A shock ruling this week by the Auckland High Court casts doubt on the extent to which directors can rely on their liability cover to help pay for defence costs in criminal and civil proceedings.
This Brief Counsel summarises the decision and comments on its implications for directors.
The Court has ruled that the former directors of Bridgecorp cannot call upon their directors’ and officers’ insurance policy (D&O) to help fund the defence of the criminal actions brought against them by the Financial Markets Authority.
This is despite the fact that their contract of insurance is valid and enforceable, and is specifically designed to insure the directors for the costs of having to defend themselves in civil and criminal claims.
The Court relied for its finding on a 75-year old statute which creates a charge over insurance policy proceeds. Section 9 of the Law Reform Act 1936 provides that where a person is indemnified against liability to pay damages or compensation, the amount of the liability is subject to a “charge” on all insurance money that is, or may become payable in respect of that liability. The charge arises when a claim or allegation is made that would trigger the right of a director or officer to call on the insurer to indemnify him or her for the potential liability.
This septuagenarian provision was designed to fix a problem in personal injury cases, where successful plaintiffs had no priority to the insurance policy proceeds in the case of the defendant being insolvent. This circumstance is a far cry from modern directors’ and officers’ liability policies, but the section still applies.
The receivers and liquidators at Bridgecorp have signalled that they may make claims against the former Bridgecorp directors. They applied to the High Court for a declaration that the charge under section 9 prevented the directors from having access to the D&O policy to meet their defence costs.
The High Court granted that order. It was satisfied that the underlying purpose of section 9 was to make sure that the insurance fund should be available to creditors. If the directors were able to have defence costs advanced to them, thereby depleting the total sum available in the insurance policies, the potential creditors could miss out on the benefit of the policy because it would be spent in defending the directors on the criminal claims.
Most D&O policies indemnify directors for costs incurred, but only after the director is acquitted of any criminal offence. Obviously this provision in the modern day and age is hopelessly inadequate to allow directors to defend themselves, given the high cost of these complex and time-consuming commercial cases. Insurance policies get around this by containing an extension, providing for the insurer to advance defence costs before any trial, with the right to have the amounts repaid in the event of a conviction. In the normal course, those amounts advanced would come off the total amount of the sum insured.
Implications of the judgment
The effect of the judgment is that any defence costs advanced to directors will not be treated as payments on account of the total sum insured. That is because the charge created by section 9 has already preserved that insurance fund for the benefit of creditors.
The consequence will be that insurers may not agree to advance defence costs, because they will remain liable for the full value of the insurance policy regardless of how much they spend on defence.
The judgment therefore deprives directors of the comfort of knowing that they will be able to pay for a defence in a criminal case, if there is also the potential for a civil claim for damages.
Existing policies, on standard current wordings, will all fall foul of this new problem.
Some practical solutions
There are a number of solutions available to directors. These include:
- having a statutory liability policy which responds only to defence costs, and
- negotiating a split of the D&O policies 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 usual D&O policies.
In the meantime, the consequence of this High Court judgment is that the directors of Bridgecorp must face a substantial criminal trial essentially with both hands tied behind their backs.
If they do not have the personal resources to defend themselves, they will be required to ask for legal aid. Based on Rod Petricevic’s recent experience, if any of them are beneficiaries of family trusts, it is possible that they will be declined even legal aid.
We are confident that this state of affairs was not intended by the drafters of the Law Reform Act in 1936. The High Court Judge, Justice Lang, recognised that the decision would cause difficulties, but His Honour felt obliged to apply the plain words of the statute and a number of cases that had considered those words over the years.
This judgment will not be the end of the issue (appeal seems likely), but in the meantime directors would be well advised to investigate whether they have adequate statutory liability cover to meet the immediate circumstances.