason, Side C cover has been removed from some Australian policies and may instead be purchased as a stand-alone product. This move is likely to become more common to deal with the erosion problem.

In addition, directors may seek their own private insurance cover if they fear that Side A cover may not be adequate for their needs. This may be the case in particular where the policy provides for A, B and C cover, and the limits of indemnity are eroded by B and C claims. Such products are found on the Australian market.

There are a number of features of D&O policies which are noteworthy.
(1) Cover is based upon liability arising from the status of the assured, ie, in his capacity as director.

(2) Cover is written on the basis of claims made during the currency of the policy, and not on the basis of events or losses occurring during the currency of the policy. Occurrences or losses occurring insurance is typically used for public liability or employers’ liability insurance, whereas claims made is used for professional indemnity policies of most types. The difference between events and losses occurring insurance is not relevant today, although note that it is a key question in the coverage of employers’ liability cover for asbestos claims, in the Court of Appeal in England in November 2009 (Durham v BAI Run-off).

(3) The directors are parties to the insurance in their own right, as co-assureds, even though the insurance is in the name of the company.17 Policies are composite, in that each individual director is an assured in his own right. The law on composite insurance is not fully developed in Australia, but in England at least it is now clear that the conduct of any one director which takes him outside the protection of the policy does not necessarily affect the rights of others: see Arab Bank v Zurich Insurance Co.18 This is often specifically stated in the policy, eg, “This policy covers each Insured for its own individual interest. No statements made by or on behalf of an Insured or breach of any term of this policy, or any information or knowledge possessed by an Insured, shall be imputed to any Insured for the purpose of determining whether any individual Insured is covered under this policy.”19

(4) Policies may have per claim deductibles and aggregate cover limits, which vary in their terminology and effect. A policy may provide for automatic reinstatement when policy limits have been exhausted, although care needs to be taken where insurance is arranged in layers as there is very often a dispute as to whether reinstatement is “round the clock” or whether it kicks in as soon as the limits on that particular policy are exhausted.

(5) Global policies may operate as excess only covers where there are local policies in force, although there is generally a “drop down” clause which allows the excess layer to be treated as a primary layer policy on the terms of the local policy where local limits have been exhausted.20

(6) Policies provide for both substantive cover for legal liability and also for defence costs.

It has recently been held that shareholders are entitled to inspect a company’s D&O policy to determine whether it is worth bringing an action against the company or its directors.21

D&O policies apply to any director or person who incurs liability in his capacity as a director, whether or not appointed to that post. Some policies restrict cover to a director solely whilst acting in that capacity, and others exclude liability arising from professional services (the territory of an ordinary public liability policy). The major problem posed by the limitation of cover to a person acting, solely or otherwise, in his capacity as director, is that the present state of the common law does not recognise that a director can incur personal liability to a third party while he is acting in his capacity as director: see Williams v Natural Life Health Foods Ltd,22 discussed above. Accordingly, if Williams is taken at face value, then, absent special words of extension, in the exceptional circumstances where liability is incurred by a director to a third party, it will not be protected by D&O cover. There is a counter-argument to the effect that the suggestion made above equates a personal assumption of responsibility with acting in a personal capacity. The counter-argument runs that a director who entices a third party to invest in, or to enter into contractual arrangements, with his company, is acting in his capacity as a director even though assuming personal responsibility: the purpose of the personal capacity limitation is to distinguish the acts of a director from the acts of a private citizen.23

Liability incurred by a director in his capacity as an employee of the company rather than by reason of his capacity as director is not covered by a D&O policy.24 In Tosich v Tasman Investment Management Ltd25 it was held that typical coverage wording “relates to those duties or liabilities imposed upon a director or senior officer as such, rather than all conduct in the course of employment” does not extend to employment duties.26 This means, for example, that if a policy expressly provides coverage for, say, discrimination or health and safety claims, and liability is incurred by a director, such liability will not fall within the terms of the policy by reason of the overriding requirement for that liability to have been incurred by the director in his capacity as such. However, it has been held in Canada that a shareholder/director who allegedly oppressed minority shareholders does so in his capacity as director and not shareholder.27 It might be thought that the capacity argument is unduly technical. The difficulty here is that capacity has proved a stumbling block to recovery in other contexts. Thus if a policy protects the assured against liabilities arising from his activities as occupier of premises, an owner-occupier may not be covered if he inflicts loss in his capacity as owner.28 Equally, a distinction has been drawn between the insured supply of professional services and the uninsured supply of products.29

Insured perils
Wordings vary, but a D&O policy covers sums for which a director becomes legally liable to pay by way of damages resulting from liability at law. Liability may be established by a judgment, arbitration award or settlement,30 at which point the obligation to pay is triggered, although the insurers always retain their right to challenge any settlement reached by the assured on the ground that it does not fall within the terms of the insuring provisions.31

Cover is aimed primarily at tort claims: contract claims are regarded as excluded32 unless the policy otherwise provides or unless the claim is one which could have been brought in either contract or tort. Employee claims are also often excluded. Separate cover is available for Securities Claims, namely, claims alleging a violation of any law or regulation regulating the purchase or sale or offer or solicitation of an offer to purchase or sell securities. But just how valuable is all of this cover?

We know from the Williams case that third party claims will fall outside the scope of a D&O policy. What, then of claims against a director in his capacity as director – which of those are insurable as a matter of the general law? Three propositions may be put forward.

The first is that a director cannot make a claim where his own deliberate or reckless conduct has caused the loss: just as an arsonist cannot recover when he has chosen to burn down his premises,33 a director cannot recover if he acts in a way designed to cause loss to the company.

Secondly, there can be no recovery where the director makes profits to which he is not entitled. If, therefore, a director takes advantage of a corporate opportunity, or corporate information, to make secret profits, and a restitutionary action is brought against him by the company for the profit to be disgorged, D&O insurance cannot respond. In many cases the company will not have suffered any loss, but breach of fiduciary duty does not rest upon the beneficiary proving loss but rather on the fiduciary making a profit.34 That point aside, as was said by Lord Phillips in Stone & Rolls Ltd v Moore Stephens,35 “If a person starts with nothing and never legitimately acquires anything he cannot realistically be said to have suffered any loss.”

The third, and perhaps the most complex, is that if the director has infringed the law, then he may be unable to recover. The scope of the public policy rule ex turpi causa non oritur action is a matter of some contention, and the most recent discussions of the point, by the House of Lords in Tinsley v Milligan,36 Gray v Thames Trains37 and Stone & Rolls itself are inconclusive. The stated principles are that an assured cannot recover if he has to rely upon his own illegality or if he is seeking to make a profit from his own illegality. This means that if a claim against a director has arisen following an infringement of the Corporations Act which gives rise to criminal liability, the policy – whatever it might say – cannot respond.38 We have already seen that s 199A(2) states that a company must not provide an indemnity in respect of a liability for a pecuniary penalty order under s 1317G or a compensation order under ss 1317H or 1317HA. It has not yet been decided whether or not liabilities under those sections is insurable as a matter of law, although it would seem that common law principles would not preclude insurance where the liability arises from mere negligence. Therefore, in principle, there may be a possibility of cover where a compensation order is made by a court in circumstances of pure negligence and no criminal sanction is involved.39 It might be thought that that scenario is relatively uncommon.40

Careful analysis of the situations in which a director may face liability to the company show that most (the author is reluctant to use the word “all”) involve conduct on his part which is uninsurable as a matter of law. As Sam Goldwyn would have said, a D&O policy stripped of defence costs cover, and just like an oral contract, is not worth the paper that it is written on.41 There are only limited exceptions. One is that of a compensation order made in circumstances where there is nothing more than negligence involved and no crime has been committed, although that may be thought a rarity. Another is demonstrated by the facts of Green v CGU Insurance Ltd,42 in which the insurers chose not to rely upon a coverage defence43 by way of response to a claim by the directors for liability incurred under s 588M of the Corporations Act 2001 in respect of insolvent trading contrary to s 588G. Section 588G(2) is infringed where there are reasonable grounds for suspecting that the company may be insolvent, and s 588G(3) goes further and creates a criminal offence in the case of dishonesty. It may be, therefore, that a claim under s 588M is insurable if it is shown that the directors were negligent but not dishonest.44 The response of the market to that possibility has been to adopt insolvency clauses of various types, the effect of which is to exclude liability under the policy if the claim arises out of or relates to the inability of the company to pay its debts. In Green the insurers pleaded non-disclosure of the declining financial fortunes of the company, a large claim against it and other significant indications of potential insolvency. The court held, under s 28 of the Insurance Contracts Act 1984, that the insurers were entitled to have their liability under the policy reduced to nil because, had full disclosure been made, an insolvency clause would have been inserted to remove potential liability for insolvency claims.
D&O policies typically exclude liability arising from: (i) any conduct or contravention in respect of which a liability is the subject of a prohibition in s 199B(1) of the Corporations Act 2001 (Cth); or (ii) the committing of any deliberately dishonest or deliberately fraudulent act. In either case, these matters have to be established by final adjudication of a judicial or arbitral tribunal45 or by any formal written admission by the assured. It will be seen that these exclusions are in most cases little more than confirmatory: the law does not permit recovery in either of these circumstances unless, at least in the case of compensation orders, no fraud is involved. The concluding words of the exclusion become significant where a dispute arises in relation to defence costs: insurers cannot refuse to defend or pay defence costs simply because fraud has been alleged, they only have the right to withdraw coverage once fraud is proved: see Wilkie v Gordian Run Off Ltd46 and Silbermann v CGU Insurance Ltd,47 discussed below.

A further common exclusion is that for “Insured v Insured” claims. This provides that there is no cover for claims by directors, or by the company against a director where the director is himself a shareholder and thus would benefit from the claim.48 To that extent the “Insured v Insured” exclusion protects the insurers against collusive claims, although it may be wider and apply to, for example, claims brought by ASIC on behalf of shareholders. Some policies limit this exclusion to US claims, a jurisdiction in which derivative and stockholder class actions are common fare. Another version of this exclusion confines it to “consensual claims” so that its scope is limited to collusion. Once the company has gone into liquidation and proceedings are brought by the liquidator, it would seem that the clause no longer applies, and the insurers are liable to provide an indemnity to the directors in proceedings brought by the liquidator,49 although this possibility is often specifically excluded independently. Further, the clause does not apply where the director is sued in his capacity as employee of the company.50 It may be that the clause is unnecessary: in Moore Stephens v Stone & Rolls Lord Brown was firmly of the view that a director/shareholder could never benefit from a derivative claim brought by the company against him in his capacity as director.

The significance of the “claim”
The term “claim” is important in a number of respects. First, there has to be a claim against the assured within the currency of the policy, so that the claim can be notified to the insurers. Secondly, there may be an aggregate limit on the sum insured for all claims or there may be a deductible to be borne for each claim. Thirdly, in determining coverage under the policy, the claim must relate to loss arising from an insured peril as opposed to an uninsured or excluded peril. Policies often define the term “claim” but rarely for each of these purposes, because the term has a different meaning in of them. Because the word is used to cover a series of different matters, there is sometimes difficulty in ascertaining whether what is being referred to is the claim by or against the assured, as where the assured is required to notify “claims” to the insurers: whose is being referred to? Fortunately, many, but by no means all, modern wordings draw the necessary distinctions. In the present context of coverage, the third use of the word “claim” identified above, the question is one of coverage, namely, to what extent are the insurers bound by the manner in which the third party claimant against the assured has framed his claim. The third party may have set out a series of facts and alleged negligence, when it is quite clear that what is being asserted is fraud (always an excluded peril) or breach of contract (generally an excluded peril). It is settled law that the courts are entitled to go behind the allegations to determine exactly what is being asserted by the third party.51
Allocation of losses
Australian policies typically state that the insurer will be liable only for loss to the extent that it arises from a covered claim. Therefore, if a claim involves both covered and uncovered matters, or both insured and uninsured persons, then the assured and insurer are required to use commercially reasonable efforts to determine a fair and equitable allocation of the loss based on established judicial allocation principles which take into account the legal and financial exposures, and the relative benefits obtained by the relevant parties. In the absence of agreement, any dispute is to be resolved by Senior Counsel. There is no definitive legal principle as to how allocations should be carried out. As was said in New Zealand Forest Products Ltd v New Zealand Insurance Co Ltd52
A study of the United States decisions53 texts and articles available to us (which now extends considerably beyond material cited in argument) indicates universal acceptance of the basic proposition that there must be allocation between covered and uncovered claims. Beyond that no single principle can be identified as governing allocation. The Courts have employed approaches and methods of allocation considered appropriate to the circumstances of particular cases. It perhaps could be said that the method adopted has been that which is considered best to effect equitable allocation in the circumstances.
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