BLG Directors' and Officers' Liability Review

Article by Francis Kean

The Higgs Review: a very cautious welcome due from D&O Insurers?

"I do not presume a "one size fits all" approach to [corporate] governance is appropriate. The Review is not a blueprint for box-tickers, but a counsel of best practice that can be intelligently implemented with discretion."

On 20 January 2003, Derek Higgs published his report on the role and effectiveness of non-executive directors (NEDs), commissioned by the Government in April 2002. This coincided with publication of the report of Sir Robert Smith's group on audit committees, the recommendations of which also emphasise a key role for NEDs, and which are expressly incorporated into Higgs' recommendations. Those recommendations take the form of a proposed revised Combined Code, which Higgs invited the Financial Reporting Council (FRC) to implement for reporting years starting on or after 1 July 2003. The FRC has now indicated that, following the usual consultation process, it intends to do so with effect from that date (together with implementing certain other changes to the Code taking into account the effect of the Directors' Remuneration Report Regulations 2002, which are of course now in force).

How then will this affect the liability of NEDs, and therefore their D&O insurers? The answers are far from clear, and indeed, as we explain below, a case can be made that the effect of the Higgs Report, if implemented, might be to increase NEDs' exposure.

The Essence Of Higgs

Higgs' views about the role and effectiveness of NEDs can be summed up in the following two conclusions, from which all of his detailed recommendations flow:

1 The role of NEDs has two principal components: monitoring executive activity, and contributing to the development of strategy and therefore to wealth creation (see paras. 1.12, 6.1-2 and 4.2). Accordingly, to realise both components it is necessary and appropriate to stick with the traditional UK model of the unitary board, that is, a single board of both executives and non-executives (paras. 1.7 and 4.3). Higgs rejects the US model of a board composed largely of "outside" directors with only a few executives, and also the European model of separating legal responsibility for running the company between a management and a supervisory board, on the basis that such models tend to over-emphasise the monitoring role at the possible expense of the strategic and wealth creation aspects (see paras. 1.12 and 4.3).

2 Corporate structures and processes are not sufficient by themselves to deliver good corporate governance, the key to NED effectiveness in Higgs' view lies as much in fostering appropriate behaviours and relationships (see paras. 1.5, 1.18 and 6.3). Accordingly, many of Higgs' detailed recommendations are directed to establishing and developing "a spirit of partnership and mutual respect on the unitary board" (para. 6.3). Higgs seeks to achieve this goal through "best practice" recommendations (strengthening both existing structures and introducing new behaviours), and rejecting legislation as the way forward (and therefore adopting, in very general terms, the European rather than the US approach).

Higgs endorses the "comply or explain" approach of the Combined Code as the way to implement his "best practice" ethos. This means however, that the vast majority of Higgs' recommendations will not apply to non-listed private companies (although Higgs' non-Code recommendations will of course apply: see 3 below).

Some practical examples

Two effects of these conclusions on the liability of NEDs can immediately be noted:

Higgs expressly endorses the current position that the legal duties of directors (both those owed to the company and to third parties) are the same for both executive and non-executive directors - classically, the law draws no distinction in that regard, and neither, formally, does Higgs. Further, Higgs expressly rejects the idea of putting NEDs into a separate legal category that would protect them in any formal way from the potential of full liability to which any executive director is subject - he rejects, for example, proportional or capped liability, or any form of "business judgment defence" (see para. 14.1).

At the same time, Higgs recognises that the perceived risks associated with being an NED are continually growing in the current climate. He seems to tackle those risks in accordance with his preference for "best practice" guidelines rather than concrete limitations upon liability.

The concept of best practice

Higgs' specific recommendations concerning NEDs' liability, fall under 3 heads:

1 Amendments to the Combined Code:

The new revised Combined Code contains many provisions intended to strengthen corporate governance, such as provision to NEDs of appropriate information and professional development services, regular board performance evaluation, and requirements relating to the balance of executive and non-executive directors on boards, including the institution of a formal new category of "independent" NEDs. Such provisions might fairly be regarded as prospective liability avoidance or education mechanisms, although plainly their usefulness remains to be tested in practice. To this limited extent, therefore, Higgs' recommendations are to be welcomed by D&O insurers.

2 A new Schedule to the Combined Code:

This is described as "guidance on liability of non-executive directors: care, skill and diligence". Higgs' idea here is that notwithstanding that the legal duties of executive and non-executive directors are formally identical, he "would expect that the Court...