Directors' And Officers' Liability Insurance: Problems And Pitfalls

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 any actual or alleged error,

mis-statement, misleading statement, act, omission, neglect, or

breach of duty by reason of that director's actual or deemed

capacity as a director. A loss will include damages, judgments,

settlements and defence costs and, depending on the wording and

facts, may include civil fines and penalties but will not include

matters uninsurable. A claim encompasses any suit or proceeding

against an insured party, a written demand evidencing an intention

to hold an insured responsible for a wrongful act, a criminal

prosecution, and, usually, administrative or regulatory

proceedings. Defence costs encompass those reasonable and necessary

fees, costs and expenses incurred as a result of an investigation,

adjustment, defence or appeal of any claim, usually with the

insurer's consent.

KEY AREAS TO WATCH

One contract, many parts

The policy should be composite and not joint. Each director

needs to have a separate interest in the insurance, which would not

be tainted by the fraud or misconduct of another director, for

themselves or for the company. This is the default position for

D&O policies (see Arab Bank Plc vZurich Insurance Co

[1999] 1 Lloyd's Rep 262). Most policies state this fact

expressly, and should do so especially where the company...