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Insurance Liability
Paying the price of inadequate cover?
Jane Harte-Lovelace and Sarah Turpin of
Kirkpatrick & Lockhart Nicholson Graham’s
Litigation and Dispute Resolution Group look
at the subject of director indemnification and
its impact on insurance premiums.
brought by third parties as well as
damages/settlement payments. These type of
claims might include, for example, shareholder
class actions, representative actions and
derivative actions brought by shareholders in the
name of the company.
These actions are a particular threat to
companies with shares or ADRs listed in the US.
While shareholder actions are relatively unknown
outside the US, the new Company Law Reform
Bill, expected to come into force in 2007, is
expected to give rise to an increased number of
shareholder derivative actions.
b) Indemnify directors in respect of defence
costs incurred in relation to any regulatory
proceedings involving the director (but not in
respect of fines or penalties imposed by
regulatory bodies). This should include
investigations by such bodies as the Financial
Services Authority (FSA) and the US Securities
Exchange Commission.
The main problem is that directors face
putting their hands in their pockets to fund
their own defence costs
The Head of Enforcement at the FSA has
recently confirmed the FSA’ s intention to bring
cases against senior management on the basis
that deterrence will be most effectively achieved
by bringing home to senior individuals the
consequences of their actions. This was
reflected in a fine of £25,000 imposed,
in December 2005, on the finance
director of Cambrian Mining, an AIM
company, for market abuse resulting
from his buying shares in the company
during a close period.
c) Fund any defence costs incurred
by directors in relation to criminal
proceedings (but such costs would have
to be re-paid in the event of conviction
and would not cover any criminal
penalties). This should include criminal
prosecutions brought by the Serious
Fraud Office and by the FSA, for
example for market abuse and insider
dealing. The FSA has already
demonstrated its willingness to bring
criminal prosecutions against directors
through its successful prosecution of 3
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March 2006
T
he subject of director indemnification has
proved highly topical. The Equitable Life saga
highlighted, not only the risk to directors of
being sued in their personal capacity, but the real
danger of inadequate insurance cover or other
protection. As the case continued, the
inadequacy of the directors and officers’ (D&O)
liability insurance cover resulted in several of the
directors having to be represented under
conditional fee agreements while others were
forced to represent themselves as litigants in
person. In the face of this, recent legislative
changes, which significantly increase the scope of
protection which companies are able to offer their
directors, are a welcome development. As a
result, many companies have been reviewing their
indemnification and funding provisions to take
account of the recent changes. There are,
however, additional steps, which need to be
taken by any company, which has, or is
considering taking out D&O cover. Failure to do so
could result in a gap in cover and a repetition of
the nightmare scenario of Equitable Life.
Prior to the recent amendments, the
Companies Act 1985 rendered void any
agreement by the company to indemnify its
directors in relation to third party claims. The only
exception was to allow limited indemnity in the
form of “after the event” reimbursement of
defence costs incurred in civil proceedings where
judgment was given in the directors’ favour and in
criminal proceedings in which the director was
acquitted. The main problem with this was that
defence costs could not be paid as they were
incurred with the result that (unless they had the
benefit of D&O cover) directors faced putting their
hands in their pockets to fund their own defence
costs (albeit with the potential for future
reimbursement). This placed an enormous burden
on directors given the potentially significant sums
involved. Concern over the effect these issues
were having on the recruitment and behaviour of
directors led to the recent changes to the
provisions of the Companies Act relating to
director indemnification.
The main changes, which took effect from April
2005, are that companies can agree to indemnify
directors in respect of third party claims, but not
in respect of: any liabilities to the company (or an
associated company); any fines or penalties
arising from criminal or regulatory proceedings;
any liabilities incurred by the director in defending
criminal proceedings in which he is convicted or
in defending civil proceedings brought by the
company or an associated company in which
judgment is awarded in the company s favour.
The practical effect of these changes is that
companies can now:
a) Indemnify directors in respect of defence
costs as they are incurred in any civil proceedings
risk mar06 liability
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Insurance Liability
Sarah Turpin
Jane Harte-Lovelace
former directors of AIT, the software company, for
market abuse arising from false and misleading
statements made to the market in relation to the
company’s financial results.
d) Fund any defence costs incurred by directors
in defending civil proceedings brought by the
company or an associated company (but such
costs would have to be re-paid in the event of
judgment in the company’s favour and would not
cover any damages payable to the company).
These changes regarding director indemnification
are likely to have an impact on D&O cover because
such policies do not usually offer stand alone
protection but are based upon the indemnification
provided by the company. Most D&O policies
provide cover for the liabilities of directors and
officers in defending claims where no
indemnification or funding is provided by the
company (often referred to as Side A cover). In
addition, many companies purchase separate cover
or company reimbursement to cover the losses
incurred by the company in indemnifying its
directors and officers in respect of their liabilities
(also referred to as Side B cover). Some companies
also purchase Side C, or entity cover, which covers
liabilities of the company itself in defending third
party claims, often limited only to securities claims.
Even if the company has offered its
directors the widest indemnity available,
further complications can arise
March 2006
If the company has given its directors the wider
form of indemnity now permitted this may have
implications in relation to the D&O policy limits.
More claims are likely to be indemnified by the
company with the result that more claims will
arise under the company reimbursement section
of the policy (Side B) than may previously have
been the case. If there are separate policy limits
for Side A and for Side B, the limit of indemnity
relating to the Side B cover may need to be
adjusted to reflect this.
The other point to consider is whether the
policy includes what is known as a “presumptive
indemnification clause”. The precise terms of
such a clause may vary but essentially it provides
that, for the purpose of policy cover, the company
is presumed to have indemnified its directors
(and to fund defence costs) to the maximum
extent permitted by law. This can result in a gap
in cover if the company has not agreed to do so,
which is a real possibility given the recent and
significant changes to the type of indemnification
which companies are permitted to provide. The
company should aim to have any “presumptive
indemnification clause” removed from the policy
wording or at least amended with a view to
lessening its impact.
Even if the company has offered its directors
the widest indemnity available, further
complications can arise in relation to D&O cover
48
where the company fails to indemnify, by not
actually paying money, or is unable to do so as a
result of insolvency. The policy will not always
provide cover to the individual directors in these
circumstances (or may limit cover to defence
costs only) and this is something that needs to
be checked. At the very least, the directors will
want to ensure that the D&O policy will cover any
liabilities arising when the company is insolvent,
given that this is the time when claims are
perhaps most likely to be made.
The other point to bear in mind is that a D&O
policy will not necessarily cover all of the potential
losses, which the company is not permitted to
indemnify. This applies not only to UK companies
but to directors of overseas subsidiaries who may
be given different types of indemnity depending on
the country of incorporation. As indicated above,
under the Companies Act 1985 (as amended),
while a company can now fund defence costs in
relation to proceedings brought by the company,
those costs have to be re-paid if judgment is
awarded against the director and would not extend
to any damages awarded in the company’s favour.
It should not be assumed that the D&O policy
will cover these liabilities simply because the
company cannot. These losses may be specifically
excluded under an “insured v insured” exclusion
which may exclude from cover any claims brought
by the company against its directors. This type of
exclusion is fairly typical in D&O policies but it may
be possible to amend the wording to restrict the
circumstances in which the exclusion applies. The
policy may also exclude losses arising from the
“fraud or dishonesty” of the director which may be
relevant in the context of company claims.
These examples illustrate the knock on effect,
which the recent changes to director
indemnification may have in relation to D&O
cover. It is essential that companies review, not
only their policy on indemnification, but the terms
of their D&O cover to ensure that there are no
unintended gaps in cover. Changes to the policy
wording should be requested where necessary.
While some D&O insurers rely upon standard
policy wordings, this does not mean that they are
not negotiable. A standard wording is more likely
to have been drafted by insurers (with legal input)
to ensure that it reflects the insurers’ best
interests, and not always those of the insured. A
D&O policy is a commercial contract like any
other and there is no reason in principle why
companies should not negotiate improved policy
terms to ensure that the directors’ interests, and
those of the company, are properly protected.
Ideally, this process should involve a combination
of risk managers, brokers and insurance coverage
lawyers with experience of advising on D&O
wordings. This may sound an expensive process
but for directors it is a question of managing risk
and potentially limiting damage - act now by
getting the wording reviewed or pay later when a
claim arises which is excluded from cover.