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...