Directors and Officers Liability Insurance

Dr Adolfo Paolini and Deepak Nambisan

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6 DIRECTORS’ AND OFFICERS’ LIABILITY TO THIRD PARTIES

I. INTRODUCTION

6.01 Professional indemnity (“PI”) insurance developed to provide indemnity to the insured in respect of damages awarded against him/her as a result of their failure to exercise reasonable care in the performance of their duties owed to a third party. PI policies provide coverage in respect of actions for breach of contract and in tort, although in practice the two causes of action stand or fall together. In each case the claimant has to show a failure by the professional to exercise reasonable care in the performance of the tasks entrusted to him.1 What might be described as “pure” contract claims, that is, claims in respect of contractual duties additional to the ordinary professional obligation to carry out the promised service, are generally excluded: such claims are covered only if the corresponding duty exists in tort.2In recent years the test for tortious liability has been developed and reformulated and the notion that liability will be recognised only if there has been a “voluntary assumption of responsibility”3 has come to the fore.4

II. DIRECTORS’ PERSONAL LIABILITY TO THIRD PARTIES

6.02 Since companies are legal entities separate in law from those who establish them, and company directors are simply the persons empowered to represent a company in its dealings with third parties and to manage the company’s affairs, when directors act on behalf of a company, it is usually the company which in law is regarded as having entered into any contract with the third party and which is responsible in tort for any wrongdoing on the part of its directors.5 As regards the liability of a director to his/her company, we have seen6 that, to date, the scope of such liability has remained relatively narrow, and indeed it has been said

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that the present operation of the common law means that directors have had a remarkable freedom to run companies incompetently.7 Cases which have led to third parties suffering considerable losses have traditionally been decided on the basis of notions of corporate personality and the organic theory,8 thereby absolving the directors from personal responsibility. More than a century after the decision in Salomon v. Salomon,9there is some ambiguity as to when and whether directors may become personally liable without lifting the corporate veil or tampering with the notion of the company’s limited liability.10 Part of the answer to this complicated issue lies in the fact that individuals may operate in different capacities within a company, assuming different levels of responsibility as to the consequences of their activities. Consequently, the notion of corporate liability does not necessarily preclude the liability of a person who happens to be a director who is acting in some other capacity,11 for example, where the director’s participation was so integral to the successful completion of a transaction between the company and the third party that he may be taken to have assumed personal responsibility in this regard leading to potential tortious liability without infringing the corporate personality principle.12 6.03 The law recognises three scenarios for liability arising from tortious behaviour on the part of a director in his/her dealings with a third party: (a) the company alone faces liability13; (b) the company and the director are jointly and severally liable; or (c) the director alone is liable. We turn now to consider scenarios (b) and (c).

III. JOINT LIABILITY

6.04 In terms of scenario (b), the question of whether a company and a director may be jointly and severally liable in tort, was comprehensively addressed in the decision of the Court of Appeal in MCA Records Inc v. Charly Records Ltd (No 5),14 where it was held that for a director or officer of a company to be personally liable as a joint tortfeasor it is necessary to find that they had procured or induced15 those acts to be done by the company or that they and the company had acted jointly and in a concerted fashion to secure that those

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acts were done.16 As a result, a director cannot be held liable with the company as a joint tortfeasor if he/she does no more than carry out their constitutional functions: it is necessary that they induce the company to exercise tortious activities.17 6.05 If there is joint liability, the question is whether it is covered by a D&O policy. The authors’ view is that it will be—the fundamental nature of the policy is not affected in these circumstances and the liability will still be covered as long as the breach is not fraudulent.18 There will, however, be allocation issues as between the company and the director, involving the court investigating what has been the real participation of the director in the wrong and what proportion of the loss is to be allocated to them.19

IV. DIRECTORS’ PERSONAL TORTIOUS LIABILITY

6.06 The approach to the question of when a director becomes personally liable to a third party lies not only in the nature of the tort committed but also in rules of agency and vicarious liability.20 For example, torts may be perpetrated on a third party by conduct (for example, negligent driving) or by words (for example, misrepresentation). As regards the first example, if the tort is committed by a director acting in the course of his employment with the company, the company will be vicariously liable for the director’s breach of duty and will be jointly and severally liable to the third party along with the director.21 By contrast, if the tortious act is committed outside the course of the director’s employment, the company will not face liability even though the director will be personally liable. In such a case, D&O insurance will not be applicable, since the director was not acting in his/her capacity as director when the liability was incurred. The second example, that of liability arising from misrepresentation, depends upon the scope of the director’s actual, implied, usual or apparent authority to act on behalf of the company.22 If the director has acted within the scope of their authority, the company will face liability in the event that the resulting agreement is found to be voidable for misrepresentation. However, if the company is insolvent and an action against it is worthless, the question arises as to whether the director may be personally liable for their own misstatements. The issue is particularly acute where the company is in effect controlled by the director. 6.07 The most recent cases have approached issues such as these by developing the notion of the voluntary assumption of responsibility, to which we now turn.

(a) Assumption of responsibility and Williams v. Natural Life Health Foods Ltd

6.08 The leading decision is that of the House of Lords in Williams v. Natural Life Health Foods Ltd.23 Personal liability for misrepresentation under the principles set out in Williams is perhaps the main purpose to which D&O policies in England are directed since it is the only area in which the company director is personally exposed to the real risk of a third party claim. The case concerned a franchise agreement under which the claimants, Mr Williams

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and Mrs Reid, established a health food shop by purchasing the franchise from the first defendant, a company formed by Mr Mistlin and of which he was the managing director. In the course of negotiations for the contract, conducted by Mr Mistlin on behalf of the company, very favourable forecasts of income were provided, thereby making the transaction very attractive in terms of profitability to the claimants. The agreement was duly entered into, but after a short period the claimants were forced to close the shop due to substantial losses and as a result, they brought proceedings against the company alleging that the income projection had been prepared negligently. Mr Mistlin was joined to the proceedings as second defendant, on the ground that his personal lack of care in the giving of the advice had induced the claimants to enter into the contract with the company. By the time the action came to be heard the company itself had been wound up, leaving Mr Mistlin as the only effective defendant. 6.09 At first instance, Langley, J held that Mr Mistlin, as managing director, was personally liable for the negligently prepared projections. The judge was particularly influenced by the fact that Mr Mistlin was an apparent expert in the field, since he had run several successful enterprises of the type in question and accordingly the claimants had relied upon his knowledge and expertise. The Court of Appeal,24 by a majority, reversed the first instance decision and, applying the decision of the New Zealand Court of Appeal in Trevor Ivory Ltd v. Anderson,25 held that a director was not personally liable in tort where the tort was committed by him/her in their capacity as director and while acting on behalf of the company. The New Zealand Court of Appeal did, however, indicate that a director might incur personal liability to a third party if there had been an assumption of a duty of care, whether actual or imputed26 on the part of the director. In other words, there was no definitive principle that directors acting in that capacity were not personally liable, since the relationship between them and (say) the company’s customers could be sufficiently close that the directors might have acquired personal duties of care and the third party motivated to enter into the contract by reason of that relationship.27 The Court of Appeal in Williams held that a company director was only to be held personally liable for the company’s negligent misstatements if the claimants could establish some special circumstances setting the case apart from the ordinary.28 6.10 The House of Lords agreed with the Court of Appeal that there was no liability in the present case. However, their Lordships pointed out that an indirect relationship between the directors of the company and the victim of the tort was not sufficient to make the directors personally liable. Instead, it was necessary for the parties to have developed a special relationship by which there had been an “assumption of responsibility on the defendant’s part and reasonable reliance on the plaintiff’s part”.29

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6.11 The House of Lords, therefore, left open the possibility of any director becoming liable to a third party as a tortfeasor.30 Although the scope for personal liability under Williams is relatively small, D&O policies are of obvious application here.

(b) After the Williams case

6.12 The cases decided since Williams indicate that the courts are willing, in appropriate circumstances, to find that there has been a voluntary assumption of responsibility (or risk) by a person dealing with a third party contemplating entering into a contract.31 In Fashion Brokers Ltd v. Clarke Hayes,32 the defendants, a firm of solicitors, acted on behalf of the claimant, who wished to acquire the leasehold of premises for use as a retail clothing outlet. Before the contract was entered into, the defendants telephoned the local authority planning department to determine whether or not the projected use of the land would contravene existing planning permission. The planning officer, whose identity was not disclosed, orally confirmed that no limitations existed as to the intended use. In fact, after purchasing the property the claimant was prevented from carrying out his activities by reason of the limitations of planning permission. The claimant sued his solicitors and they joined the planning department to the proceedings. The preliminary issue for the Court of Appeal was whether the planning department had assumed responsibility by providing, via one of its employees, inaccurate information which led to the claimant’s loss. The Court of Appeal unanimously33 dismissed the defendants’ appeal against the first instance decision dismissing the third party claim against the planning department, agreeing that there was insufficient proximity between the defendants and the planning department such that a duty of care existed.34 6.13 Similarly, in Electra Private Equity Partners v. KPMG Peat Marwick,35 an auditors’ negligence strike-out case, the Court of Appeal, applying Williams, affirmed that a conscious assumption of responsibility is required whenever it was sought to impose personal tortious liability above and beyond that ordinarily assumed by a professional.36 6.14 In Noel v. Poland,37 the claimant was an underwriting Name at Lloyd’s who had joined Lloyd’s through the agency of John Poland and Co Ltd and had been placed in a number of syndicates (general non-marine and general marine). Although she resigned her membership in 1988 she found herself locked into two syndicates and remained exposed to liabilities to meet claims as a result of their accounts being kept open by reason of their exposure to a number of environmental pollution and asbestosis claims. The claimant alleged that she has been deceived into becoming a Name for the relevant years by reason of fraudulent or negligent misstatements by the director and the non-executive director of the

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agency and that they had become personally liable to her by an application of the ordinary tort rules in Hedley Byrne. 38 Toulson, J struck out the claims on the basis of Williams: the existence of a special relationship between the claimant and the defendants could not be shown and accordingly it could not be said that there had been the necessary assumption of responsibility by the defendants. 6.15 Merrett v. Babb 39 concerned an action by a mortgagor against a firm of surveyors and raised the issue of the potential personal liability of an employee. The case concerned the negligent valuation of a property carried out by an employee surveyor for a third party mortgagee, the Bradford & Bingley Building Society. The surveyor had not entered into a personal contract with the claimant purchaser nor was the claimant a client of the firm of surveyors, although the valuation report—signed by the surveyor in his personal capacity and stating his personal qualifications as well as the name of the firm—had been relied upon by the claimant. A professional valuer owed a personal duty of care to a mortgagor where two requirements were met: (1) it was appreciated that the mortgagor would rely upon the valuation in order to enter into the transaction; and (2) the mortgagor intended to have an independent survey carried out. The Court of Appeal held that these requirements had been satisfied and that a duty of care arose by reason of a voluntary assumption of responsibility.40 6.16 More recently, in European International Reinsurance Co Ltd v. Curzon Insurance Ltd,41 the principles laid down in the earlier cases were codified by Gross, J. The question in this case was whether two individuals employed by placing brokers had voluntarily assumed responsibility towards insurers for the placing of reinsurance, the producing brokers themselves having been appointed by the insurers’ placing brokers under delegated authority. Gross, J refused to strike out the claims against the individuals, ruling that the test of Hedley Byrne liability for negligent misrepresentation was whether the defendant had made a conscious assumption of responsibility for the task, as opposed to a conscious assumption of responsibility to the claimant for its careful performance. There would normally be an assumption of responsibility where the relationship was equivalent to a contract, but the court would not willingly find such an assumption of responsibility where this was inconsistent with a contractual chain or contractual structure. Gross, J further held that an individual employee acting in the course of his employment could incur Hedley Byrne liability, although it was equally the case that an agent could assume responsibility on behalf of another for the purposes of the Hedley Byrne rule without assuming personal responsibility. The question in every case was whether there had been reasonable reliance on statements made and conduct shown by the agent or employee: reliance in fact was not the test. This reformulation makes it clear that there is no rule against personal liability and that all depends upon an objective view of whether the agent’s statements and conduct justified reliance by the claimant.

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V. DIRECTORS’ PERSONAL LIABILITY FOR FRAUDULENT MISREPRESENTATIONS?

6.17 The House of Lords recently confirmed, in Standard Chartered Bank v. Pakistan National Shipping Corporation,42 that a director cannot escape personal liability for the tort or the fraud by alleging that he was acting fraudulently on behalf of the company. This case concerned the fraudulent backdating of a bill of lading in order to comply with bank requirements, so as to secure payment under a letter of credit opened by the bank. The director had personally arranged the backdating of the bill of lading, thereby making a fraudulent misrepresentation. The issue was whether the director could be held personally liable for the tort or whether he could shelter behind the corporate personality. 6.18 The House of Lords held that a director could not avoid liability by relying on the fact that they were acting on behalf of the company: their liability was not imposed because he/she was a director, but because they carried out the deceit. Lord Hoffmann pointed out that no one can escape liability for fraud by saying “I wish to make clear that I am committing this fraud on behalf of someone else and I am not to be personally liable.” The director was not being sued for the company’s tort. He was being sued for his own tort and all the elements of that tort were proved against him. In the circumstances the concept of assumption of responsibility was in fact completely irrelevant.43 Fraudulent misrepresentation, therefore, falls outside the scope of Williams: a director’s liability for fraudulent misrepresentation arises not from breaches of fiduciary duty or from acts of negligence but from the tort of deceit, which means that a director becomes liable not qua director but qua individual (in other words they become liable for the fraudulent act irrespective of their position within the company). Thus, the claim in Standard Chartered Bank succeeded because it was made against an individual who happened to be a director: if it had been otherwise, as the House of Lords emphasised, the defendant could easily have been shielded by the corporate veil.44 It will, therefore, be appreciated that this case is of no significance for D&O cover, since it is clear that—irrespective of the terms of the contract itself—a D&O policy will not respond to a claim where the director has to pray in aid his/her own fraud. Furthermore, even if it had been possible to provide coverage, the fact that a director would be liable not qua director but qua individual does not accord with the fundamental nature of a D&O policy.

VI. DIRECTORS’ DUTIES TO EMPLOYEES AND CREDITORS

(a) Duties owed to employees?

6.19 The duty of company directors to take into consideration the interests of employees comes from the wording of section 172(1)(b)(c).45 The duty cannot be enforced by proceedings brought by employees. Accordingly, the duty is owed to the company and it is only

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enforceable by the company.46 Section 172(1)(b) is widely regarded as being of little significance, and any failure to adhere to its terms is incapable of giving rise to personal liability on the part of directors for D&O purposes since employees lack locus standi to enforce this provision. In any case—as noted above47— the insured vs insured exclusion is potentially of relevance in this scenario (where entity cover)48 is provided.

(b) Duties owed to creditors?

6.20 The issue here is to ascertain to what extent directors may owe duties to creditors,49 what sort of liability is involved and whether D&O insurance may play a role. 6.21 While the company remains in existence and solvent, it owes duties to creditors.50 Where the company is in danger of insolvency, the directors may potentially owe additional duties in order to preserve the assets of the company51 and to preserve intact its creditors’ interests. This argument does not arise by reason of duties owed directly to creditors, but rather because the liquidation of the company will adversely affect their interests.52 Insolvency grants creditors the power to displace the interests of the company and its shareholders.53 6.22 When a company is insolvent the interests of creditors come to the fore, replacing the interests of the shareholders. The insolvency legislation reflects this, replacing the directors (who are appointed by the shareholders) with an insolvency practitioner who is (at least on some level) accountable to the creditors. As we shall see, the common law has recently recognised the application of directors’ duties to creditors’ interests where insolvency is on the horizon, although formal statutory insolvency mechanisms have not yet been activated. Directors’ duties are, therefore, to be viewed as being owed to those with the ultimate financial interest in the company’s affairs. In a solvent company, this will be the shareholders, but in a company approaching insolvency, this will be the creditors. 6.23 From Walker v. Wimborne 54 and Nicholson Permakraft 55 which later influence the decision in West Mercia Safetywear Ltd v. Dodd,56 following the dictum in Kinsela v. Russell Kinsela Pty Ltd,57 it could be suggested that the liquidation process moves the attention of directors from company’s members to creditors, as the creditors are entitled to be satisfied

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first in the event of insolvency.58 In the Australian case of Kinsela v. Russell Kinsela Pty Ltd, Street, CJ said59:

“In a solvent company the proprietary interests of the shareholders entitle them as a general body to be regarded as the company when questions of the duty of directors arise. If, as a general body, they authorise or ratify a particular action of the directors, there can be no challenge to the validity of what the directors have done. But where a company is insolvent the interests of the creditors intrude. They become prospectively entitled, through the mechanism of liquidation, to displace the power of the shareholders and directors to deal with the company’s assets. It is in a practical sense their assets and not the shareholders’ assets that, through the medium of the company, are under the management of the directors pending either liquidation, return to solvency, or the imposition of some alternative administration.”

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