Directors’ Liabilities, Indemnities and D&O Insurance

Jane Harte-Lovelace and Sarah Turpin

Programme Overview

D&O in context – hot topics for your boardroom agenda

Director indemnification – the new regime and the implications for D&O cover

D&O insurance – is your board properly insured for claims and investigations?

Responding to a claim Potential pitfalls Necessary steps to minimise coverage disputes

Director indemnificationThe new regime and the implications for D&O cover

Sarah Turpin, Senior Associate

Director indemnification – the law prior to 6 April 2005

Any provision which exempted or indemnified any director of the company against any liability for negligence, default, breach of duty or breach of trust in relation to the company would be VOID (Section 310 Companies Act 1985)

EXCEPTION – limited “after the event” indemnity for any liability incurred in successfully defending civil or criminal proceedings

PROBLEM – too late and too little comfort!

Director indemnification – the law since 6 April 2005

The Companies (Audit, Investigations and Community Enterprise) Act 2004 relaxed the prohibition on indemnities (from 6 April 2005)

The existing prohibition on any provision which purports to exempt directors from liability or provide an indemnity against any liability remains (Section 309A) BUT

Companies are now permitted (but not obliged) to grant a “qualifying third party indemnity provision” (Section 309B)

Companies are also permitted to advance defence costs as they are incurred (Section 337A)

What is a “qualifying third party indemnity provision”?

A “qualifying third party indemnity provision” (QTPIP) is a provision which covers any liabilities incurred by directors, except any liability: to the company or any associated company to pay any fines imposed in criminal proceedings to pay any regulatory penalties incurred in defending any criminal proceedings in which the

director is convicted incurred in defending any civil proceedings brought by the

company or an associated company in which the director is found liable

in relation to any application to the court for relief (where such relief has been refused)

So what does this mean in practice?

Companies are now permitted to indemnify directors (and directors of associated companies) for: damages and defence costs arising from third party

proceedings defence costs relating to criminal proceedings (but not criminal

fines and defence costs subject to “claw back” in the event of conviction)

defence costs relating to regulatory proceedings (but not regulatory penalties)

costs relating to any application to the court for relief (unless court refuses to grant relief)

So what does this mean in practice? (Cont.)

Companies are also permitted to advance defence costs as they are incurred, even if the action is brought by the company (but not in respect of any damages payable to the company and defence costs subject to “claw back” if director found liable to the company)

Some practical considerations

Most companies include an indemnification provision in their articles of association which may need updating in light of recent changes

Consider the need for express incorporation in directors’ service contract or separate deed of indemnity

Important to ensure obligation to indemnify survives directors’ retirement (many claims against directors arise after they have left company)

Disclosure requirements – any “qualifying third party indemnity provision” (QTPIP) must be available for inspection at the company’s registered office and disclosed in the directors’ report with the statutory accounts for the relevant financial year

Companies Act 2006 – further changes from1 October 2007

Introduction of “qualifying pensions scheme indemnity provision” (QPSIP) allowing companies which are trustees of an occupational pensions scheme to indemnify their directors against liabilities incurred in connection with company’s role as trustee

Such provision cannot cover any liability of the director for: Criminal fines or regulatory penalties Any liability arising from criminal proceedings where the director

has been convicted Creation of a right for shareholders to request a copy of any

QTPIP or QPSIP

Director indemnification – implications for D&O cover

D&O cover normally taken out by company as policyholder

Structured around indemnification provided by company to its directors and officers

3 Types of D&O cover

Side A- D&O Liabilities- No indemnification by company

Side B (Company reimbursement)- D&O Liabilities- Company indemnifies

Side C (Entity cover)- Liabilities of Company- Often limited to securities claims

So why is D&O insurance still needed?

For Directors (Side A): Company insolvency - company indemnification only as good as

the company’s ability to pay Legal restrictions - Side A may provide broader indemnification

than company permitted by law to indemnify Criminal defence costs even if director convicted

(but check fraud/dishonesty/criminal acts exclusions) Damages and defence costs relating to claims by the company

(but check “insured v insured” exclusion)

Company refusal - Side A may even respond if company refuses to indemnify but essential to check policy wording

So why is D&O insurance still needed? (cont.)

For the Company (Side A and Side B) Side A – to attract high calibre directors (particularly

non-executives) Side B – balance sheet protection

Combined code – “the company should arrange appropriate insurance cover in respect of legal action against directors”

D&O insurance is not a legal requirement but many companies now regard it as essential

D&O InsuranceIs your board properly insured for claims and investigations?

Sarah Turpin, Senior Associate

Is your board properly insured for claims and investigations?

D&O policy wordings vary enormously “Devil is in the detail” Minor variations can have significant impact on

scope of cover available Directors should have clear understanding of what

is and is not covered and who can benefit and share the cover

What are the policy limits?

Lessons learned from Equitable Life Combined D&O cover for all directors believed to be

£5m Civil claim against 15 former directors Each director faced £1.7 bn claim No finding of liability against directors but total legal

costs estimated at over £20m Conditional fee agreements/litigants in person

How do the policy limits apply?

“Claims made” cover = claims made against director or officer (and reported to insurers) during policy period

“Per claim” with separate “sub-limits” for certain types of claim “Series” provision may seek to limit number of policy

limits in event of multiple claims Insurance claims arising from 9/11 terrorist attacks on

World Trade Centre

How do the policy limits apply? (cont.)

“Per year” whereby policy limit applies in the aggregate i.e. to all claims against any insured during policy period Can prove problematic where number of insureds

covered by same policy Scope for insured making first claim to exhaust policy

limits Care needed on mixed policies e.g. PI plus D&O

Who is covered?

Past, present and future directors and officers of company and any subsidiaries

Should also expressly include: De facto directors Shadow directors Directors who act as shadow directors of any other company Directors appointed to “outside entity” (subject to specific terms) Lawful spouse of director (only for “wrongful acts” of director) Executors of deceased directors’ estate

Consider also: Employee acting in managerial or supervisory capacity Employee named as party in claims against directors

What types of claim?

“Claim” should be expressly defined to include:- Written demand (monetary and non-monetary relief)- Civil proceedings- Criminal proceedings- Administrative or regulatory proceedings

May not include regulatory investigations/enquiries e.g. FSA, SEC (Sir Philip Watts/Shell), OFT (British Airways), DTI (Farepak), HSE (important such investigations covered)

“Claim” must arise from “wrongful act” by the D&O – should be widely defined to include any actual or alleged breach of duty, breach of trust etc or any matter claimed against director or officer by reason of their status as such

What losses are covered?

Loss should include defence costs, damages and settlement payments

Punitive, exemplary and multiple damages may be excluded Fines and regulatory penalties excluded Defence costs

Usually require advance written consent Advancement preferable to reimbursement

Extensions of cover e.g. investigation costs, emergency defence costs, crisis management costs, mitigation costs, regulatory investigation costs

The Long Arm of US Jurisdiction – do you need cover for extradition costs?

The Long Arm of US Jurisdiction – do you need cover for extradition costs?

The publicity surrounding the “Nat West Three” fuelled concerns over the risk of extradition to the US

UK/US Extradition Treaty 2003 (implemented by Extradition Act 2003 with effect from January 2004) heavily criticised for non-reciprocal evidence requirements: No requirement for US (and other ‘category 2 territories’) to

show prima facie evidence of criminal offence

The perceived creative approach taken by the US authorities in relation to the “double criminality” requirement

Offences of wire fraud/mail fraud used to extend jurisdiction

Nat West Three – extradited on charges of “wire fraud” - alleged misconduct took place outside US but connection with Enron clearly an important factor

Nigel Potter (former MD of Wembley leisure group) – alleged “conspiracy to bribe” also took place outside the US and “bonus” never actually paid – avoided extradition by agreeing to co-operate with US authorities (currently serving 3 year prison sentence in US)

Ian Norris (former CEO of Morgan Crucible) attempting to resist extradition on basis alleged cartel activity only made criminal offence for individuals by Enterprise Act 2002 (i.e. prior to alleged offence)

Do you need cover for extradition costs? (cont.)

Do you need cover for extradition costs? (cont.)

Up to half the extradition requests under the Extradition Act have related to white collar crime offences

The scope of the Act is very broad provided the authorities can satisfy the “double criminality” requirement

Examples of relevant offences include bribery, corruption, fraud, insider trading, tax evasion, cartels and health & safety offences leading to fatal accidents

Directors of any business with US presence or dealings with US may face extradition/prosecution in US

Do you need cover for extradition costs? (cont.)

“Claim” should be defined to include criminal claims and investigations

“Defence costs” should therefore include the costs of fighting extradition

In the light of concerns over the “Nat West Three”, some D&O Insurers now provide express cover for “extradition costs”

BUT beware US exclusions and consider a “carve out” for extradition costs if such an exclusion applies

Do you need cover for claims and investigations in the US?

Cover for US claims/investigations likely to result in significant premium increase

Need to assess directors’ potential exposure to such claims/investigations (defence costs for US regulatory investigations can be significant)

Even if no US operations/shareholdings need to consider:

- relaxation of extradition requirements

- long arm of US jurisdiction/offences of wire fraud/mail fraud

Do you need cover for claims and investigations in the US?

U.S. Regulatory Investigations of non-US Companies

Directors of companies with shares registered in US may face investigations by the following: SEC (Securities and Exchange Commission)

In relation to disclosure violations, accounting violations and internal control deficiencies e.g. Shell (Netherlands), Vivendi (France), Royal Ahold (Netherlands)

CFTC (Commodity Futures Trading Commission)currently investigating BP (Lord Browne) for possible price

manipulation of the U.S. propane and crude oil markets PCAOB (Public Company Accounting Oversight Board)

Created by Sarbanes-Oxley to oversee accounting firms – both foreign and domestic – that audit companies issuing securities. Requires an inspection of each firm every three years

Sarbanes-Oxley – another hurdle for non-US companies with U.S. securities Among other things, Sarbanes-Oxley (“SOX”) requires:

Officers of companies to take personal responsibility for financial disclosures and prohibiting conflicts of interest

An assessment of the effectiveness of internal controls by management, to be audited and approved by the company’s independent accountants

September 2006 – Directors of TV Azteca became first international D&Os to settle enforcement action under SOX Liable D&Os agreed to establish a “Fair Fund” to compensate

investors Chairman Ricardo Salinas Pilego - $7.4 million Former CEO Pedro Padilla Longorio - $1 million

U.S. Securities Class Actions involving Non-U.S. Companies

In past two years, almost 10% of securities class actions filed in the U.S. involved a European company

Overall number of class actions is decreasing, but settlement amounts are on the rise (exceeded $9.6 billion in 2005)

Foreign issuers are paying out large settlements In 2005, two of the ten largest class actions settlement involved

foreign issuers: Deutsche Telekom AG ($125 million) Royal Ahold NV ($1.1 billion).

In 2006 Canadian Nortel Networks settled for nearly $2.5 billion

U.S. Securities class actions - U.S. opening courtroom doors to foreign investors

Some courts allowing non-U.S. investors to maintain suits against foreign issuers In re Vivendi (New York 2004) Royal Ahold (Maryland 2004) Royal Dutch/Shell (New Jersey 2005)

Not all foreign investors maintain claims successfully In re Bayer AG (New York 2005) Daimler Chrysler (Delaware 2006)

In re Royal Dutch/Shell Transport Securities Litigation

Shareholder class action arose from Shell overstating its oil reserves, which led to massive dip in stock price once alleged fraud discovered Putative class included both U.S. and non-U.S.

shareholders Shell filed a motion to dismiss for lack of subject

matter jurisdiction, arguing that the court had no jurisdiction over the claims made by non-U.S. shareholders

In re Royal Dutch/Shell Transport Securities Litigation(cont.)

Court allowed non-U.S. shareholders to remain part of putative class: Misstatements by Shell representatives to analysts and

investors in the U.S. (the acts that allowed for subject matter jurisdiction) affected both domestic AND foreign investors – U.S. market activity “has become an example for foreign investors and exchanges”

Court dismissed argument that there was no guarantee U.S. judgment would be enforced in investors’ home countries (and could therefore lead to duplicative litigation) as merely “speculative”

U.S. Securities class actions – directors’ contributions to settlements

WorldCom Former CEO Bernard Ebbers -- $5.6 million cash and

other assets valued at over $18 million Former Chairman Bert Roberts -- $4.5 million out of

pocket 10 former outside directors -- $18 million

(collectively) out of pocket Enron

10 directors to pay $13 million from profits selling Enron stock

D&O insurance - what is not covered?

Essential for directors to understand not only what is covered but what is expressly excluded

Number, wording and extent of policy exclusions varies enormously

Preamble to exclusions section may extend application of exclusions to claims arising from other people’s actions

Generally speaking, the longer the preamble, the greater the scope for the exclusion to apply

Reasonable exclusions – liabilities likely to be covered by other policies

Death or bodily injury (request carve out for defence costs relating to corporate manslaughter claims)

Physical damage or destruction of property Pollution and environmental claims (request carve out

for defence costs) Product liability Pension trustee liabilities

Exclusions commonly found but worth negotiating

Most D&O policies expressly exclude claims involving: Dishonest or fraudulent acts/illegal personal profit or

gain- Should not include “criminal or wilful acts”- Requirement for judgment or final adjudication- Repayment of defence costs (if established)- Importance of severability provision

Exclusions commonly found but worth negotiating (cont.)

Insured –v- insured e.g. Equitable Life (carve outs essential)

Outside directorships Professional services (possible carve out) Known claims and circumstances Prior and pending litigation (could include claims

against company) Material changes in risk/changes in securities listing

Unreasonable exclusions

Depends upon nature of business but following should be avoided:- Actual or alleged failure to maintain insurance- Major shareholder exclusion- Blanket or absolute professional indemnity exclusion- Blanket or absolute bodily injury or property damage

exclusion (preceded by widely drawn preamble)- Blanket or absolute pollution exclusion

Will “dishonest” directors forfeit D&O cover for “innocent” directors?

Avoidance of policy D&O policy (like all insurance contracts) is contract of utmost

good faith = insured under duty to disclose all material facts Scope for Insurers to seek to avoid policy on grounds of

material non-disclosure or misrepresentation prior to inception

Typically arises in D&O context where there are errors, or even intentional misstatements, in the financial statements accompanying the proposal form (e.g. Enron/Worldcom)

Importance of severability provision

Will “dishonest” directors forfeit D&O cover for “innocent” directors? (cont.)

“Basis of contract” clause = converts statements in proposal form into warranties

Breach of warranty automatically discharges insurers from liability

No need to demonstrate ‘materiality’ Policyholders should aim to delete clause Important to limit definition of proposal/documents

relied upon

Exclusion of dishonest/fraudulent acts Importance of severability provision/final adjudication

D&O InsuranceResponding to a Claim

Jane Harte-Lovelace and Sarah Turpin

Responding to a claim

Potential pitfalls relating to claims notification

The D&O policy, being written on a “claims made” basis, will normally provide for notification of claims and circumstances likely to give rise to a claim

Notification of claims: Within a specific time limit or “promptly” or “as soon

as practicable” Often condition precedent to insurers’ liability Breach enables insurer to deny cover even if no

prejudice suffered

Potential pitfalls relating to claims notification

Notification of circumstances which may/are likely to give rise to a claim: Within a specific time limit or simply within policy

period May need to specify claims predicted Potential problems if not accepted

Importance of early notification ensure compliance with claims notification provisions obtain consent in relation to defence costs

Potential pitfalls relating to claims co-operation

Insured has duty to defend BUT

May be no express right to chose own lawyers May be no express right to appoint separate lawyers (in case of

actual or potential conflicts) May be required to give full co-operation and information to

insurers No defence costs/settlements without consent of insurers May be conditions precedent to policy cover Scope for conflicts of interest (QC/Hammer clause)

Necessary steps to minimise coverage disputes

Ensure full disclosure of material facts at pre-contract stage

Review policy wording and negotiate improvements, particularly to any ambiguous or unduly onerous terms and conditions

Notify any material changes of risk during policy period eg acquisition of subsidiary/offering of securities (in accordance with policy terms)

Notify claims and circumstances promptly and in accordance with policy terms

Necessary steps to minimise coverage disputes

Ensure D&Os aware of notification requirements Obtain insurers’ consent to any defence costs incurred in

advance Seek to comply with any defence costs guidelines insurers

may seek to impose Ideally request improvements to costs guidelines at pre-

contract stage Ensure lawyers aware of guidelines and keep adequate

records (particularly for “mixed” claims) Keep insurers informed of material developments and consult

with insurers in relation to any proposed settlements

Conclusion

Dangerous to make assumptions about what is and is not covered by D&O policy

Policy wordings differ significantly FSA contract certainty initiative provides

policyholders with opportunity to review policy wordings at pre-contract stage

Policyholders should seek to negotiate improvements to policy wordings

Seemingly minor variations can have significant impact on the cover available

Strive for contract clarity as well as contract certainty!