Cover charge

Company directors are increasingly culpable for scandals such as Enron. David Leibowitz reports on the extent to which directors’ and officers’ insurance cover can protect them

It is a fundamental principle of English law that a company is a separate legal entity from its directors and shareholders. The principle attraction of trading by a company is limited liability and the avoidance of personal liability. However, the tide is turning. Directors are increasingly finding themselves in the firing line. Corporate scandals such as Enron and financial crises such as the one currently being experienced by Equitable Life leave the public looking for someone to blame.

Insolvency often results in a close examination by officeholders and the Department of Trade and Industry (DTI) of steps taken by the directors in the ‘twilight zone’ – the run up to the insolvency. Directors may need legal advice in respect of potential or actual claims relating to wrongful trading, transactional avoidance, misfeasance and so on. The DTI may be considering disqualification or a Companies Act investigation. Even a director who has acted perfectly honestly and diligently can find that they need legal advice over a protracted period of time.

Current trends

There has been a steady increase in disqualifications in recent years. In 1995 there were a little less than 400 disqualifications per year; by 2002, that figure was nearly 1,800. Since the introduction of the Enterprise Act on 15 September 2003 the Crown has lost its preferential status. The expectation is that it will become increasingly vigilant in seeking to recoup some of this loss, possibly by funding actions against directors.

In the US, even where a claim is more naturally against the company, it is the automatic reaction of claimant lawyers to include the directors. There are signs that the trend being experienced in the US towards greater rights for shareholders and imposing higher standards for those running companies has arrived in the UK.

The Equitable litigation is a high-profile example of this trend. In July 2000, the House of Lords ruled that Equitable had to honour guaranteed annuity rates that it had offered to policyholders during better times. Equitable now says that the directors in place between 1996 and 2000 acted negligently. The company has subsequently sued former directors, including nine non-executive and six executive directors.

Lawyers for the non-executive directors applied to have the case against them struck out. They argued that the case had no real chance of succeeding because the allegations were totally flawed. On 17 October, Mr Justice Langley rejected the application. The consequence is that the non-executive directors, who only worked for a few days each month and who were paid annual retainers of £25,000, now face the prospect of defending claims for £3.3bn, a six-month trial and total trial costs estimated at £30m.

Directors’ and officers’ insurance coverage

A directors’ and officers’ policy has two aspects. One part will reimburse the director, or pay on their behalf, any liabilities that they have to third parties that are not paid by the company. The other will reimburse the company for any costs, expenses or liabilities that it meets on behalf of the director, where it is obliged to do so by virtue of a contract, including the articles of association.

There are normally no automatic provisions for termination or cancellation on the appointment of an insolvency officeholder. Directors who remain in office will find that their cover will continue until its normal expiry date. Cover is available under most wordings to directors in all guises, whether properly appointed or not, including de facto directors and shadow directors. The scope of the coverage for non-directors in managerial and executive capacities will depend upon the precise definition in the wording.

Tensions can arise between the directors and the insolvency office-holder as to the future conduct of the business, with both looking further down the line as to the extent to which the policy would either protect them or provide a source of recovery for creditors.

Individual directors need to be aware of the notification requirements of the policy once an insolvency event has occurred. Many policies provide that notification within a stipulated period is a condition precedent to coverage. They also need to be aware of what has to be notified. Notification of claim is relatively straightforward. The service of proceedings or receipt of a letter alleging a wrongful act counts as a claim under any definition. Many policies require the notification of circumstances. The degree of probability required for such a notification varies according to each policy’s wording. The directors may have to speculate as to what events have occurred over the last part of the company’s life that may give rise to claims for beach of duty, wrongful trading, misfeasance or other corporate misdeeds. If a matter is accepted by insurers as a circumstance, then any subsequent claim will be dealt with under that policy, even if the policy has lapsed before a formal claim is made.

While most policies use the phrase ‘wrongful act’ as a basis of coverage, the extent to which this term is defined varies. Some policies define the phrase in terms of itself: “wrongful act is any actual or alleged wrongful act on the part of the directors…”. Others adopt more detailed definitions by reference to breach of duty, misfeasance, misrepresentation or other acts of omission.

For current and future proceedings, directors want to be certain as to the position regarding defence costs. Some policies oblige insurers to advance defence costs on an ongoing basis, while others give them a discretion of whether or not to do so. An insolvency does not have an immediate impact on those provisions, it simply brings the question into sharper focus where the company might have been paying ongoing defence costs for current litigation while it was in a position to do so.

Some policies will expressly cover wrongful trading claims. Even where there is no specific reference in the policy, the general consensus is that such claims are covered because the proceedings are compensatory in nature and the award made by the court is to recompense the company and its creditors for the loss caused as a result of the director’s conduct. On the other hand, fraudulent trading claims are sometimes expressly excluded. If not, it tends to be assumed that they are not covered, as indemnity for such a claim would fall foul of the principle that a person cannot insure themself against their own criminal act, and that fraudulent trading liability necessarily connotes some degree of dishonesty.

Another concern that arises upon insolvency is the applicability of the ‘insured v insured’ exclusion. In the early days of directors’ and officers’ policies, there was concern that a company could bring claims against its directors for negligence and in effect recoup its own loss. This happened in a number of US cases. Insurers then went to the other extreme, excluding all claims that arose from actions between the company and its directors. That proved unsatisfactory to directors, as many of the claims against which they seek protection are by the company itself, albeit under different management or control. Most policies now buy back the exclusion in part, so that coverage will be available where the claim by an insolvency officeholder is brought without the “instigation, participation or assistance” of the director concerned. Other wordings have somewhat complex provisions regarding the submission to insurers of Counsel’s opinions as to the nature and prospects of such a claim before coverage will be provided.

Issues relating to misrepresentation and non-disclosure can arise. There is a somewhat peculiar nature to these policies, as they are there to protect not only the directors, but also the company. The question of attribution of knowledge for disclosure purposes can be important. Most wordings will provide that the knowledge of an individual director is not to be attributed to their fellow insureds under the policy. If the non-disclosure of dishonest conduct by one director means that the insurers are entitled to avoid the policy in respect of their liability to that individual, the policy will continue in force to benefit others.

There are no reported cases in this country relating to the terms of directors’ and officers’ policies. The difficulties faced by the non-executive directors in Equitable’s case do not, at least in legal terms, concern directors’ and officers’ insurance, although that is part of the backdrop against which the claim is being pursued. What is clear is that the claims that have now been made are far beyond the somewhat limited coverage that was purchased for the directors in what were considered to be rather more simple and straightforward times. These policies are likely to be of increasing relevance in legal proceedings.

David Leibowitz is a corporate recovery partner at Berwin Leighton Paisner. He was assisted in this article by insurance partner Andrew Rose