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The turbulence continues - D&O woes and more action on directors' duties

05 November 2011

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This article first appeared in the November 2011 issue of Boardroom magazine.

Directors and the responsibilities which attach to the office of director have been subject to particular scrutiny in the last few months as a result of both law change and decisions in the courts – and the pace shows no signs of slowing as the year draws to an end.

Two recent events of significance to boardrooms are a move to make serious breaches of directors’ duties a criminal offence and a surprise High Court ruling which casts doubt on the extent of the protection provided by standard directors and officers (D&O) insurance.

Among the welter of bills outgoing Commerce Minister Simon Power pushed out last month as he cleared his desk before quitting politics was the Companies and Limited Partnerships Amendment Bill which, among other things, provides for criminal sanctions where a director engages in conduct which he or she knows is seriously detrimental to the interests of the company and/or which will result in serious loss to the company’s creditors.

Proposed penalties are up to five years in prison, or up to $200,000 in fines. 

Policy papers leading up to the Bill recognise that there is a tension between deterring misconduct and deterring people from taking up directorships and boards from taking legitimate commercial risks.  The Bill seeks to address this by criminalising only intentional and egregious offending.

This sets up a requirement to prove beyond reasonable doubt that a director had actual knowledge that his or her actions, or inaction, would definitely cause a particular effect.  That is a very high threshold to meet and should mean that the diligent director has nothing to fear.

But the Bill is in limbo until the new Parliament convenes so it is enough for now simply to mark its introduction.  We will have the opportunity to evaluate it more fully next year.  Not so the D&O decision, the ramifications of which are immediate and unsettling. 

First a brief recap of the facts behind the case.  The former Bridgecorp directors, having exhausted their statutory liability cover, sought in August this year to draw on their D&O entitlements to fund their defence against criminal charges brought by the Financial Markets Authority.

The Bridgecorp liquidators and receivers, who had asserted a charge over the monies in 2009 on the basis that they intended to claim against the D&O policy in subsequent civil proceedings, applied to the High Court for a declaration to block the directors’ claim.

Astonishingly, the Court granted the order. 

Astonishing because the directors’ contract of insurance was valid and enforceable, and was specifically designed to insure them for the costs of defending civil and criminal claims.

Astonishing also because the Court relied for its finding on a 75 year old statute which was designed to fix a problem in personal injury cases in situations when the defendant was insolvent and the successful plaintiffs had no priority to the insurance proceeds.  This circumstance is far removed from modern D&O policies, but – according to the High Court at any rate - the provision still applies.

The Judge recognised that the decision would create confusion in the insurance market and was probably not what Parliament had intended when it passed the relevant Act in 1936.  Nevertheless, he felt compelled to follow the plain words of the statute.

We understand that the judgment is being appealed and will await the result of the appeal with interest.  In the meantime, directors need to be aware of the uncertainty it has created in relation to their liability cover.

Most D&O policies indemnify directors for costs incurred, but only after the director is acquitted of any criminal offence.  Obviously this is hopelessly inadequate to allow directors to defend themselves these days, given the high cost of these complex and time-consuming cases.

Insurance policies get around this by containing an extension under which the insurer can advance defence costs before trial with the right to have the amounts repaid in the event of a conviction.  In the normal course, the money advanced would come off the total amount of the sum insured.

But the effect of the ruling is to deprive directors of the comfort of knowing that they will be able to fund the litigation of a criminal case, if there is also the potential for a civil claim for damages. 

Existing policies, on standard wordings, will all fall foul of this new problem.

So what can you do?

The two most obvious solutions are:

  • to have a statutory liability policy which responds only to defence costs, and
  • to negotiate amendments to the D&O policies to split cover into two, so that the defence costs aspect is ring-fenced from the potential liability to pay damages.

The first solution is easy to achieve.  The second will require substantial work on the conventional D&O policy.

Adam Ross is a partner at Chapman Tripp specialising in commercial dispute resolution.