A common pitfall for directors with D&O insurance policies is that they do not realise they are not covered for a particular event until they try to claim. Emilios Kyrou, partner, Mallesons Stephen Jaques, identifies some undesirable gaps in D&O insurance policies and suggests how to overcome them.

    Does your D&O policy cover your risks?

    The needs of directors in relation to indemnity and insurance are very simple: if a claim is threatened or made against them, or they are caught up in an inquiry, they want immediate access to a competent legal team who will protect their interests, and whose fees will be paid by someone else. While most directors believe that any claim that might be made against them would lack any merit, they also want the assurance that if a claim succeeds, someone else will pay the resulting judgment or other liability. In short, directors and officers want to sleep easy at night.

    In the case of a reputable and solvent company, directors prefer for the claim to be handled, and for any payment to be made, by their own company rather than an insurer for the following reasons:

    • the director knows the company’s people and has a sense of loyalty and trust concerning the company which is unlikely to be the case with an insurer, especially if the director has not previously dealt with the insurer;
    • corporate indemnities usually do not contain any excesses or upper limits on cover; and
    • corporate indemnities usually only have the minimum exclusions required by law, compared to insurance policies which may have a multiplicity of exclusions and other restrictive provisions.

    When this is coupled with the fact that the company reimbursement component is the dominant part of a typical D&O policy, it is essential to look at a D&O policy and the relevant corporate indemnity as a complete package in order to properly identify gaps in cover.

    There are legal restrictions on the indemnities companies can give under the Corporations Act, so at a minimum a D&O policy must cover the liabilities which cannot be the subject of a corporate indemnity. Other features that a D&O policy must have in order to avoid significant gaps in cover are:

    (a) the policy should contain a true automatic advancement of defence costs clause;
    (b) the policy should make clear that an excess will never be payable by a director;
    (c) the exclusions in the policy should be minimal, and there should not be any unusual exclusions;
    (d) there should not be any onerous or restrictive provisions in the policy; and
    (e) there should be an effective severability and non-imputation clause.

    Liabilities for which corporate indemnity is prohibited

    All D&O policies are structured so that indemnification from the company is the primary source of protection for directors. It is therefore vital that the policy provides cover for liabilities that the company cannot legally indemnify its directors against. If this gap exists a director’s personal assets may be exposed. Specifically, it is vital that the policy provides cover for the liabilities which are subject to the prohibition on indemnity in section 199A of the Corporations Act, namely:

    • a liability for compensation orders under sections 1317H or 1317HA, or civil penalties under section 1317G of the Corporations Act;
    • liabilities to the company and its subsidiaries;
    • liabilities to third parties which did not arise out of conduct in good faith; and
    • in certain circumstances, payment of costs for defending proceedings.

    Compensation orders and civil penalties

    Various Acts empower courts to order a person who has breached the Act to pay compensation to a person who has suffered loss as a result of the breach. Section 1317H of the Corporations Act is an example of such a provision. It provides that the court may order a director who has contravened a civil penalty provision to compensate the company for damage suffered as a result of the contravention. As compensation orders are a form of compensatory relief, they are likely to fall within the definition of ‘loss’ in a D&O policy. However, it is safer for the policy to expressly refer to compensation orders. Furthermore, as other Acts may authorise the making of compensation orders, it is prudent to require the policy to cover all compensation orders under any Act. There are D&O policies in the market which expressly cover compensation orders made under any statute anywhere in the world.

    The Corporations Act imposes civil penalties for breaches of various provisions of the Act, including the core directors’ duties in sections 180, 181, 182 and 183 of the Corporations Act. The recently enacted Trade Practices Legislation Amendment Act (No 1) 2006 prohibits indemnification for civil penalties imposed for breaches of Part IV of the Trade Practices Act (see new section 77A). ASIC has been using civil penalty proceedings as its primary enforcement mechanism in recent years. Other regulators, particularly the ACCC and APRA, are adopting similar approaches.

    Given that civil penalties are an important exposure for directors, and given also that the company is prohibited from indemnifying directors against key civil penalties, it is vital that the company’s D&O policy provides cover for civil penalties. A policy which does not is unacceptable. Insurers are becoming less reluctant to provide cover for civil penalties. While there are policies which provide broad cover for civil penalties, this is now the exception. What is more usual is for a D&O policy to provide cover for civil penalties in the form of a sub-limit. The minimum sub-limit is usually $500,000. Many large Australian public companies now have a sub-limit of at least $2 million. This cover is usually confined to civil penalties imposed in Australia or New Zealand.

    Liabilities to the company or its subsidiaries

    Given that directors owe legal duties principally to their company, the primary source of liability for them, if they breach their duties, is a damages claim by the company itself, especially after a hostile takeover or liquidation. As section 199A of the Corporations Act prohibits a company from indemnifying the directors for liabilities to the company itself, it follows that it is important that the company’s D&O policy provides cover to the directors for liabilities they incur to the company.

    A D&O policy which contains an insured versus insured exclusion, which excludes cover for claims against a director brought by his or her company, a subsidiary, or another director or officer, is deficient. The D&O policies of many leading public companies do not contain such exclusions. Instead, they contain an exclusion for collusive claims.

    Third party claims involving absence of good faith

    No D&O policy excludes cover based on the absence of good faith, as distinct from fraud or dishonesty.

    Defence costs

    As the costs of defending proceedings are often significant, a director may not be able to adequately defend proceedings if he or she is required to pay the costs personally. It is thus vital that, where a director is sued, someone other than the director pays the costs. Moreover it is essential that the amounts payable are sufficient to enable the director to be represented by experienced and competent lawyers.

    As sections 199A and 212 of the Corporations Act impose some restrictions on a company paying legal costs on behalf of its directors, there may be circumstances where the company cannot or will not pay legal costs on behalf of directors. It is thus important that directors have secure entitlements to payment of defence costs under their D&O policy.

    The key issues concerning defence costs provisions of D&O policies relate to:

    • reasonable and necessary defence costs;
    • advancement of defence costs; and
    • costs of representation at inquiries.

    Reasonable and necessary defence costs

    It is not unusual for D&O policies to provide that the insurer will pay ‘reasonable’ defence costs. While it is appropriate for insurers to protect themselves from excessive expenditure on legal costs, in practice insurers tend to adopt a narrow interpretation of reasonableness in relation to costs. Some have artificial rules, including that they will not pay more than $400 per hour for any solicitor when the market rates of many partners in the major law firms are in the $500-$700 range. It is obvious that such a restrictive approach to hourly rates creates a hidden gap in cover. In a large case, the gap can run into hundreds of thousands of dollars.

    Some D&O policies go one step further and require that the costs be ‘reasonable and necessary’. This has the potential to narrow the quantum of costs payable by the insurer. It can encourage nit-picking by the insurer and create disputes as to whether an item of legal costs was ‘necessary’ as well as ‘reasonable’. As the expression ‘reasonable and necessary’ is likely to widen the hidden gap in cover, it should not be accepted.

    Some D&O policies define ‘defence costs’ so as to confine cover to costs ‘incurred in defending any claim’. The best practice wording is ‘incurred in investigating, defending, settling or appealing any claim’.

    Advancement of defence costs

    Where a claim is made against a director, it may sometimes take several months for a D&O insurer to investigate the circumstances of the claim and decide whether cover is available. Where circumstances exist which might attract an exclusion, some insurers adopt the approach of reserving their position (ie, not making a decision one way or the other as to whether cover is available) until the outcome of the claim is known, either through a court judgment or a settlement. In cases where insurers reserve their position, or delay a decision pending investigation, it is of fundamental importance for directors that the legal costs they incur in the relevant proceeding are paid by someone other than them. For this reason, it is important for D&O policies to provide for the insurer to advance defence costs pending determination of whether cover is available under the policy.

    D&O policies adopt different approaches to advancement of defence costs. Some policies oblige the insurer to advance defence costs until a positive decision is made to reject cover. Others oblige the insurer to advance costs up to a certain sub-limit prior to the insurer making a positive decision to reject cover. Other policies leave it to the discretion of the insurer whether to advance defence costs.

    The ideal advancement of defence costs clause is one that provides that the insurer must automatically advance defence costs as soon as a claim is notified, until such time as the insurer rejects the claim, and does not contain a sub-limit. The clause should provide that the insurer cannot reject a claim on the basis of an exclusion dealing with improper conduct such as fraud, dishonesty, wilful breach of duty and gaining a benefit to which a director is not legally entitled, unless and until that improper conduct is established by a court, or by an admission by the relevant director.

    Many policies provide for advancement of defence costs for ‘covered claims’. This is not a true advancement of defence costs provision because costs are payable only after the insurer makes a decision that the claim is covered. Where a claim is covered, it follows that the costs of defending it are covered. Therefore, the advancement of defence costs clause is potentially misleading because it does not add anything to the normal insuring clause.

    The next article in this series will consider the costs of representation at inquiries, undesirable or unusual exclusions in D&O policies, and the need for an effective severability and non-imputation clause.


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