Directors and Officers Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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2 THE NATURE AND LEGALITY OF D&O LIABILITY INSURANCE

I. GENERAL

2.01 D&O liability insurance forms part of the complex area of professional indemnity insurance1 and as such deals with three main areas of cover:

(1) the director’s own liability to third parties as a result of a breach of contractual2 or fiduciary duties or actions amounting to a tort;
(2) defence costs which the director himself or the company may incur as a result of legal proceedings concerning liability under the preceding sub-paragraph3; and
(3) reimbursement of the company in respect of any indemnity paid in advance to its directors.4

2.02 Additional protection exists in the form of “entity cover” which, as composite insurance (that is, together with D&O cover), offers cover for both directors and companies’ liability.5 Entity cover in one sense contradicts the fundamental purpose of D&O insurance because the former’s existence potentially allows for the exhaustion by the company of the aggregate limit on claims under the composite policy, thus leaving the directors without protection. 2.03 The manner in which companies work represents the interconnection of three parties within an “infernal triangle”6 in which directors, the company itself and third parties all battle to achieve self-interested goals. The operation of the various principles governing the conduct of company directorships and the potential liabilities of company directors compels directors and officers to comply with complex duties which, in case of default, may leave them highly vulnerable at both civil and criminal law. One may suggest that liability insurance is, therefore, essential to allow directors to exercise their functions without fear of potential pecuniary losses from a variety of sources.

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II. THE LEGALITY OF D&O INSURANCE—THE COMPANIES ACT 2006

2.04 As one might expect, it is a requirement of valid professional indemnity insurance that it is lawful to insure the activity sought to be insured. Prior to the enactment of the Companies Act 1929, it had been accepted that a company’s articles of association could exculpate directors and officers from liability as long as they were not guilty of fraud or wilful default. In other words, it was perfectly legal to incorporate indemnity clauses within the articles of association that operated so as to alleviate directors’ fears of non-fraudulent and non-wilful liability.7 This principle was completely transformed by the work of the Greene Committee on Company Law which in 1926 recommended that this practice be prohibited, a recommendation implemented by section 152 of the Companies Act 1929. Section 152 was followed in turn by section 205 of the 1948 Act, section 310 of the Companies Act 1985 and section 309 of the Companies Act 1985 (as amended by the Companies (Audit, Investigations and Community Enterprise) Act 2004).8 The point is now governed by section 232 of the Companies Act 2006, which came into force on 1 October 2007. 2.05 Nowadays it is clear, as is also suggested by the principle of “moral hazard”, that companies are prohibited in all circumstances from indemnifying their directors against damages awarded against them as a result of the dishonest or negligent performance of their duties.9 Accordingly, section 232 of the Companies Act 2006 provides as follows:

“(1) Any provision that purports to exempt a director of a company ( to any extent) from any liability that could otherwise attach him in connection with any negligence, default, breach of duty or breach of trust in relation to the company is void.
(2) Any provision by which a company directly or indirectly provides an indemnity (to any extent) for a director of the company, or of an associated company, against any liability attaching to him in connection with any negligence, default, breach of duty or breach of trust in relation to the company of which he is a director is void, except as permitted by:
- (a) section 233 (provision of insurance);
- (b) section 234 (qualifying third party indemnity provision) or;
- (c) section 235 (qualifying pension scheme indemnity provision).
(3) This section applies to any provision, whether contained in a company’s articles or in any contract with the company or otherwise.
(4) Nothing in this section prevents a company’s articles from making such provision as has previously been lawful for dealing with conflicts of interest.”

2.06 The effect of this section is that attempts by the company to exclude the liability of the directors to the company or to agree to indemnify the directors for breach of duty are void as a matter of law.10 A number of points arise from this. (a) First, it is important to emphasise that section 232 does not prohibit a company from indemnifying its directors in circumstances of its choosing. Rather, it is that any such indemnity “obligation” is in fact void and

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therefore unenforceable. (b) Secondly, the limitation applies only as regards liability in relation to the company and not in relation to third parties.11 2.07 Historically, there was an important issue as to how to reconcile the operation of section 309A of the Companies Act 198512 (now section 232 of the 2006 Act), with article 85 of Table A13 since under that article certain provisions exempting directors from liability clauses of this nature are perfectly permissible. Directors’ responsibilities may be viewed as falling into two different classes: (i) duties owed to the company; and (ii) disabilities.14 The first of these classes encompasses duties which could not be modified without infringing section 309 of the 1985 Act. The duty to act honestly or in good faith15 and the tortious duty of care and skill16 both fall into this group. 2.08 Public policy constraints preclude the likelihood of exclusions from the articles and/or indemnity clauses being allowed where directors either disregard the company’s interests or act negligently to its detriment. The basic point underlying the concept of disabilities is that directors are unable to carry out certain activities in breach of their fiduciary obligations unless they have been disclosed to the company. For example, the general prohibition on a director contracting with the company is a disability capable of being modified by the consent of the shareholders.17 Another way of analysing disabilities is by looking at them as amendable duties. Viewed from this perspective, the “no conflict”18 and “no profit”19 rules can be seen to belong to this category.20 Using exclusion clauses contained within the articles of association, disabilities such as the no conflict and no profit rules can be amended effectively, at least to some degree. Where the company has not drafted its own articles but has adopted articles 85 to 90 of Table A21 this is in fact the default position. The decision of Vinelott, J in Motivex Ltd v. Bulfield 22 provided unambiguous guidance as to the interpretation of what was then section 310 (now 309) of the Companies Act 1985, concluding that it could indeed co-exist with article 8523 and holding that exclusion clauses such as those contained within article 85 are indeed permissible.24 2.09 One further problem arose from the fact that, under the original version of section 310 of the Companies Act 1985, it was unclear whether or not companies could actually incur the cost of a premium in respect of insurance against the directors’ potential liability in

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damages without contravening the terms of that section.25 In the absence of any clarity on the point, the development of the UK market for D&O insurance cover was severely hampered for a number of years. Fortunately, the matter was resolved when section 137 of the Companies Act 1989 came into effect, amending section 310 and establishing the legality of this type of cover.26 The position was further ratified in 2005 by the insertion of a new section 309(5) of the Companies Act 1985.27 2.10 The position is now dealt with by section 233 of the Companies Act 2006, which provides:

“Section 232(2) (voidness of provisions for indemnifying directors) does not prevent a company from purchasing and maintaining for a director of the company, or of an associated company, insurance against any such liability as is mentioned in that subsection.”

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