Directors' and Officers' Liability Insurance
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DIRECTORS’ LIABILITY AT CIVIL LAW
I. INTRODUCTION
7.01 In this chapter we outline how directors’ and officers’ civil liability in civil law jurisdictions may arise in order to ascertain the effectiveness of D&O policies and their reinsurance. As we shall see, overly simplistic translations of the terms “directors” and “officers” into civil law jurisdictions and their corresponding liability principles result in difficulties in light of the variety of rules and differing tests of diligence in existence in civil law systems, and the possibility that in such systems direct liability to third parties may be incurred in a manner not generally recognised by English law. 7.02 The origins of what is nowadays understood as civil liability are to be found in ancient Rome. Rome’s jurisprudence and legal principles strongly influenced the development of later European law in relation to both contract and tort law. Those principles were also exported to and adopted by the vast majority of (if not all) Latin American countries.1 The remainder of this chapter addresses particular aspects of civil law liability from the perspective of company directors and officers. 7.03 For these purposes, one of the most important principles of civil law liability is that the victim of a wrongdoing is entitled to claim an indemnity by means of compensation—not only in the form of a sum of money but also in kind—so as to put him, as far as possible, in the position he would have been in had the wrongful act never occurred. In other words, anybody who causes damage is obliged to make that damage good. That obligation may arise from two different sources: first, as a result of a breach of contract (“contractual liability”); and secondly, as a result of a failure to comply with the general duty of care not to cause damage to third parties (the resulting liability being termed “delictual” or “quasi-delictual”).2 We consider those two sources in turn.II. CONTRACTUAL LIABILITY
7.04 Where a contractual relationship exists between the parties, one can ascertain the extent of the wrong and measure the damage thereby caused by assessing what the parties promised to each other and were, therefore, entitled to expect. In civil law a number of principles of contractual liability have developed as follows:Page 138
(a) Good faith
7.05 Contracts must be executed in good faith.3 This abstract concept, difficult to define with clarity, imposes upon the parties the duty to act fairly and reasonable in performing their contractual obligations, from the early stages and throughout the execution of the agreement. The duty, therefore, embraces the process of contract formation, seeking to ensure that anybody who has given their consent to enter into a contract, in so doing, has proceeded with absolute freedom and willingness and with knowledge of the subject-matter of the contract. The concept may have a further role to play in that there is “good faith” when due care is exercised while performing a contract. Having said that, a contract is performed in good faith when the parties in so doing proceed with due care and honesty.(b) Equity, usage and law
7.06 The parties commit themselves not only to what is agreed upon in the contract but also to general principles of “equity, usage and law”,4 each of which is significant in relation to the construction of contracts. 7.07 The term “equity” is used here to denote a rule of contractual interpretation used to ascertain the substance and extent of the obligations agreed upon, with the understanding that a particular interpretation of a contractual term may lead to an unfair imbalance as between the parties. 7.08 As for “usage”, it has long been accepted that the construction of contracts may be aided by looking at commercial practice, technical concepts, etc. Interpretative or conventional usage is concerned with commercial or professional practices which may help in ascertaining the will of the parties.5 7.09 Finally, as to the role of “law” in this context, there are two points to be made. First, the law may impose extra burdens upon the parties by regulating certain contractual areas, leading to the formulation of certain rules of conduct to be adhered to by the parties to a contract. In the modern context one example is the implication of contractual terms by statute. Secondly, the law may intervene notwithstanding the parties’ wishes, not to impose extra contractual requirements but to prevent or prohibit certain practices, as with the concept of “public policy”.6III. DELICTUAL AND QUASI-DELICTUAL LIABILITY
7.10 It has long been accepted that, for reasons of public policy, criminal or delictual liability does not find a remedy in insurance. Nevertheless, it is worth considering the origin of thisPage 139
IV. REQUIREMENTS FOR DIRECTORS’ AND OFFICERS’ CONTRACTUAL LIABILITY
7.14 It is well accepted that the relationship existing between the company and its directors is a complex one; as in England there is controversy in respect of whether it is organic,Page 140
V. ACTS OR OMISSIONS (CULPA IN FACIENDO AND IN NON FACIENDO 22)
7.17 Unlawful acts or omissions are the triggers for the right of indemnity. The key point as far as D&O insurance is concerned is whether the act or omission in question is malicious, negligent or innocent.23 7.18 The duties to which directors are subject may be categorised into the following groups24:- (1) Statutory duties: the vast majority of directors’ duties, which are in the main concerned with the protection of the company’s capital, belong to this group.25 Civil jurisdictions take the view that compliance with obligations of this nature is mandatory or “orden publico”.26 Any contravention of these rules of law leads to
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- (2) Duties arising from the articles of association: these duties usually complement statutory provisions which set down the minimum permissible legal standards.29 For example, the articles may increase the quorum required to convene a general meeting or establish the structure of the board of directors and the number of directors. The effects of a failure to comply with these duties are comparable to those of a breach of statutory duties.30
- (3) The duty of care in exercising a directorship: this issue is dealt with below31 but is worthy of mention here. Civil law jurisdictions do not apply the same test of diligence as under English law; the tests applied range from what might be called the more demanding systems which are mainly in continental Europe to less severe ones in Latin America.
- (4) Complementary duties: like executing shareholder’s general meeting decisions. Now, whether or not directors are under any duty to accomplish general meeting decisions is a matter for debate. What could be said is that it is generally accepted that directors might discharge themselves from liability in executing an unlawful general meeting decision by recording in the corresponding minutes their nonconformity and giving subsequent notice to the company or auditor.32
VI. CULPABILITY: DOLUS AND CULPA
7.19 Once the relevant act or omission33 has been identified, it is necessary to show that is the result of unlawful conduct. It follows that proving dolus, culpa (or as stated above, contravention either of stated law or the articles of association) may be the only means of fixing a director with liability. 7.20 Civil law recognises that directors’ duties are not obligations to produce a given result for the company. Although directors are required to use their best endeavours to achieve a company’s aims there is no liability per se if those objectives are not achieved.34 This distinction is of major relevance when assessing the level of diligence demanded in the execution of a director’s duties. In this regard “culpa” as a concept is somewhat ambiguous. Where an individual’s duties encompass the obligation to achieve a particular result,35 the standards of diligence are raised, rendering them liable for culpa levissima which corresponds with the standard of care to be expected of the best “pater familiae”,36 or a personPage 142
(a) Culpa and the test of diligence
7.23 The notion of culpa may be defined as the failure to observe that level care and skill demanded in accordance with the nature of the obligation in question which is unlawful and/ or injurious to a third party.46 The point is that a careless person (for example, director or officer) is culpable.47 7.24 In civil law systems the concept of diligence is important and is very different from that in English law. There are three main different tests to be found in Italy, Germany and Latin America, respectively. We consider each in turn. 7.25 In Italy article 2392 of the Codice Civile 48 (as amended) provides that directors must comply with the law and abide by the company’s articles of association. The article further provides that in so doing directors must observe the required level of diligence, the proper nature of their functions and the level of their personal skills and competence. The authors take the view that the nature of directors’ functions are likely to include: (1) the structure, size and complexity of the company’s business; (2) the corporate form adopted49 ; and (3) whether its shares are available to the public market. It follows that there is no standard test—the bigger the company, the higher the standard demanded.Page 143
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- (1) Culpa in contraendo 61 means carelessness in the performance of a duty. Whenever directors fail to exercise the level of care and skill demanded in the performance of their obligations this is a breach of duty which attracts personal liability. However, directors have a certain freedom in taking and acting upon their decisions. So the business judgement rule62 allows directors to avoid liability merely by errors of judgement which result in losses to the company. Thus, wrongful perceptions of the reality surrounding certain business activities or market fluctu-ations affecting the value of shares, for example, do not attract a finding of negligence (in terms of culpa).
- (2) It may be possible for directors to delegate functions and indeed on some occasions, due to the size and complexity of business, delegation is compulsory. Culpa in eligendo 63 (a Roman law principle of liability) refers to the liability a director may incur in wrongfully choosing either an incompetent or inexperienced person to perform the delegated activities. Consequently, directors could incur liability by failing to enquire as to the competence of person in whom the duty has been delegated.
- (3) Culpa in vigilando 64 refers to the fact that directors are not excused from their duties of vigilance once an appointment has been made. This principle holds that directors are at fault if they fail to inspect and scrutinise those in whom managerial functions have been vested.
(b) Sharing the blame
7.29 It is a feature of a number of civil law jurisdictions that the directors’ joint liability is presumed unless certain conditions are met (as to which see below).65 This is an important issue as regards the effectiveness of insurance cover and subsequent allocation.66 7.30 The presumption of unlimited and joint liability affects the board as a whole unless any of the following are satisfied: (a) the director successfully proves their lack of participation and/or knowledge in either the decision-making process or the execution of the decision in question67 ; (b) those directors who are aware of the wrong used their best endeavours to prevent the damage or at least opposed to the execution the wrongful act68 ; or (c) if thePage 145
(c) Damage: pecuniary loss
7.31 As stated above, in order to establish civil liability loss70 has to be shown. Such damage can take a variety of forms, including bodily injury, death, personal property damage and third party patrimonial loss. Only financial loss suffered by a person other than the director him/herself is recoverable under a D&O policy.71 Because there is no contractual relationship per se between a company’s directors and the shareholders, the creditors or other third parties, there is no possibility of a director incurring contractual liability to anyone other than the company,72 which can recover either “damnum emergens”73 and/or “lucrum cesans”.74 Consequently, the locus standi to bring such a claim rests with the company, acting through the general meeting75 of shareholders by means of unaffected or new directors, a required quorum of minority shareholders76 or, in the case of the company’s insolvency, its creditors.77(d) Causation
7.32 In order for contractual liability to arise there must be a causal link between the director’s conduct (a wrongful or negligent act or omission) and the damage in respect of which the claim is made. This principle applies to civil law liability generally and is based on the assumption that the immediate cause of the damage must be the agent’s act or omission.78VII. EXTRA-CONTRACTUAL LIABILITY
7.33 In contrast to the situation under English law,79 the majority of civil law jurisdictions do not hesitate to recognise the possibility of directors incurring personal liability toPage 146
VIII. THE LIABILITY OF OFFICERS
7.35 Generally speaking, “officers” are those to whom the company’s directors delegate certain managerial functions and such individuals are usually put in charge of the practical execution of decisions taken by the board of directors. However, this does not necessarily mean that officers do not play a role in the decision-making process.84 The relationship between a company and its officers is characterised by their subordination to the authority of the company, exercised by the board of directors.85 In other words, instead of performing their functions at board level, officers are lower in the corporate hierarchy.86 7.36 In the English market it is common practice to insure both directors and officers under the same policy, on the basis that the source of any liability they may incur is identical.87 However, in civil law jurisdictions directors and officers may not be exposed toPage 147
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IX. CONCLUSIONS
7.44 A number of conclusions are apparent:- (1) In relation to the circumstances in which a director or officer could face liability under civil law:
- (a) Civil law jurisdictions recognise the possibility of incurring both contractual and extra-contractual liability. The first species of liability arises only in relation to the company; the second arises in relation to third parties including shareholders. As noted above,106this position contrasts with that under English law, where a director’s personal liability to third parties is uncommon save in very specific circumstances such as where there has been an assumption of responsibility or fraudulent misrepresentation.
- (b) Civil law jurisdictions impose contractual liability on directors in respect of deliberate, wilful or negligent breach of duty on the basis that directorship is a contract of mandate between the company and its directors. This point contrasts dramatically with the position under English law, where that relationship is fiduciary in its nature and not founded in contract.107
- (2) As for the nature of liability of a director or officer at civil law:
- (a) As stated above,108 a director may be liable, whether contractually or extra-contractually, if his conduct is dolosa 109 or culposa 110 and if the wrongful act inflicts damage.111 More or less the same approach is followed in England.112 In this context issues of public policy and insurability may prevent insurance irrespective of the jurisdiction at issue.
- (b) Liability may arise irrespective of fault by breaching the law (statutes, civil and/or commercial codes) or failing to comply with the obligations set out in the company’s articles of association. This results in the tricky situation of insurers having to prove the director’s state of mind if they want to avoid liability.
- (c) Culpa as a concept may have more than one meaning and even the test by which it is assessed may vary. As we have seen, some jurisdictions (mainly European) impose different tests, which to some extent impede harmonisation in this field. Although English law may be moving—in accordance with section 214 of the Insolvency Act 1986 and the decision in Re Barings Plc (No 5)
113 —towards a stricter test that is in harmony with its neighbours, what may still lead to confusion is the fact that less developed jurisdictions still attribute to directorship the most basic form of negligence, which, as explained above,114 impedes standardisation. This is a relevant because reinsurers may have to take into consideration the fact that what may lead to liability in some jurisdictions may result in directors not being liable in others, including
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- (1) First, there is the concept of director for the purpose of defining the insured under the policy. Some (for example, Latin American) jurisdictions tend to be casuistic and write extensive articles of association with the intention not only of delimiting directors’ duties but also of determining who is to be deemed a director. With regard to “officers”, insurers may successfully challenge their obligation to provide an indemnity by reason of not being able to find an exact counterpart for the expression “officers without representation” in the English legal system. Additionally, officer’s liability may not correspond with the notion of liability to a third party such that the effectiveness of third party insurance cover in this scenario could be challenged as well. The exact construction of the Insured vs Insured exclusion could be also a matter for debate.
- (2) Secondly, since the company-director relationship is contractual (and based on mandate116 ), the construction of the “liability in contract” exclusion analysed above,117 needs further clarification. In terms of effectiveness in civil law jurisdictions, this clause must be interpreted as excluding contractual liability between either the company or its directors and third parties and not between the company and its directors. If that were not the case D&O policies containing this exclusion would be of no use in the English legal system.
- (3) Thirdly, one of the major features is the possibility of directors incurring extra-contractual liability to shareholders and third parties. From both an insurance and a reinsurance perspective this is something to be considered as an influence not only on premium (or deductible) calculations but also on the assessment of the risk itself which apparently is larger.
- (4) Finally, the presumption of unlimited and joint liability among members of the board may give rise to complicated insurance issues, for example, concerning allocation when the board is not insured as a whole or where directors take different policies with different insurers.