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D & O Insurance – An Overview

by Stephen on August 19th, 2012

June 2012

D & O Insurance – An Overview

Directors’ and officers (“D & O”) insurance is a type of liability insurance cover which is typically comprised of two limbs:

• individual cover for the director/s for the insured loss arising from a wrongful act of the director (where the director/s is/are not indemnified by the company); and

• cover for the company itself where the company indemnifies the director.

D & O cover is a form of “claims made” cover . The policy covers liability arising from a “wrongful act”. Wrongful acts are frequently defined very broadly to include errors or omissions, negligence, breach of duty in the capacity as a director/officer. Modern D & O policies are often much more than cover for civil claims and often include cover for:

• employees and “deemed directors” ;

• limited cover for director/officer’s liability to employees; and

• defence costs associated with such events as:

o attendance at an official investigation or inquiry into the affairs of the company (including such things as coroner’s inquests and disciplinary tribunals);
o successful defence of a criminal prosecution;
o HSE (health and safety) prosecutions; and
o pollution claims

Why obtain D & O cover?

The general response to the “why?” question is that, other than in those cases where the director has breached their duty to the company and is being sued by the company to recover the loss it has suffered as a result of that breach, directors are required to act in the interests of the company and their first line of defence is the company itself. As a result, they can be said to be hostage to the fortunes of the company.
In the SME sector, typically the directors are also the company’s shareholders – in which case a director indemnity is circular (i.e. it is coming from their own pocket). This is not the case for larger corporates with a deeper pool of capital available for the director’s protection. One argument is that this means that the directors of SMEs should have a higher rate of protection in the form of D & O cover.
Examples of the risks to a director include:

Insolvent trading: One of the primary exposures of a director is for insolvent trading (sections 135 and136 Companies Act 1993). Such proceedings are typically initiated by a receiver or liquidator – and are an exception to the “insured v insured” exclusion . Obviously, the greater the risk of company insolvency the greater the need for D & O cover. And insolvency practitioners, often funded by the IRD or major creditors, pursue the directors of many more small companies than those featured in the major corporate failures.

Derivative actions: These actions are also an exception to the “insured v insured” exclusion and are brought by shareholders in the name of the company under the Companies Act 1993 for a breach of duties owed by the director to the company. Whilst they are very common in the USA, there is a growing experience of such clams in New Zealand, based on that US experience.

Transactional Risks: When a company enters into a significant transaction (e.g. M & A transactions or refinancing) there is a risk of claims of misrepresentation, inadequate disclosure or a failure to follow proper process. Arguably, these risks may be greater in the SME sector due to an absence of good processes and/or the absence of good professional advice.

Competitor Actions: The rising tide of competition and consequent squeeze n market share and profitability means that there is a greater risk of directors facing claims by competitors, such as trade practices claims (under the Fair Trading Act 1986 and the Commerce Act 1986) and claims based on alleged infringements of intellectual property rights.

Fraud: In recessionary times, the prevalence of fraud claims (e.g. on the part of management) is greater – exposing unwitting directors to claims by either a third party or the company itself.

Employment claims: Anecdotal evidence suggests that in recessionary times and with redundancy and restructuring prevalent, there are a greater number of claims being made. Where the employer / company is no longer trading, directors are exposed as being the only existing / solvent target.

Regulatory action: The growing trend for ‘public order’ type legislation to backstop compliance obligations on the part of the company with duties owed by directors (to ensure that the company complies) has triggered a growth in the area of regulatory action against directors. Regulators such as the FMA have a statutory duty to proceed against companies in areas such as capital-raising and some trade practices claims. This backstop formula can result in criminal prosecutions being taken against directors with perhaps the most high-profile examples being in the case of HSE matters (noting that insurance cover cannot extend to the fines and penalties imposed by a court under such a prosecution – for public policy reasons).

International trade: Our export economy brings with it an increased risk of claims being brought as a result of acts or omissions in an overseas jurisdiction – particularly where (in the case of the SME sector) there was not the means or opportunity to obtain jurisdiction-specific advice.

Concluding comments
A number of commentators have pointed to a paradigm shift as a result of the GFC and, in a New Zealand context, the collapse of the finance company sector. This structural shift has brought about an increased readiness on the part of insolvency practitioners, creditors, competitors, employees and more proactive regulators to bring claims against company directors.
There is an ambulance at the bottom of the cliff element to insurance cover and a concern that the best form of protection comes from good systems, vigilance and sound advice. Nonetheless, D & O cover should be regarded as a key part of a director’s protective armoury.

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