Directors and Officers Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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5 SOURCES OF LIABILITY AND THE CONSEQUENTIAL LOSS: D&O COVERED RISK

I. THE RELATIONSHIP BETWEEN THE COMPANY AND ITS DIRECTORS

5.1 In terms of defining the relationship between a company and its directors, there are two competing theories, viz. “the “organic”1 and “agency” theories. English case law has, in the main, endorsed the former.2 5.2 The organic theory holds that any company acts through its organs, the most important of which is the board of directors. So, for example, the decision of the House of Lords in Lennard’s Carrying Co Ltd v. Asiatic Petroleum Co Ltd 3 had the effect of removing from each director their personal legal identity in this context and transferring it to the corporate body by treating the directors as its directing will and mind, that is, “the very ego and centre of the personality of the corporation.”4 The consequence of this theory is that the acts attributed to the company are those carried out by the persons in charge of the company’s business,5 on the basis that they act as the company and not for the company.6 Therefore, directors and officers may only incur civil liability to the company itself where some duty owed to the company has been breached, but such liability cannot arise in relation to third parties since “no personal consequences can result from their actions as the organ of the company.”7 The alter ego theory, if accepted, would radically reduce the efficacy and relevance of D&O insurance, since such insurance could only ever provide cover in respect of the directors’ liability to the company for breach of duty. Third parties, that is, shareholders, creditors, employees and customers (whose protection, albeit indirectly, is guaranteed by D&O insurance as it operates today) would be left only with remedies against the company itself. 5.3 English law has, in general, endorsed the agency theory, in accordance with which directors and officers act for the company, thereby preserving their separate legal identity8

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and permitting the application of the ordinary agency rules to this particular relationship.9 As a result, those representing the company may incur personal liability not only to the corporate body but also to third parties, for example, as a result of a personal assumption of responsibility or by acting in excess of their authority.10 5.4 The relationship between a company and its directors is further complicated by the fact that there are four main sources of potential liability for a director, some of which may overlap:

(a) First, the duty of a company director to exercise care and skill is governed by the general law of negligence and remains important because a negligent director is not, without more, guilty of breaching his fiduciary duties.11 Whatever level of skill may be required of a director, he must show such care 12 as an ordinary man might be expected to take on his own behalf.
(b) The second main source of directors’ duties in English law derives from the director’s fiduciary relationship with the company. There are a number of fiduciary duties that vary in their application and also overlap in some respects.13
(c) Thirdly, many directors enter into contracts with the company, usually in the form of service agreements, which fix the rights and obligations of the contracting parties and also give rise to a relationship governed by employment law principles.14 Directors may, therefore, face civil liability in respect of breaches of contract.15
(d) Fourthly, various duties are imposed upon directors by statute.

5.5 The interaction of the above sources of duties and/or liability provides the background against which the effectiveness and significance of D&O insurance fall to be assessed. In a work of this nature, primarily concerned with the insurance of liabilities and not the underlying liabilities themselves, it is not possible to explore in detail the fundamental nature, scope and underlying theory of directors’ duties.16 In the sub-sections that follow, we briefly describe and attempt to classify the relevant duties in order to determine the nature of the liability which may be faced by a director—whether contractual, tortuous, equitable or criminal—and consequently the degree to which such liabilities are potentially insurable via the mechanism of a D&O insurance policy.

II. COMMON LAW DUTIES OF SKILL AND CARE

(a) General

5.6 The basic coverage provided by any class of liability insurance is in respect of negligence on the part of the insured. D&O insurance bears the same characteristic. Plainly,

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negligence on the part of the directors in the exercise of their duties, and the consequent personal liability which will ensue, is the primary ground upon which a D&O policy may be called upon to provide an indemnity to the directors.17 5.7 Compared with the fiduciary duties owed by directors, the duties of skill, care and diligence which directors owe to a company were, until recently, remarkably relaxed. While fiduciary duties are generally concerned with negative obligations, restricting particular forms of conduct on the part of the directors, the common law duties emphasise the diligence and prudence they must put into their roles. The duty of a company director to exercise care and skill is governed not only by the Companies Act 2006,18 but also by the general law of negligence and remains important because, as already stated, a negligent director is not, without more, guilty of breaching his fiduciary duties. The remedy for a director’s negligence lies in damages and does not allow a claimant to avail himself of the various remedies for breach of fiduciary duty. 5.8 Much more is now expected of directors than was previously required under the subjective test of Re City Equitable.19 The principles set out by Romer, J in that case may be broken down as follows:

(a) A director had to exercise that degree of skill as would amount to the reasonable care that an ordinary man might be expected to take, in the circumstances, on his own behalf, but did not need to show a greater degree of care and skill than would be reasonably expected of a person of the same knowledge and experience. The extent of the duty of care expected was, therefore, measured by reference to the particular director’s knowledge and experience and was not one that requires the taking of all possible care, rather, a degree of care the breach of which was characterised by terms such as “gross negligence”. A director was not required to bring any special knowledge or experience to the task, but, if he or she did, then a commensurate degree of skill would have to be shown.
(b) A director was not bound to give continuous attention to the affairs of his company. He was not bound to attend all board meetings, although he ought to when reasonably able to do so.
(c) In the absence of grounds for suspicion a director could rely on his delegation of duties to other officers or experts, trusting that they would perform such duties honestly.

5.9 More recent formulations of the duty20 have accepted a distinction between (a) the duty to be skilful, defined by reference to the particular director’s level of skill and experience,21 and (b) the duty to take care, defined by reference to the standard to be

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expected of the ordinary man.22 Whatever level of skill may be required of a director, he must show such care 23 as an ordinary man might be expected to take on his own behalf. It should be noted both that it might be expected that an ordinary man would take a high degree of care on his own behalf but also that it is difficult to draw a line between an objective duty of diligence (or care) and a subjective duty to exercise skill. 5.10 Importantly, in two decisions the courts have applied a test which looks to the requirements of the particular company, the skills which the director actually has, and those which he or she ought to have: see Norman v. Theodore Goddard 24 and Re D’Jan of London Ltd.25 In each of these cases, Hoffmann, J (as he then was) explicitly accepted that the common law duty was in fact accurately stated in section 214(4) of the Insolvency Act 1986 (liability for wrongful trading). The conduct required was that of “a reasonably diligent person having both: (a) the general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company; and (b) the general knowledge, skill and experience that that director has.”26 5.11 It is important to emphasise that, in accordance with section 239 of the Companies Act 2006, this conduct can be ratified by a company.27

(b) Continuous attention to the company’s affairs

5.12 In Re City Equitable, Romer, J said28 :

“A director is not bound to give continuous attention to the affairs of his company. His duties are of an intermittent nature to be performed at periodical board meetings, and at meetings of any committee of the board upon which he happens to be placed. He is not, however, bound to attend all such meetings, though he ought to attend whenever, in the circumstances, he is reasonably able to do so.”

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