Directors and Officers Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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3 PERSONS COVERED BY D&O INSURANCE

I. DIRECTORS: WHO ARE THEY?

3.01 Companies, upon registration, are required to appoint a number of persons,1 designated as directors, whose function is to carry out—whether acting jointly or individually—the obligations imposed on them by the companies legislation. Subsequent appointments are made by the shareholders in general meetings, following whatever procedure may be agreed in the articles of association or in the default provisions of article 73 of Table A2 which establishes a rotation system.3 While companies acquire personal and legal capacity4 through the issuing of the certificate of incorporation by the companies registrar, they obviously need to be represented by human beings, that is, the directors.5 3.02 Although the Companies Act 2006 does not give a clear definition of a “director” as such, what little there is by way of definition6 emphasises that the position of directors is not recognised merely because of the title given to them. Rather, the test is functional.7 As a result, the actual name given to the persons operating the company’s business does not present any obstacle to them being “directors” and thereby assuming the role, duties and liabilities which such position embodies. Consequently, directors may in fact be called, for example, governors,8 trustees and even council members, without affecting the true nature of their relationship with the company and/or the level of liability they could incur. 3.03 There are few limitations on the persons who may become a director. The main limitation is the requirement that the person appointed enjoys full legal capacity. This principle may be used to explain why an undischarged bankrupt is not permitted to hold such office9 —they are not considered to be in a position to carry out activities demanding the performance of a high level of fiduciary duties. Additionally, the Companies Act 2006 establishes that a person may not be appointed as director of a company unless he has attained the age of 16 years.10

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3.04 Special attention needs to be given to the issue of appointing corporate bodies as directors. In fact, contrary to the opinion of some scholars in this field, English legislation does not forbid companies from becoming directors of other companies and this can often be the case with, for example, parent and subsidiary companies and even in joint venture enterprises. The position has to some extent been clarified by section 155 of the Companies Act 2006 which requires companies to have at least one director who is a natural person. 3.05 However, the reality is that companies could be appointed as directors and the imposition of fiduciary and other duties on a corporate body director gives rise to difficult questions of agency and liability in terms of how the director itself acts. This is why policy wordings, in the vast majority of cases, exclude from the meaning of “directors and officers” any legal person or corporate body. So, for example, Lloyd’s Form LSW 736 provides: “3(a)(i) Director or Officer shall mean: (i) any natural person who was or is or may hereafter be a Director or Officer of the Company.”11 3.06 The number of directors a company is required to have is governed by section 154 of the Companies Act 2006, which provides that every private company must have at least one director and every public company at least two. Where there is more than one director, problems arise under D&O policies in relation to the allocation of defence costs.12

II. TYPES OF DIRECTORS

(a) De jure and de facto directors

3.07 The main difference between de jure and de facto directors surrounds their appointment. De jure directors are those designated according to the rules governing such appointment13 to undertake the affairs of the company. An express appointment is thus required for a person to become a de jure director. Additional requirements include that the appointed director has agreed to hold office, enjoys full capability by not being disqualified and has not vacated office.14 3.08 On the other hand, de facto (or assumed) directors15 are either individuals appointed as directors but with a defect in appointment, or unappointed persons who are treated as directors by reason of their assumption of directors’ duties. The term covers those who have assumed the role of directors or have been so held out to the outside world. In determining whether a de facto directorship exists, the court will look at all relevant circumstances.16 Those factors include at least whether or not there was a holding out by the company of the individual as a director, whether the individual used the title of director, whether the individual had proper information (for example, management accounts) on which to base decisions, and whether the individual had to make major decisions. The essential question is

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whether the individual was part of the corporate governing structure,17 such that they performed their functions in a manner consistent only with acting as a director.18 3.09 Regarding insurability, there is nothing in principle which prevents a de facto director from insuring against liabilities incurred in that capacity. Nevertheless, the policy itself may require, by way of a contractual provision, that only duly appointed directors are covered in order to avoid the inconvenience of having to ascertain in the first instance precisely who is a director in order then to activate the potential indemnity. In some cases, insurers agree to cover “the board” as such and in this situation, whoever carries out the functions of a director—irrespective of any appointment—may be deemed to be the assured for the purpose of D&O insurance. In the absence of such deeming provisions, the position is plainly open to doubt.

(b) Shadow directors

3.10 A shadow director is someone never actually appointed but who is: “ … a person in accordance with whose directions or instructions the directors of the company are accustomed to act.”19 3.11 This definition has been incorporated within two of the most important statutory provisions namely, section 251 of the Insolvency Act 1986 and section 22(5) of the Company Directors Disqualification Act 1986. 3.12 The term “shadow director” includes persons who exercise a measure of regular control over the company (whether or not in some concealed or sinister manner), although the statutory definition set out above excludes professional advisers acting in that capacity. The general test is that shadow directors will be those, other than professional advisers,20 who exercise real influence in the direction of the company’s affairs. It does not have to be shown that the board was subservient to the alleged shadow director and this is a common misapprehension. Direction can include “advice” and does not have to be shown to be mandatory.21 3.13 In Secretary of State v. Deverell,22 the Court of Appeal held that the term “shadow director” was to be construed so as to give effect to the parliamentary intention underlying it. The purpose of the legislation was to identify those, other than professional advisers, with real influence in a company’s corporate affairs, although it was not necessary that such influence was exercised over the whole of its corporate activities. The court, therefore, had to ascertain objectively, in the light of all the evidence, whether any particular communication from an alleged shadow director, whether by words or conduct, was to be classified as a direction or instruction. While it would be sufficient to show that, in the face of directions or instructions from the alleged shadow director, the properly appointed directors or some of them cast themselves in a subservient role or surrendered their respective discretions, it was not necessary to do so. Finally, a shadow director might act quite openly and certainly did not have to be shown to reside in the shadows. A good example was of a person resident abroad who owns all a company’s shares but chose to operate the company through a local board of

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directors and from time to time, to the knowledge of all concerned, gave directions to the local board as to what to do but took no part in the company’s management. Such a person could be a shadow director despite the fact that he/she took no steps to hide the part they played in the affairs of the company.23 3.14 The question which arises is to what extent shadow directors may incur personal liability to the company and possibly to third parties. The point commonly arises in an insolvency context and the application of section 214 of the Insolvency Act 1986 (wrongful trading)24 is of considerable importance here. Shadow directors may be liable to the same extent as appointed and de facto directors, either to account for profits or to compensate the company.25 Wrongful trading has been the subject of extensive debate in the literature26 and in practice it is a very common allegation in claims in which banks and parent companies are involved.27 However, the issue, although significant in insolvency and company law, is of far less importance in the context of a D&O policy because insurers refuse to extend cover to entities acting in their capacity as director.28 3.15 The second important area concerning shadow directors is that of disqualification.29 Under section 22(5) of the Companies Directors Disqualification Act 1986, shadow directors are subject to the disqualification jurisdiction to the same extent as appointed or de facto directors. Even though the disqualification sanction is, by its nature, uninsurable, there is nothing to prevent directors from indemnity in respect of defence costs incurred in contesting such proceedings (and whether successfully or not). So it cannot be said that disqualification proceedings are strangers to D&O coverage. 3.16 Finally, section 417(1)(b) of the Financial Services and Markets Act 2000 is to be interpreted as encompassing a shadow director and, therefore, identifying this form of directorship is relevant here.

(c) Executive and non-executive directors

3.17 Executive directors tend to work and manage the company’s affairs on a full-time basis, usually pursuant to contracts of employment. Executive directors are in charge of the management of the company and exercise the powers conferred upon them by the articles of association.30 The distinction between executive and non-executive directors is not defined in the Companies Acts,31 but the January 2003 Review of the Role and Effectiveness of Non-Executive Directors (“the Higgs Report”) described non-executive directors as “the custodians of the governance process”. Non-executive directors will not be in charge of the daily management and are unlikely to have any responsibility for the company’s employees. They are appointed because of the skills, knowledge and prestige that they may bring to the board of directors.32 They may be entitled to a fee in respect of the role they perform.33 Since the non-executive directors are not involved in the day-to-day running of the business, their role

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involves seeking to establish and maintain their own confidence in the conduct of the company, in the performance of the management team, the development of strategy and the adequacy of financial controls and risk management. The role of the non-executive director is, therefore, both to support executives in their management of the business and to monitor and supervise their conduct. There is an obvious tension between monitoring executive activity and contributing to strategic development: too much emphasis on the former casts the non-executive director in the role of policeman, on the latter, it can lead to undermining of the custodianship of the governance process. 3.18 Executive and non-executive directors in theory owe the same legal duties to the company, but as Langley, J noted in Equitable Life Assurance Society v. Bowley and others 34 :

“ … the extent to which a non-executive director may reasonably rely on the executive directors and other professionals to perform their duties is one in which the law can fairly be said to be developing and is plainly ‘fact sensitive’. It is plainly arguable, I think, that a company may reasonably at least look to non-executive directors for independence of judgment and supervision of the executive management.”

3.19 One of the main areas of the Higgs Report concerned the topic of “insurance and indemnification”. As already noted, section 309 of the Companies Act 1985 and now section 233 of the Companies Act 2006 permits a company to insure its directors’ liability to third parties and to the company itself. It is also permissible to indemnify the directors in respect of third party claims even where such claims succeed.35 However, any provision in the company’s articles of association that amounts to an indemnity against defence costs or liability contravenes section 232 of the 2006 Act and is therefore unenforceable. The Higgs Report proposed that companies be allowed to indemnify their directors in advance36 in respect of the costs of contesting proceedings,37 including those brought by the company, but where the director’s liability was established they would be obliged to repay the costs.38 The Report went still further in saying that D&O insurance was now necessary39 and that companies should also be permitted to indemnify directors against any uninsured liability to the company by way of insurance deductibles or caps on liability.40

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3.20 What is said above leads to five conclusions particularly relevant to D&O policies:

(a) First, it is not yet clear that any expectation of the same level of skill and care from executive and non-executive directors is either fair or reasonable. Because non-executive directors are not involved with the company on a day-to-day basis their levels of awareness and involvement may be expected to be lower than those of executive directors. This does not mean that non-executive directors ought to be excused from knowing about the company’s business and affairs, but it may simply dictate that a split standard of skill and care might reflect the realities of the situation. How might such a double test affect D&O cover? D&O policies offer cover in one of the two following forms. The first is board cover—which is usually the case—protecting whoever holds the functional position of director. From this perspective, the degree to which non-executive directors may potentially be liable assumes lesser importance. Put simply, what matters here is that their potential liability is insurable under the umbrella of board cover. The second form of cover is individual cover, which is often suitable either (i) for those who hold office as non-executive directors in more than one company or (ii) as ancillary protection to a director’s personal liability insurance. The latter type of cover may require a more searching assessment on the part of insurers in order to fix the premium and allocate the risk, particularly in respect of instance (i) above.41 However, only by embarking upon such an assessment could a D&O policy ever be sufficiently bespoke and, therefore, effective in the context of a split standard of skill between executive and non-executive directors. If that were the case, it might be the case that the nature of a D&O policy would remain intact, the only real impact of a different test for non-executive directors lying in insurers’ perception and assessment of the risk.
(b) Secondly, it may be that imposing the same duties of skill and care upon executive and non-executive directors eventually leads to the position where the distinction between such directors is no longer of any great use in company law.42
(c) Thirdly, it seems unlikely at present that company law will take further steps towards allowing the company (i) to indemnify directors for wrongs committed in their capacity qua directors and (ii) to advance defence costs without requiring them to have been being cleared of intentional or fraudulent breaches of duty owed to the company. Moral hazard issues continue to be of the utmost importance in the context of arguments surrounding the mitigation of directors’ liability and even with the duties currently owed by directors, companies are regularly involved in financial scandals. Most of the time, as one would expect when anything other than nominal loss or damage is suffered, the directors in question become insolvent. In that context, the prospects of reimbursement by directors in the additional circumstances suggested by the Higgs Report are slim. This is particularly so when one has in mind the recent history of the relevant legislative provisions. First, there was the coming into force of the new Companies (Audit, Investigations and Community Enterprises) Act 2004, which amended section 310 of the Companies Act 1985 by

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introducing new sections 309A, 309B and 309C substantially relaxing the prohibitions against companies protecting and/or indemnifying directors against liability. Section 234 of the Companies Act 2006 takes the same approach.43
(d) Fourthly, the Higgs Report may be interpreted as an invitation for the implementation of a two-tier board structure within the UK.44 Of course, the implementation a two-tier board system, albeit extremely unlikely in the UK, would force a wholesale revision in D&O policy wordings regarding definitions, aggregate limits and deductibles. In theory, however, the nature of D&O insurance would remain unaltered.
(e) Finally, the Higgs Report emphasises the need for D&O cover as a means of alleviating the potential burden faced by third party claimants who face against directors and who, without the existence of such cover, might be exposed to the risk of a director’s insolvency. Of course, whether D&O insurance in fact proves to be necessary going forward depends on how insurers, parliamentary bodies and the courts each assess, develop and assist in the effective implementation of this type of insurance.45

(d) Nominee directors: nominee, alternate and additional

3.21 One of the class rights attached to shares is the right to nominate one or more of a company’s directors, who, predictably, are often there to take into account the interests of those who have nominated them. Nominee directors are common in large companies, mostly representing majority shareholders or major creditors where huge investments have been put into the business.46 Notwithstanding the source of the nominee director’s authority, the liaison between the nominating shareholders or creditors and the nominee breaks up as soon the director is appointed, because the general interests of the company prevail over the limited interest of the nominating shareholders and the director must act accordingly.47 It has

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been noted that this is a strict view48 and incompatible with modern practice, since nominee directors are placed in a dual and conflicting position. On the one hand, they must have regard to the interests of the company and, on the other hand, they are there to have regard to the interests of those who have appointed them.49 As for the liability of nominee directors, the law imposes upon them full responsibility and they owe to the company not only the ordinary fiduciary and statutory duties but are also obliged to comply with the same duty of skill and care common to all directors. 3.22 Alternate directors,50 following articles 65 to 69 of Table A, are those who temporarily replace a director who is absent, ill or on vacation. As far as the responsibility of an alternate director is concerned, he is not an agent of the absent director. He owes duties to the company as a whole and consequently assumes personal liability while holding office. Alternate directors may follow the absent director’s instructions as to the manner in which decisions are to be taken and by doing so both the absent director and his alternate may be regarded as jointly and severally liable for direct losses and any consequential damage inflicted on the company.

III. PERSONS COVER: THE COMPANY

3.23 A company is a legal person formed by means of the association of two or more individuals who have decided to create, with the provision of capital51 and for a lawful purpose, a legal entity with a personality independent52 and distinct from that of the human members who found, control and administer the organisation.53 That legal personality is achieved by the registration of the memorandum and the articles of association in accordance with section 9 of the Companies Act 2006 and the issuing of the certificate of incorporation by the companies registrar.54 This enables a persona ficta to be deemed to exist and treated to the same extent as to any natural person in respect of its powers, rights and duties.55 3.24 In practice, D&O policies define companies very broadly but without drawing any distinction between the different forms companies may take. For example, Lloyd’s Form LSW 736 defines a “company” very simply, stating (at section 3(b)) that it shall mean “the company stated in the schedule and shall include subsidiary companies”. Although a definition of this nature implies that as soon as the entity assumes one of the available forms for a corporate body the policy attaches, it should be noted that companies—depending upon the particular form they acquire—are not in fact subject to the exact same regulations and statutory provisions. On the contrary, for instance, a listed plc attracts the application of the Financial Services and Markets Act 2000, which imposes additional norms of conduct and sanctions on directors, in addition to those contained in the Companies Act 2006.56

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(a) Types of companies

3.25 In fact, companies may be classified in a number of ways, including, for example, whether they have limited or unlimited liability, whether they are constituted for profit or not for profit, whether they are registered or not and whether they purport to be publicly or privately owned. In this section, therefore, we classify and analyse the types of companies that may exist and scrutinise the relevance of such classifications to D&O insurance. Special attention is given to registered private and public companies because they are the most common form of corporate entity and it is from these two types of company that D&O insurance has developed.

(i) Private companies

3.26 Private companies, which unsurprisingly are not permitted to offer their securities to the public,57 are the most common type of company in the UK. Such companies are, therefore, the most popular corporate form chosen by those who wish to set up a commercial enterprise without risking the totality of their assets. That protection is provided by the principle of limited liability. There is no limitation in respect of the number of shareholders and it is perfectly legal for one person to hold a company’s entire share capital. 3.27 In accordance with section 3 of the Companies Act 2006, private companies can be classified as belonging to one of the following three groups:

(a) Private companies limited by shares, in which the liability of the shareholders is limited by the memorandum to the capital originally invested, that is, the nominal value of the shares and any premium paid in return for the issue of the shares by the company. This is the most popular form adopted.
(b) Private companies limited by guarantee, in which the liability of their shareholders is limited by the memorandum as to the amount that shareholders undertake to contribute to the assets of the company in the event the company is wound up.Shareholders thus guarantee the company’s solvency.
(c) Unlimited private companies, in which every member is, in the event of a winding up, jointly and severally liable for all the company’s obligations. Members of such companies are in this respect in the same position as partners in a partnership.58

3.28 As far as a private company’s legal framework is concerned, it is very common to find a lack of demarcation between corporate governance and membership and the manner in which the company is controlled. It is a feature of this type of company that its share capital is commonly held by a small number of shareholders (often family members), who do not clearly demarcate the boundaries between corporate governance and the status of membership of the company. This means that in private companies shareholders are very often also directors as well and they control the company at their own will. Such a close relationship implies that corporate governance operates in an environment in which legal proceedings are not commonplace. In essence this is because, as explained below, the locus standi to bring an action against the board lies in the hands of the company. It follows that it is unlikely that shareholders acting on behalf of the company will sue themselves. 3.29 Of course, this does not mean that directors are not exposed to the risk of personal liability. Rather, it means that because of the ownership status of a private company, directors

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may believe, perhaps erroneously, that they are in an advantageous position when it comes to avoiding litigation.59 While the original directors are in control of the board or maintain their influence on decisions, the situation is likely to remain stable but this may change, for example, where (i) a new set of directors replaces the old ones, or (ii) when the company becomes insolvent and the board is replaced by an insolvency practitioner.60 Consequently, directors of private companies should not underestimate their potential exposure to personal liability and the costs of defending potential claims. 3.30 A second issue arises with regard to the type of protection offered to the shareholders of a private company. The principle that directors do not owe duties to shareholders is well established.61 This explains why shareholders are forced to seek their remedies through the company on the basis that protecting the matter may serve as indirect protection for the shareholders’ investment. To this end UK company law offers three actions to minority shareholders, namely:

(a) the derivative action;
(b) the claim in respect of unfairly prejudicial conduct; and
(c) the application for an order winding up the company in circumstances where the making of such an order is just and equitable.

3.31 Since this work is concerned only with relevant aspects of company law covering insurability, the just and equitable winding-up remedy—which does not per se give rise to any liabilities on the part of company directors—is not considered further.

(ii) Derivative actions 62

3.32 Although the position may in theory change in the very near future, derivative actions are increasingly rare nowadays and, in any event, have never featured that commonly in relation to private companies. This is due, at least in part, to the disproportionate cost of legal proceedings and also the potential availability to locked-in shareholders of private companies of alternative statutory remedies. 3.33 Following section 260 of the Companies Act 2006, the derivative action is based on the notion that a wrong has been done to the company by those in control of it and the controllers have refused to allow the company to bring an action itself to correct that wrong. That section provides as follows:

“(1) This Chapter applies to proceedings in England and Wales or Northern Ireland by a member of a company—(a) in respect of a cause of action vested in the company, and (b) seeking relief on behalf of the company. This is referred to in this Chapter as a ‘derivative claim’. (2) A derivative claim may only be brought—(a) under this Chapter, or (b) in pursuance of an order of the court in proceedings under section 994 (proceedings for protection of members against unfair prejudice). (3) A derivative claim under this Chapter may be brought only in respect of a cause of action arising from an actual or proposed act or omission involving negligence, default, breach of duty or breach of trust by a director of the company.The cause of action may be against the director or another person (or both). (4) It is immaterial whether the cause of action arose before or after the person seeking to bring or continue the derivative claim became a member of the company. (5) For the purposes of this Chapter—(a) ‘director’

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includes a former director; (b) a shadow director is treated as a director; and (c) references to a member of a company include a person who is not a member but to whom shares in the company have been transferred or transmitted by operation of law.”

3.34 The possibility of a derivative action exists only in respect of conduct which is not capable of being ratified by the general meeting. So, where ratification is possible there can be no derivative action.63 It follows that “the greater the possibility of effective ratification, the less scope there will be for any derivative action”.64 3.35 Assuming that a derivative action is possible, the question is whether a D&O policy affords financial protection to the directors. The answer is unclear. The locus standi to bring a derivative action is vested in the company’s members (its shareholders), who proceed on behalf of the company (in the company’s name) against the wrongdoers (the directors).65 Understanding this procedural point is crucial in any analysis of the enforceability of a D&O composite policy in the scenario where both the company and its directors are insured under the same insurance policy. Although we analyse this issue later on,66 it is worth noting here that if the requirements for a derivative action are met and the claimant is successful the company will be classified as the “third party” since it is nominally the victim of the wrong. This is because, despite the fact that the action is brought by a shareholder or shareholders, they are in fact acting in the company’s name and anything achieved will derive to the benefit of the company. Because the company is the claimant in the action so it is the company itself which is entitled to any relief awarded. So the issue here is whether the company can be treated as the “third party” under a policy to which it is itself a party (where there is composite cover). However, since the policy is one that provides cover in respect of the company’s liability rather than its first party loss, the company should be in no different a position to that of any other third party. 3.36 Another important issue here relates to the costs in respect of derivative actions and, more particularly, whether or not shareholders pursuing an action of this nature actually incur the legal costs of the proceedings or whether it is the company which ought to meet them. The answer is provided by the decision of the Court of Appeal in Wallersteiner v. Moir 67 where it was held that a court might in a minority shareholder’s action order the company to indemnify the shareholders in respect of the costs of the action incurred by them in mounting proceedings on the company’s behalf.68 3.37 What then is the relevance of this argument in the context of D&O insurance? Again, the answer is far from simple. Let us suppose that entity cover69 is provided, so that both the directors and the company are insured under the same policy, and the outcome is that the derivative action succeeds. In these circumstances it is the wrongdoer director(s) who will be

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ordered to pay the costs of the action. However, if the director cannot pay those costs then the court may order the company to indemnify70 its agent, in this case the shareholder(s) who brought the derivative action in the company’s name. This leads to the conclusion that whenever entity cover is offered and the insuring clause provides defence costs cover for both of the assureds—director and company—the insurer may have no choice but to pay defence costs to the shareholders, provided always that the claim attaches to the contractual terms and it is not excluded by the policy.71 3.38 What of reflective loss? The rule against reflective loss debars a shareholder from suing to recover a loss which is merely a reflection of the loss suffered by the company of which he is shareholder. The rule originated in the Court of Appeal decision of Prudential Assurance Co Ltd v. Newman Industries Ltd (No 2) 72 and was authoritatively discussed by the House of Lords in Johnson v. Gore Wood & Co. 73 This rule has been extended to include not only claims brought by a shareholder in his capacity qua shareholder, but also claims in his capacity qua employee or qua director, as well as in his capacity as a creditor.74 The dual-rationale behind this prohibition is to (i) prevent a shareholder from effecting double recovery and/or (ii) prevent the director from being required to indemnify both the company and the shareholder.75 It follows that reflective losses are outside the scope of D&O cover. 3.39 The second remedy available for minority shareholders is that contained in section 994 of the Companies Act 2006 in respect of unfair prejudice. Section 994 is in the following terms:

“(1) A member of a company may apply to the court by petition for an order under this Part on the ground—(a) that the company’s affairs are being or have been conducted in a manner that is unfairly prejudicial to the interests of members generally or of some part of its members (including at least himself), or (b) that an actual or proposed act or omission of the company (including an act or omission on its behalf) is or would be so prejudicial. (2) The provisions of this Part apply to a person who is not a member of a company but to whom shares in the company have been transferred or transmitted by operation of law as they apply to a member of a company. (3) In this section, and so far as applicable for the purposes of this section in the other provisions of this Part, ‘company’ means—(a) a company within the meaning of this Act, or (b) a company that is not such a company but is a statutory water company within the meaning of the Statutory Water Companies Act 1991 (c. 58).”

3.40 In practice, section 994 is unlikely to give rise to many liability issues concerning directors. Its primary purpose is to give protection to a locked-in shareholder in a private company who, by reason of some internal dispute, is unable to exercise management control in the fashion that was originally anticipated when the company was formed and is unable to dispose of his interest in the company. There may or may not be a formal breach of duty by the directors in this process and accordingly section 994 operates irrespective of a breach of duty. The main difference between the unfair prejudice action and the derivative action is that the former is motivated by the inability of the shareholder to realise his investment whereas the latter is motivated by a breach of duty on the part of the company’s controllers against the company as a whole. The remedy available under section 994 is against the company rather than against the directors and what is generally sought is an order from the

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court regulating the future conduct of the company or, as an alternative, the imposition on the majority of an obligation to buy out the dissenting shareholder.76 3.41 This provision, which has been the subject of a number of decisions and which replaces an earlier and far more limited provision,77 places the petitioner under the burden of proving that the manner in which the company’s business has been carried on is unfairly prejudicial to their interests.78 The true meaning of “shareholder’s interests” in this context must not be confused with that of “shareholders’ rights” in the sense that any conduct on the part of those who control the company, whether they are directors or shareholders,79 may be “legal” but may nevertheless be actionable under section 994 of the Companies Act 2006. 3.42 This conclusion may be reached by noting that the unfair prejudice remedy applies to two different situations. The first is an action against wrongdoers who contravene the company’s constitution. If this is the case, it can be said that the controllers have acted unlawfully by acting in breach of the company’s constitution. This involves an objective assessment80 which is independent of any harm inflicted on the claimant. 3.43 The second situation is where what the directors or the wrongdoing majority shareholders have done may be legal—in the sense that it is in accordance with company’s constitution—but it is nevertheless in breach of an informal agreement (or understanding) involving the claimant and the controlling wrongdoers.81 Such an agreement, following the decision of the House of Lords in O’Neill v. Phillips,82 is a necessary prerequisite for an action brought on these grounds to succeed.83 This second scenario in essence leads to a different species of action under section 994, where so-called “equitable considerations” make it unfair for those conducting the company’s affairs to rely on their strict legal powers.84 It should be noted that section 994 is of relevance only to small private companies, and unfair prejudice actions have taken the form of proceedings involving, inter alia, a member’s exclusion from the board of directors,85 increase of issued share capital, alteration

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of articles of association,86 misappropriation of company’s assets, excessive remuneration to directors and non-payment of dividends.87

1. REPERCUSSIONS FOR D &O INSURANCE

3.44 D&O insurance is of limited relevance where minority shareholder remedies are sought but in the case of a derivative action, it is potentially of some significance. The action is brought against the wrongdoers who are in control of the company and who have caused it harm. The main issue, however, is the capacity in which liability has been incurred. If one accepts that directors are likely to be in control of a private company almost inevitably as a result of a majority shareholding, it is far from obvious that any liability which they may incur arises as a result of their directorship as such. Rather, it is because they control the company. However, it should be pointed out that the subject-matter of the action is not the directors’ control of the company but rather the wrongful act in respect of which their control has precluded an action by the company itself. Thus, in principle, a D&O policy should respond to a derivative action, subject to the doubts expressed above in relation to the situation where the policy is also taken out by the entity. 3.45 The position is different where the action is brought under section 994. Such an action is not necessarily related to any wrongful act on the part of the directors and may simply be an attempt by the minority shareholder to achieve the release of their investment. Indeed, there is no mention of the word “director” in section 994 and it is clear that the targets of the action are the controllers of a company and not the directors as such (even though the directors will inevitably be the controllers). There is symmetry here with the point made above,88 suggesting that the wrongful act to which the D&O policy attaches must be committed qua director and not in any other capacity (here, for example, qua majority shareholder). It is a well-accepted principle in company law that directors are not members of the company simply because they are directors89 and thus they are not bound by the contract contained in the articles of association.90 3.46 Consequently, for example, the mandatory purchase of shares resulting from a successful allegation of unfair prejudice is not a remedy enforceable against the directors qua directors but against directors purely because they are also majority shareholders. Therefore, any liability which may be incurred is not sustained qua director. This, of course, is the fundamental prerequisite for the enforcement of a D&O policy.91 The conclusion must, therefore, be that the role of D&O insurance is of little significance in relation to section 994 of the 2006 Act. Even though it could conceivably be argued that a director suffers loss if forced to purchase minority shares by reason of a court order made under section 996 of the Companies Act 2006,92 and in any event the problem remains that the capacity in which the order is in truth made is against the controlling shareholders and not against the directors as such.

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3.47 However, the question of defence costs cover remains a live one. As noted above,93 the insurers’ liability for defence costs usually takes the form of a separate undertaking under the insurance policy. Section 996 of the Companies Act 2006 provides a variety of remedies applicable to unfair prejudice, including the following:

“(1) If the court is satisfied that a petition under this Part is well founded, it may make such order as it thinks fit for giving relief in respect of the matters complained of.
(2) Without prejudice to the generality of subsection (1), the court’s order may:
- (a) regulate the conduct of the company’s affairs in the future;
- (b) require the company:
  - (i) to refrain from doing or continuing an act complained of, or
  - (ii) to do an act that the petitioner has complained it has omitted to do;
- (c) authorise civil proceedings to be brought in the name and on behalf of the company by such person or persons and on such terms as the court may direct
- (d) require the company not to make any, or any specified, alterations in its articles without the leave of the court;
- (e) provide for the purchase of the shares of any members of the company by other members or by the company itself and, in the case of a purchase by the company itself, the reduction of the company’s capital accordingly.”

3.48 Since the court may also allow the petitioner to bring a derivative action on behalf of the company, it may be that two sets of proceedings are completed in order to obtain final redress. Although such a situation is relatively unusual, there have been some reported decisions in this regard.94 The question which therefore arises is whether the D&O policy will cover two sets of costs or just those in respect of any breach of duty on the part of the director. 3.49 The authors’ view is that the issue of allocation of legal costs falls to be resolved by reference to a determination as to which part of the costs is to be apportioned to the defendant qua member (that is, the unfair prejudice costs) and which part is to be apportioned to the defendant qua director (that is, as part of the defence of the derivative action). Only legal costs in relation to the second scenario may be covered under a D&O policy. In line with the decision of the Court of Appeal in Clark v. Cutland,95 if an application for relief under section 996 of the Companies Act 2006 is also made, the company can be ordered to pay such costs.96 If the company pays those costs it gives rise to subrogation rights.97

(iii) Public companies

3.50 To acquire “public limited company” (or “plc”) status requires special provision in the memorandum of association and compliance with certain registration requirements.98 There are a number of important differences between private and public companies, the most important being that the latter are permitted, though not obliged, to offer their securities to the public.99 Public limited companies’ securities may be listed on the London Stock Exchange (the primary market) or in the Alternative Investment Market (“AIM”). In both

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circumstances the interests of the general public are protected via various mechanisms, including the Financial Services and Markets Act 2000, administered by the Financial Services Authority (“FSA”), and by imposing ancillary duties upon such companies additional to those contained in the Companies Act 2006. Authorisation to offer securities in the primary market imposes upon the company the obligation to comply with the Financial Services and Markets Act 2000 (Official Listing of Securities) Regulations 2001 (“the Listing Rules”). 3.51 To what extent does assuming the form of a listed plc affect the effectiveness of D&O policies? In addition to the Companies Act 1985, the Financial Services and Markets Act 2000 imposes extra duties upon both the plc and its directors. These supplementary obligations aim to protect the investors against two main types of detrimental act on the part of those who act on behalf of the corporate body, namely: (i) misleading promotion; and (ii) market abuse. Third parties, in this case investing shareholders, may be affected by the non-disclosure of vital information regarding company’s financial health and economic stability. The aim is, therefore, to compensate by way of indemnity all the losses incurred as a result of the provision of misleading information.100 Corporate representatives may also wrongfully influence and affect the market price of securities, making it appear more or less attractive than it is in reality. Such conduct, known as market abuse, is penalised by fines imposed by the FSA in order to protect the investor once the securities have been purchased; the aim here is nothing more than keeping the securities at what is said to be their true price in the market. 3.52 The issue of minority protection within public-listed companies is of concern because, although in principle the derivative action and the unfair prejudice remedy are available, it is very unlikely that either of them will assist a minority shareholder. As noted above,101 the substantive requirements of a derivative action include the effective control of the board and the subsequent impediment—by way of ratification—of any attempt to initiate proceedings. Given the widespread distribution of the share capital of a listed plc, it would be an extremely rare case indeed where a shareholder could derive any appreciable benefit from initiating a derivative action on behalf of the company. Thus, there is virtually no prospect of the directors of a listed plc facing personal liability to the company, as derivative actions simply do not exist in practice. 3.53 As regards the unfair prejudice remedy, it is clear that this too is ill-suited to resolve problems of minority oppression within a plc. A plc, whether listed or not, because of its nature and the mechanisms employed in raising capital, is designed to have a considerable number of shareholders (a figure which may be in the thousands). It will, therefore, often be virtually impossible to allege and/or prove the existence of any informal agreement and thus to identify “equitable considerations”102 which are alleged to have been disregarded by the company’s controllers. The possibility of establishing the informal agreement required in order to establish an entitlement to a remedy in the context of unfair prejudice is therefore remote.103

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3.54 As noted above, directors may in some circumstances face liability for breaching their duties to the company by means of the unfair prejudice remedy. In order for this type of action to succeed, a breach of duty, a failure on the part of the majority to initiate proceedings and prejudice to the claimant’s interests are required. Since the only possibility of fulfilling the first two requirements arises from a director being either a majority shareholder or exercising a de facto control of the majority of the company’s shares, in a listed plc this specific situation is extremely unlikely to arise due to the vast number of shareholders and, perhaps more importantly, due to the sheer size of the company’s share capital. 3.55 However, the most pragmatic argument against the application of the unfair prejudice petition in the context of a listed plc is the fact that the corresponding remedy usually sought under section 996 of the Companies Act 2006 is the purchase of the claimant’s shares at a fair price. Given that this is something that may easily and readily be achieved by offering such securities in the stock market (or AIM), the usual remedy therefore becomes redundant.104 3.56 Lastly—and no less importantly from a legal perspective—the assessment of potential liability of directors to third parties should be noted here.105 In light of the decision of the House of Lords in Williams v. Natural Life Health Foods,106 the likelihood of a director of a plc assuming personal responsibility to the customer as result of a close relationship—is remote in the extreme. It is, therefore, the case that any personal liability is almost certainly confined to directors of private companies. 3.57 To what extent does the above analysis impact upon the operation of D&O insurance? If the available actions—derivative and unfair prejudice—are of almost no significance within the universe of plcs (and particularly listed plcs), the obvious conclusion is that D&O policies provide benefits only in the following circumstances:

(a) Where the company faces insolvency and it is proved that there has been wrongful trading on the part of the directors.107 The reasoning here is that the locus standi to sue—despite being vested in the company itself—is exercised by a liquidator acting on the company’s behalf; thus, the board’s control and shareholders’ economic rights are displaced in favour of those of creditors, thereby overcoming the hurdles of derivative and unfair prejudicial actions.
(b) Where the policy offers defence costs cover as a separate undertaking to that of the insuring director’s personal liability. In practice, this appears to be the risk in relation to which directors of plcs are most afraid.108

(iv) Subsidiary or holding company

3.58 A subsidiary company is a company owned or controlled by another company. Section 1159 of the Companies Act 2006 provides:

“(1) A company is a ‘subsidiary’ of another company, its ‘holding company’, if that other company:
- (a) holds a majority of the voting rights in it, or
- (b) is a member of it and has the right to appoint or remove a majority of its board of directors, or
- (c) is a member of it and controls alone, pursuant to an agreement with other members, a majority of the voting rights in it, or if it is a subsidiary of a company that is itself a subsidiary of that other company.
(2) A company is a ‘wholly-owned subsidiary’ of another company if it has no members except that other and that other’s wholly-owned subsidiaries or persons acting on behalf of that other or its wholly-owned subsidiaries.
(3) Schedule 6 contains provisions explaining expressions used in this section and otherwise supplementing this section.
(4) In this section and that Schedule ‘company’ includes any body corporate.”

3.59 D&O policies are generally written so as to cover the directors of the parent company and the directors of its wholly-owned subsidiary and associated companies. The coverage of corporate bodies acting as directors, for example, shadow directors of the subsidiary company, is excluded. This may be inferred from the usual wording of D&O policies defining directors as any natural person.109

IV. WHO IS THE INSURED?: COMPOSITE POLICIES

3.60 Of course, insuring clauses may take different forms and wordings. Lloyd’s Form LSW 736 contains insuring clauses in the following terms:

“ Underwriters agree, subject to the terms, conditions, limitations and exclusions of this policy to:

(a) Pay on behalf of the Directors or Officers of the Company Loss arising from any claim first made against them during the Period of Insurance and notified to Underwriters during the Period of Insurance by reason of any Wrongful Act committed in the capacity of Director or Officer of the Company except for and to the extent that the company has indemnified the Directors or Officers.
(b) Pay on behalf of the Company Loss arising from any claim first made against the Directors or Officers during the period of insurance and notified to underwriters during the period of insurance by reason of any Wrongful Act committed in the capacity of Director or Officer of the Company but only when and to the extent that the Company shall be required or permitted to indemnify the Directors or Officers pursuant to the law, common or statutory, or the Memorandum and Articles of Association.”110

3.61 It will be seen that this insurance policy contains two different parts, commonly known as Side A and B.111 On the one hand, it offers cover for individual directors or officers (Side A). On the other hand, it offers reimbursement to the company itself to the extent that the company has indemnified the wrongdoer (Side B). Some policies offer in addition Side C cover,112 which overlaps with the basic forms of cover and insures against both the company’s liability and that of its directors and officers. This type of cover is known as “entity” or “corporate” cover. Because of its importance it will be considered separately below.113 3.62 The directors, under Side A, and the company, under Side B, are each insured under a D&O policy. It is, immaterial for this purposes that only the company has paid the premiums (as is usually the case), since such payment may be viewed as consideration for the

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insurers’ promise to indemnify both the directors and the company. It is also likely that there is no common law issue in relation to privity of contract since the directors and the company are joint promisees. However, to the extent that a privity problem may arise, in that the company has taken out the policy in its own name with the directors simply as named beneficiaries,114 the Contracts (Rights of Third Parties) Act 1999 has removed all difficulties.115 That statute allows a named or identifiable person to rely upon a contract as if he were a contracting party in his own right. Accordingly, whatever the position may have been prior to the 1999 Act, the directors are entitled to claim under the policy as if they were insured persons in their own right, as long as the policy does not exclude the operation of that statute.116 3.63 The fact that the policy provides cover both to the directors and to the company when it has indemnified the directors raises the question of whether D&O policies are structured on a joint or composite basis. The answer to this question is of major significance. The parties to a joint policy have indistinguishable rights which stand and fall together, so that if one joint insured is unable to claim then the same bar applies to other joint insureds. By contrast, in the case of a composite policy the legal analysis is that each of the parties has a separate contract of insurance with the insurers, albeit embodied in a single document. A composite policy is, therefore, a bundle of parallel bilateral contracts. The point here is that each composite insured has a separate claim against the insurer and the insurer for its part may have separate defences against the insureds. If one co-insured has, for example, failed to disclose material facts, broken a condition or warranty or submitted a fraudulent claim117 the rights of innocent co-insureds are unaffected.118 3.64 In answering this question it is necessary, as is the case with all other forms of insurance, to consider the insurable interest of the parties in the subject-matter of the insurance and not simply the words used by the policy. In general terms, a policy is joint where the insurable interests of the parties are indivisible and it is composite where the insurable interests of the parties are separable.119 It may be that the only true instances of joint insurance are policies procured by spouses on their mutually-owned property or by partners whose ownership of assets and whose liabilities are joint.120 It is, on that basis, generally accepted that D&O insurance assumes the form of composite cover, so that each of the directors is insured separately and the company is also an insured person to the extent that coverage is extended to it. 3.65 This principle was applied in Arab Bank plc v. Zurich Insurance Co,121 Rix, J affirming that whenever a company and its directors enter into a contract of this nature, each insured must be deemed as a separate insured, each for their own interest. Hence, any

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dishonesty on the part of one director would prejudice neither the innocent company nor the remaining innocent directors, as to their rights to be indemnified under a liability policy. We return to this case in more detail below.122 3.66 It is obvious that the interest of the individual directors and officers in a D&O policy is protection against personal liability and also to protect their personal assets. The interest protected under Side A cover may, therefore, be categorised, generally speaking, as peace of mind in relation to the possibility of financial vulnerability to third parties. 3.67 Where then does this leave the company itself under the Side B cover contained in a typical D&O policy? Assuming that the company itself is not a party to any legal proceedings against the director, but chooses to compensate the director in respect of any damages awarded against them in favour of a third party,123 it is clear that the company is not thereby accepting any primary liability to the third party and is making payment to the director only because it has agreed, separately, to do so.124 The company’s insurable interest in a D&O policy written on the terms considered here is thus quite different to that of the director and as a matter of law it has entirely separate rights. 3.68 The flipside of this is that even though insurers may have the right to refuse to pay one or more of the directors under the policy, they may nevertheless still be obliged to indemnify the company if the company has itself paid the directors by virtue of contractual arrangements it has entered into with them.125 It should also be noted that there is no link between Side A and Side B of the cover, so that Side B may be relied upon by the company even if Side A is inapplicable in the circumstances. A clear illustration of the point was found in section 337 of the Companies Act 1985, which established that the company is not prohibited from providing a director with funds to meet the costs incurred in defending either civil or criminal proceedings. In this scenario, and in light of the composite nature of D&O policies, a company which lawfully advances costs to its directors is plainly entitled to rely upon its Side B cover to recover from insurers regardless of the fact that the latter may successfully resist liability in respect of the Side A directors’ liability.

(a) Corporate cover: is the company a party or a third party to D&O insurance?

3.69 In principle, D&O insurance may take three different forms:

(a) First, it may provide an indemnity for individual directors only, and, as noted above, to the company if it chooses to indemnify the director for any sums paid by him to third parties under legal liability. This type of cover will protect those directors who perform their duties in more than one company within the corporate group so that the insurance follows them wherever they are at the relevant time.126
(b) Secondly, the insurer may offer cover to solicitors or accountants who hold office in their clients’ companies, thereby exposing them to personal liabilities not

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necessarily covered by their professional indemnity insurance.127 In other words, D&O insurance may offer ancillary protection or extended cover for professionals who become directors or assume their position.
(c) Thirdly, by offering “corporate cover” the insurer may extend coverage to the insured entity for claims brought against the company itself.128 Such cover will in any event be necessary, given that the company may face primary or vicarious liability for the acts and defaults of its directors, and is normally provided under ordinary public liability insurance. However, D&O cover may be extended in this regard.

3.70 Special attention must be given to the consideration that D&O insurance has been developed to cover the liability of directors and officers to third parties and not to cover directors’ and officers’ liability to the company itself. Nevertheless, there is no rule of law which actually requires this outcome and whether the company is entitled to the benefit of a D&O policy depends upon the terms in which it is drafted. Two possibilities may be distinguished here. 3.71 The first is where the company itself has been directly harmed by the actions of the directors acting beyond the scope of their authority and wishes to bring proceedings against them. In principle there is no reason why a D&O policy should not cover this form of liability, as the company is simply in the position of a third party who has suffered harm at the hands of the directors. There is no reason why the fact that the company itself is also the assured129 should be an insurmountable obstacle to recovery under the policy. While there is generally an implied term in first party insurance contracts that one co-assured may not sue another,130 the principle operates only where the parties have intended that loss suffered by one of them at the hands of the other should be satisfied by a first party claim against the insurers, so that the insurers cannot exercise subrogation rights against the wrongdoing co-assured. That cannot be said of the situation in which the policy is one against liability and the company has no possibility of a first party claim against the insurers. 3.72 The second situation is where the company faces primary or vicarious liability towards a third party131 by reason of the activities of its directors. Here, in principle the company may make a claim against the directors who may in turn recover the sums payable to the company by them from their D&O insurers. The question whether a company can claim to be a third party victim in this scenario does not permit a straightforward answer, but one may comment that the effect of such an approach is to convert a D&O policy which insures only the liability of the directors into a liability policy which is indirectly to the company’s benefit. However, it is generally accepted that where a wrongdoer inflicts harm upon a third party, for example, by supplying defective products and the third party incurs liability to its own customers on the resale of those products, the third party is able to claim damages against the supplier in contract or tort and the insured’s liability insurers will be

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liable to indemnify him in respect of those damages.132 In this way, the third party is in effect utilising the insured’s liability policy to cover his own liability in much the same way as the company as a claimant against the directors in respect of its liability in damages to third parties may seek to argue.

(b) Problematic areas

3.73 The composite nature of D&O insurance leads to complex legal issues concerning both the validity of the contract and compliance with contractual terms. The main question which arises is the extent to which any breach of duty by a director—such as non-disclosure, misrepresentation, breach of condition or warranty—may affect the rights of other directors (or indeed the company) to make a claim against the D&O insurers. As noted above, in Arab Bank plc v. Zurich Insurance Co,133 Rix, J held that the professional indemnity policy in question was truly composite. The effect is that misconduct on the part of one director does not affect the right of the other parties to the policy to make a claim. From a logical perspective, D&O insurance would be of very little use if the answer were otherwise134 and indeed some insurance policies specify that any contravention of any contractual or extra-contractual obligation on the part of one director leaves the rights of the others unaffected.135 3.74 In Arab Bank the policy was silent on this issue, but Rix, J nevertheless reached the same conclusion. In that case a professional indemnity policy was incepted for the benefit of a firm and its directors, who were estate agents and valuers. The policy proposal was signed by the managing director with the authority of the company and the remaining directors. The policy required disclosure of events known to the insured and likely to give rise to a claim. Perhaps unsurprisingly the managing director failed to disclose that he had participated in a series of mortgage frauds involving the gross over-valuation of properties to be used as security for loans. One of the victims obtained judgment against the company, which had by this time gone into liquidation, and the victim accordingly claimed compensation from the individual directors. The directors in turn sought indemnity under the policy. The insurers denied liability on the ground that the fraudulent withholding of information on the part of the managing director prevented any of the directors from recovery. 3.75 Rix, J construed the policy as providing composite cover, so that each of the directors was individually insured under the policy: this meant that a personal bar affecting the managing director could not affect the claims of the others. The decision has further significance in that Rix, J held that the guilty knowledge of a director—including the managing director—was not to be regarded as imputed to the company itself, since the whole purpose of a composite liability policy such as that under consideration was to give protection to individual directors and to the company.136 Rix, J further held that the insurers did not have the right to avoid the policy on the basis that an agent to insure is required to

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disclose all material facts to the insurer.137 Leaving aside the vexed question of whether anyone other than a placing broker could be an agent to insure for these purposes, Rix, J held that the law did not expect an agent to disclose his own fraud.138 Accordingly, the policy was not avoidable on this basis.139