UK: The Future For Directors’ And Officers’ Liabilty

The directors’ and officers’ (‘D&O’) liability insurance market has been disappointing for insurers since approximately 2004: rates have been stunted whilst coverage has expanded. Some insurers are even offering policies under which they promise to pay where third-party policy limits are exhausted or compromised.

For the future, there are at least two forecasts: insurable exposures will augment, and average settlement values will elevate.

Some of the most modern insurable exposures may be categorised as follows:

1. Environmental
2. Reporting obligations
3. Companies legislation

1. Environmental

   The potential for corporate environmental liability could be pandemic. For instance, it is suspected that radiation from wi-fi technology and mobile telephones injures bees. If this is substantiated, there may well be claims against companies from beehive-owners. Further, because natural pollination relies on bees, many others in agriculture might also seek to sue.

   Directors and officers are liable on their own account to third-party claims under the general law, including the laws of negligence, agency and breach of warranty. Of course, the law of negligence only rarely compensates a third-party for economic loss, but directors’ statutory exposure to their own company circumvents many of the negligence principles. Quoted companies must specifically include information about environmental impact in their business review; and any director should address such impact as a factor of his or her duty to promote the success of the company. In theory, shareholders could mount a derivative action on the putative behalf of the company in which they assert that directors have under- or over-prioritised the environment contrary to the promotion of the company’s success; although the courts are likely to be wary of such actions as discussed under the heading Companies legislation below.

   As regards affirmative environmental action, there may be generic (alleged) business interruptions if legislation compels companies to curtail their emissions.

   Individual directors and officers are especially at risk in circumstances of an "environmental incident": i.e. the unlicensed release of pollution or waste into the environment. Any director, manager or equivalent office-holder is liable to criminal prosecution where an environmental incident constitutes an environmental or health and safety offence committed by the company with the consent or connivance of the individual or is attributable to neglect on the part of the individual. Environmental regulatory entities are also empowered to require individuals and their employers to rectify environmental casualties such as by cleansing contaminated land, recycling waste and restoring watercourses. Directors and officers will be grateful that hitherto they have seldom personally been convicted in environmental proceedings or charged with clean-up costs, but prosecutions by the Environmental Agency are on the up.

   From 1 July 2007, the inimitably-named WEEE Directive is to be fully implemented in the United Kingdom. It is one of a series of directives from the European Union that renders businesses responsible for how EEE (i.e. electrical and electronic equipment) is disposed of. In short, where a business manufactures, brands, sells, imports, treats, dismantles or merely stores any EEE anywhere within the European Union, it must promote the eventual treatment and recycling of the EEE, so that the products do not simply surface in landfill sites.

   Insurers will be relieved that environmental risks are often excluded from D&O cover, but such exclusions are often themselves subject to an exception for defence costs.

2. Reporting obligations

   The Companies Act 2006 and the listing and disclosure rules of the Financial Services Authority (‘FSA’) both reflect the obligations under the European Union’s Transparency Directive which has been in force since January 2007. The directive stipulates that issuers of securities that are traded on a regulated market in the European Economic Area must publish periodic financial reports that, at minimum, review the issuer’s business fairly and that disclose the principal risks and uncertainties that it faces. Further, if the report contains a false or misleading statement or omission of a material fact, and a director or senior executive who is responsible for the report knows the statement to be untrue/misleading or is reckless as to whether it is untrue/misleading or knows the omission to be a dishonest concealment of a material fact, then an investor who suffers loss consequent on the misstatement or omission has a cause of action for compensation. The conditions of dishonest/reckless mens rea and the need for the claimant to quantify its consequent loss may mute some claims, in particular where the issuer reports on novel or evolving matters such as the company’s environmental policies.

3. Companies legislation

   On the face of the Companies Act 2006, Parts 10 and 11 of the Act may appear alarming to companies and their insurers. These Parts regulate directors’ general duties and derivative actions respectively. Part 10 enumerates directors’ general duties for the first time in statute, as opposed to simply at common law and in equity. Part 11 facilitates an action by shareholders against directors in the name of the company for negligence or breach of duty. With the exception of the conflict of interest rules, the provisions will be in force from 1 October 2007.

   However, it is improbable that there will be an immediate tide of D&O lawsuits and claims. There are safeguards in the Act. For example, the court must grant leave to the claimants in a derivative action to proceed. The court’s evaluation will entail inter alia whether the claimants are acting in good faith. The absence of good faith is likely to preclude a derivative action by political or environmental campaigners who have only just purchased shares in the company and who are presenting the action primarily to vindicate their political/environmental cause. The English courts have also pronounced a ‘business judgment rule’ which defers to directors’ decisions made in good faith for the best interests of the company. In addition, the claimants pay their own legal costs during the proceedings; and any recovery in favour of the claimants is payable to the company so that litigants should not be tempted by an instant personal windfall.

   By contrast, companies and insurers should expect some gradual escalation in litigation. This is for several reasons.

   First, the statutory codification of directors’ duties and the electronic communication of company material will advance shareholder awareness.

   Second, any shareholder can mount a derivative action under the Companies Act 2006 no matter how minimal their stake in the company. Indeed, the shareholder may now own only a single share.

   Third, it is not certain that the codified duties in fact replicate the common law and equitable rules: shareholders may seek to explore or exploit the dissonance in court.

   Fourth, it is predicted that the epidemic of class actions will infect Europe. Institutional investors have already become more active in supervising and policing corporate governance and performance. Litigation-funding firms have proliferated. The pharmaceuticals industry may be particular prey, above or alongside the com-tech businesses. In addition, directors in com-tech may be subject to suits in respect of back-dated share options; and their D&O insurers are likely to have to reimburse the defence costs.

   It will be illegitimate for companies to indemnify directors for any adverse awards in a derivative action: insurers should be cautioned that directors may resort to their D&O cover instead.

   Further, insurers should not ignore regulation of themselves: especially where non-resident insurers purport to provide domestic cover in non-European Union overseas’ jurisdictions. There may be internal legislation which penalises the foreign insurer, although the insurer is rarely excused from indemnifying the insured under the policy. Latin American companies are especially notorious for expensive fines, at multiples of up to ten times premium.

As average settlement values escalate, insurers will become more aware and more wary of whether and how they indemnify any settlement of the underlying claim against a director or officer. For instance, there may be issues such as:

1. whether it is a condition precedent of the D&O policy that the insurer may participate in any settlement of the action; and if so, whether this condition affords the insurer more than the right to attend the inter partes negotiations;
2. whether the insurer must consent to any settlement; and if so, whether the insurer must not unreasonably decline consent; and if so, what does ‘unreasonableness’ imply;
3. whether all of the claimant’s causes of action against the individual are within the scope of the D&O policy;
4. whether the insured has substantiated that he or she was in fact liable to the claimant for at least as much as the settlement sum.

A typical example of the last two of these issues is where the insured has settled several claims against it, only some of which are subject to the insurance, or where the insured has contributed to a global settlement with other defendants who were not insured. The case law once mandated that the settlement itself distinguish the insured’s indemnifiable liability from the other non-insured claims/defendants: Lumbermens Mutual Casualty Co v Bovis Lend Lease Ltd [2004] EWHC 2197 (Comm), [2005] 1 Lloyd's Rep 494. By contrast, the recent jurisprudence has been more liberal and more practical: the insured can now ascertain the quantum of its insurable loss by any evidence in the settlement agreement or elsewhere: see Enterprise Oil Ltd v Strand Insurance Co Ltd [2006] EWHC 58 (Comm), [2006] 1 Lloyd's Rep 500 and AIG Europe (Ireland) Ltd v Faraday Capital Ltd [2006] EWHC 2707 (Comm), [2007] 1 All ER (Comm) 527.

For the future, pursuant to these latest authorities, it is likely that insurers will query any ex post apportionment of the settlement sum, and will invoke their right not to be bound by any settlement to which they were not party. Conversely, sensible insureds should invite the insurer to engage in the inter partes negotiations and to confirm the settlement in advance, and ideally should verify the amount of the insurer’s prospective indemnity prior to signing the settlement.

The fact that settlement sums are soaring does not denote that it is ‘safer’ for insurers for their insured to be in court. In the case of Plymouth & South-West Cooperative Society Ltd v Architecture Structure & Management Ltd [2006] EWHC 3252 (TCC), [2006] Lloyd’s Rep IR Plus 3, the defendant’s professional indemnity insurer was not party to the action between the claimant and their insured client. Yet, the insurer funded and instructed the client’s substantive defence which the judge rejected. Subsequent to the judgment, the successful claimant sought to recover its costs from the non-party insurer, given that the insured was insolvent, on the basis of the insurer’s self-interested interposition in the proceedings. His Honour Judge Anthony Thornton Q.C. awarded one million pounds’ worth of costs against the insurer in favour of the claimant under section 51(3) of the Supreme Court Act 1981. The insurer was ordered to pay this sum in addition to the coverage limit of £2,000,000 under the policy: which thus multiplied the insurer’s maximum budgeted exposure by 150%. In the future, insurers which are notified of litigation are advised to: explore the insured’s solvency; if the insured is financially insecure, elicit as to whether or not the insured retains any interest in resisting the claims; and in any event, collaborate with the insured and any excess layer insurer or re-insurer in directing the defence.

Since approximately 2003, the United Kingdom has enjoyed a bull market. Yet, this is bound to terminate sometime, and probably sometime soon given that this is the fourth year of the boom. If and when share prices do slump, shareholders may seek to challenge corporate conduct in court: including pursuant to the Transparency Directive and Companies Act remedies described above.

In order to define and to price cover properly, insurers should question the prospective insured in the proposal form or renewal notice as to all of the matters above: e.g. including the company’s environmental policies.

From the perspective of directors and officers, they should verify that their new responsibilities are within their existing policies. Notwithstanding the current soft market, it has been identified that small and medium sized enterprises in the United Kingdom often lack modern covers such as employment practices liability insurance, which reimburses the insured in the event of discrimination and similar claims by employees.

It was observed at the outset of this text that D&O premiums have scarcely risen recently. In part, this is insurers’ own ‘fault’: more insurers are issuing more policies, and underwriting more risks. It is wondered whether the new legal and ancillary exposures will quell insurers’ generosity.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.