Risks facing directors and officers in Australia

November 2010 | TALKINGPOINT | RISK MANAGEMENT

financierworldwide.com

FW moderates a discussion between John Edmond at Allens Arthur Robinson, Michael Herron at Chartis and Louise Cantrill at Henry Davis York, on the risks and challenges facing Australian D&Os.

FW: Reflecting on the past 12-18 months, have you seen an increase in claims made against directors and officers of Australian companies? If so, do you believe this has made it more difficult for boards to recruit individuals at the highest level?

Edmond: There is certainly evidence in the market of there having been an increase in the numbers of claims and circumstances notifications made over the last 18 months. This appears primarily to relate to the significant rise in the number of corporate insolvencies since 2008 and to the increased intervention of the Australian regulators. The changing legal landscape has also had an effect by making it easier to bring claims against directors and officers. A background of increased claims will inevitably deter some individuals from accepting board appointments. If you couple this with the long-standing position that the laws relating to directors’ personal liabilities and insolvent trading are very strict, it is not hard to see why board level recruitment has become more difficult.

Herron: Many Australian directors are questioning whether to take on new board positions or even maintain existing ones in what they see as an increasingly hostile jurisdiction. It has been estimated there are as many as 700 laws where directors can be held liable for something in which they were not personally involved. While GFC related actions are still washing through, the market volatility of the past 12-18 months continues to stimulate new plaintiff and regulatory activity.

Cantrill: Over the past 12 to 18 months, claims against directors and officers in Australia have reached unprecedented levels, both in terms of number and quantum. It is likely that this, coupled with increased personal liability for directors and officers, has made it more difficult for boards to recruit individuals at the highest level.

FW: What are some of the key sources of D&O related disputes? For example, what are the reasons behind the uptick in shareholder class actions?

Cantrill: Regulatory changes and judicial considerations have increased the scope of potential claims that can be brought by shareholders and investors. This has been coupled with an increase in entrepreneurial law firms, the legitimisation of litigation funders and the introduction of more accessible class action procedures in most Australian jurisdictions. The GFC saw some increase in insolvency rates with an associated rise in shareholder, investor and creditor claims. Litigated claims of this nature have not been as numerous as may have been expected, probably due to the relatively mild impact of the GFC on the Australian economy. However, there are signs that this is about to change, with the past year seeing the commencement of a number of liquidator examinations of directors and officers of companies in liquidation, a traditional precursor to the commencement of legal action. ASIC has also shown a significant appetite for taking its own action and has been given increased powers to do so.

Edmond: The most common causes of D&O disputes arise from alleged breaches by directors of their statutory duties under the Corporations Act 2001 (Cth) and their contravention of the prohibition against misleading or deceptive conduct contained in the Trade Practices Act 1974 (Cth). The rise in the numbers of shareholder class actions is due to several factors. Perhaps the most significant factor is the recent economic downturn which has provided the conditions for shareholder losses to occur. The continued growth of the class action litigation industry has also undoubtedly played a part. For instance, more litigation funders have entered the market and plaintiff law firms now increasingly seek to take advantage of the commercial opportunities these types of claims offer.

Herron: The key driver of D&O claims has been securities class actions for a breach of continuous disclosure. These claims generally target the company and often precede any regulatory or liquidator actions against the directors who may be subsequently pursued for compensation, disqualification and even fines and penalties.

FW: To what extent are you seeing an increase in disputes between companies and their directors?

Herron: Directors are increasingly defending (company) derivative actions concerning related party transactions, executive compensation and conflicts of interest. A former management team is particularly susceptible to such allegations following a change in management or insolvency event. Any review of contracts awarded to companies in which a director has any current, or imminent, financial interest may not benefit from hindsight. Companies and directors are also facing employment practices claims by other directors or employees. Dismissal, harassment and discrimination claims can be emotionally charged and potentially toxic when senior managers are involved. Dismissal actions concerning non-performance of CFOs and executives can be costly and complex to resolve.

Cantrill: As claims have become more significant and complex, disputes between companies and their directors have increased. ASIC has been aggressive in its pursuit not only of individual directors but also of officers and other senior personnel, as we have seen in the James Hardie case. This approach has also been reflected in class actions and in the approach of liquidators. As a result, conflicts of interest between the company and its various directors and officers are more likely to arise.

Edmond: Although it is hard to assess precisely, to my observation the increase in the numbers of claims made against directors over the past few years has resulted in a consequential increase in the numbers of disputes between companies and their directors over issues such as indemnity arrangements. For example, disputes occasionally arise as a result of inconsistencies between the company’s constitution and a deed of indemnity provided to a director. Alternatively, a company may seek to challenge the basis upon which it has agreed to provide an indemnity, particularly where the company’s D&O insurance does not cover this reimbursement exposure.

FW: What impact has litigation funding had on D&O disputes?

Edmond: Although liquidators have enjoyed the ability to appoint litigation funders to bring claims against directors (and others) for many years, the main impact of the more recent emergence of the litigation funding of shareholder class actions has been to focus attention on limits of cover in D&O policies and the potential erosion of personal insurance cover for directors. Although the number of funded D&O claims are still relatively small, the significance lies in the severity of these claims. Litigation funders are attracted to, and have the capacity to finance, large claims on behalf of thousands of shareholders that can seek compensation running to several hundred million dollars.

Cantrill: In terms of D&O disputes, litigation funding tends to be focused on the funding of class actions, most typically shareholder claims based on allegations of a breach of the continuous disclosure obligations or the prohibitions against engaging in misleading or deceptive conduct. Claims against directors or officers will generally be couched in terms of the director’s or officer’s involvement in such contravention. There has been an increase in the filing of claims of this type in recent years, particularly in NSW and Victoria, and it is likely this trend will continue. The commercial reality of litigation funding is that it will generally only be available for claims of a substantial size. Any defendant to such an action should assume that before agreeing to fund, the litigation funder has conducted an assessment of the claim and the ability of the defendant to pay, and has formed the view that the matter may be resolved favourably from the funder’s perspective. In that circumstance a funded claim will likely only be resolved if it is resolved early, for a substantial sum, or via judgment.

Herron: Without litigation funders backing the lead plaintiff with costs security, securities class actions – the key driver of D&O claims – would never get off the ground. This is a relatively recent phenomenon and the spectacular success of litigation funders has really only emerged and developed with changes to the Australian legal and regulatory framework post 2001. As at mid 2010 Australia’s best known litigation funder had over 30 cases – also referred to as an investment portfolio – of significant value. Going by recent announcements from litigation funders and plaintiff firms in the context of recent market volatility, any company that has issued a revised earnings statement (and there are many) could be a potential target.

FW: In your opinion, what do Ds & Os need to know about their potential personal liabilities in today’s market?

Cantrill: Apart from the expected personal liability attaching for breach of duty owed to the company, directors and officers need to know that they are facing increasing potential for personal liability in the Australian market in other areas. Most importantly, ASIC has made it clear that it will focus on recovering against directors and officers personally where debts are incurred when the company is insolvent. Liquidators are also taking this approach. Recent guidelines issued by ASIC emphasise the need for directors to keep themselves informed about the financial position of the company, proactively investigate financial difficulties, obtain advice and, where the director suspects the company is insolvent, take active and timely steps to prevent debts being incurred. This particularly severe regime (including personal liability for debts incurred) is at odds with other jurisdictions and international insolvency practice generally, which emphasises the desirability of workouts for companies under stress. Directors and officers also need to know about their potential for personal liability for occupational health and safety breaches and environmental and pollution claims.

Herron: Directors are being held to increasingly higher standards and simply staying on top of what is required will be a challenge in itself. In many cases the duties, obligations and conduct of the various directors are unclear and directors find themselves facing potential liability simply because of their position as a director of the company. Strict or derivative liability is becoming increasingly common for a breach of directors’ duties, particularly for pollution and occupational health & safety matters.

Edmond: They should be aware that they are exposed under Australian law to significant risks of personal civil and criminal liability arising out of the performance of their professional duties. There is a particular trend for corporations (and other) legislation to impose personal liability on directors and officers because of the office they hold rather than as a result of their actual conduct. Reform of this issue is currently being considered by the federal government. Any substantive reform, however, is likely to be a long process and I’d recommend that directors and officers keep themselves appraised of developments here.

FW: What issues arise from Australia’s continuous disclosure regime?

Herron: Unlike the US which is the common reference point for securities class actions, an Australian continuous disclosure action requires no evidence of fraud or dishonesty or even intent. If the disclosure is misleading, questions will be asked. Legal commentators warn that directors will not always have as much information as they would like before going to market and the adequacy of their disclosure can be scrutinised harshly with the benefit of hindsight.

Cantrill: Continuous disclosure is likely to remain in focus given the recent high profile cases and settlements, the focus of ASIC and the ASX on the continuous disclosure obligations, and the ongoing volatility of the financial markets. An entity’s breach of its continuous disclosure obligations not only opens it up for prosecution by ASIC and potentially also claims by investors, but persons involved in the contravention may also be personally liable. To take advantage of the due diligence defence available under the Corporations Act, companies and their directors will need to ensure that there has been an effective continuous disclosure compliance program in place. It is also worth noting that ‘awareness’ of information which requires disclosure will include circumstances where a director or executive officer ought reasonably to have come into possession of the information in the course of the performance of their duties. The inclusion of the words ‘ought reasonably to have’ means that ignorance will be no defence and a company needs to have a system for ensuring that information requiring disclosure is identified and communicated to the person or persons authorised to disclose.

Edmond: Continuous disclosure cannot be ignored in the context of seeking to avoid D&O claims. In the current economic climate, in my view, the materiality threshold that triggers a company’s disclosure obligations is now lower than it has ever been; people have lost money in the GFC and are looking for someone to blame. In light of this, directors should satisfy themselves that their company’s disclosure policy has been recently reviewed, represents industry best practice and that they (and other staff) have received adequate training on continuous disclosure issues. More generally, appropriate systems should be in place to produce and monitor accurate financial information and a company’s disclosure committee should have adequate resources to deal with issues immediately as they arise.

FW: How might the outcome of Australia’s James Hardie case alter the playing field going forward? Will it mark a turning point in the way directors manage their personal risks and liabilities?

Edmond: This case is relevant because it focuses on the required degree of skill and care that should be employed when considering the approval of public announcements. In particular, it has highlighted that there are limits on the ability of directors to delegate their decision-making powers and to rely on information provided to them by others. In terms of managing their personal exposures, this case is more of a reminder than a turning point for directors to ensure that they properly understand these when agreeing deeds of indemnity and reviewing the terms of their company’s D&O cover.

Herron: Directors are now acutely aware of the potential for personal liability for a breach of duties of care and diligence in respect to the company’s misleading statements. Their responsibility for important strategic matters cannot be effectively delegated to co-directors, internal legal corporate departments or actuaries or other external advisers. Regardless of the appeal outcome, it has been said that these proceedings have lifted the bar for non-executives and senior executives below board level.

Cantrill: The decision sounds a note of caution to directors and management in terms of decision making processes; the way information is obtained and presented to the board, and the form in which decisions are conveyed to the market. The decision stands for the proposition that board members owe a duty to avoid exposing the company to the risk of harm to reputation or legal claims, and that by allowing a company to be exposed to harm through the public release of an inaccurate announcement, they could be in breach of their duties to the company, even if no harm eventuates. Directors may not abdicate responsibility for the consideration and approval of significant public statements by delegating to co-directors, or by simply relying on management. Directors are obliged to take an active interest in such matters and ensure that they are fully informed before permitting decisions to be made. Members of senior management (including general counsel) can also be exposed to claims of breach of duty in this situation.

FW: How would you describe Australia’s D&O liability insurance market? What are some of the key trends in D&O policy terms and pricing?

Cantrill: Australia’s D&O insurance market continued to harden over the last 12 months, although not to the extent that may have been expected given the increase in claims. There has been some hardening of insurance terms, but reasonable availability of underlying risk capital and continued competition between insurers has, so far, prevented a major spike in insurance premium pricing. At least one significant insurer has taken the step of removing securities entity cover (otherwise known as Side C cover) from its D&O wording, offering it instead as a separately priced, stand alone policy. Insurers at all layers have sought to reduce the limit they provide per policy, making the completion of large programs more difficult and increasing associated premium costs. There has also been an increase in portable coverage available for directors and officers, designed to ‘fill the gaps’ in other D&O cover obtained by the company and to step in when the underlying D&O policy fails to cover them.

Herron: A review of the Australian general insurance industry in the July 2010 publication of Pendulum by Finity Consulting, projected D&O loss ratios in excess of 100 percent for recent notification years, from 2003-2009. D&O insurers’ claims experience has shown that Company Securities (Side C) claims generate extreme exposure in the context of the D&O premium pool. D&O insurers are increasingly wary of exposure to company securities claims and coverage is being offered on a selective basis. For the insurance buyer, it is important to recognise that there is a real need to consider the coverage and claims services provided. Chartis is the only insurer currently offering separate director indemnity and company securities policies to protect the separate and competing interests of the individuals and the companies.

Edmond: Australia has a robust and well-capitalised D&O liability insurance market that includes a number of experienced local and international insurers. I’ve already commented on side C, which is the most obvious area where policy terms are changing. It is currently in a state of flux with a number of new products and policies on the market which we are often asked to review. The general view in the market is that that coverage remains broad. As a broker friend of mine explained, they are increasingly working with their client’s lawyers in finalising wordings (although he didn’t necessarily put this as a good thing)!.

FW: Could you outline the risks and/or benefits of including Side C cover in D&O policies in Australia? How does this compare to the situation in other countries?

Herron: Side C originated in the US as an extension of cover for securities actions against the company. It was intended to align the interests of the company with the directors in the common defence of an action. While this rationale may apply in the US and other parts of the world where actions name both the company and the directors, Australian securities actions generally target only the company. This distinction can be critical where a securities claim crystallises ahead of any regulatory or derivative action against the directors. Side C can then become a ‘trojan’ coverage extension, having the potential to completely erode the entire D&O policy limit with company claims leaving the directors to face claims for personal liability alone. This is a particular issue for Australian directors.

Cantrill: Side C cover has been available as part of the standard D&O policy wording issued by many Australian insurers. The main benefit of including Side C cover is an alignment of the directors’ and officers’ interests with those of the company under a single policy, reducing potentially difficult coverage issues for claims involving both a claim against the company and its directors and officers. The main problem with including side C cover is that the recent sharp increase in shareholder claims in Australia (to which Side C cover responds), particularly class actions, has the potential to quickly erode the limit of cover under the policy (unless separate limits apply), thereby leaving directors and officers personally exposed for any future claims. The Australian market has seen recent movement away from insurers providing Side C cover as part of the usual D&O cover, but this has been associated with increases to premium costs.

Edmond: Side C cover offers the benefit of balance sheet protection against securities claims in return for additional premium and within the same policy as traditional Side A and B covers. Side C cover was developed before significant shareholder class actions became commonplace. There is a risk, which most insurers and brokers are grappling with, that large claims such as these will exhaust the available limit of cover under Sides A and B and so leave directors’ personal assets exposed to claims against them. For companies particularly at risk of Side C claims, some insurers have moved to address this risk by offering Side C cover that operates either under its own ‘tower’ or on a stand-alone basis. To my observation, all insurers are trying to ensure that the Side C exposure is adequately priced.

FW: Looking ahead, what are your predictions for the D&O insurance market through 2011?

Edmond: I would expect to see a number of claims developing from existing notifications and continuing or even increased regulatory investigations. In addition, I expect a steady continuation of announced shareholder class actions and a greater awareness on the part of directors and officers to ensure that they are sufficiently protected.

Cantrill: I predict a continued hardening of the market in terms of both wording and pricing. Directors and officers will need to review the extent of cover provided to ensure it is adequate in light of the increased potential for personal liability, particularly in areas of insolvent trading, securities, environmental obligations and OH&S. Directors will have to balance the competing interests of obtaining adequate coverage for themselves as directors of the company and cover for the company’s own risks for potential securities claims. They will also need to balance the need for coverage versus the cost of obtaining that coverage.

Herron: The D&O market has attracted new entrants in 2010 as premiums firmed in response to the spike in D&O claims from prior years. This has added capacity and sharpened competition for market share. There is also a real divergence in claims handling readiness and ability in the D&O market, particularly from new entrants and developing markets. While experienced D&O insurers will anticipate competition in 2011, they will also be cautious of the ongoing D&O risks attaching to the difficulty directors have in forecasting earnings, stress testing and identifying asset valuations in a volatile investment market. Recent statements from the corporate regulator provide a timely reminder of the risks facing directors in the current economic conditions, particularly around disclosure and for companies exposed to finance or debt stress from an increased tightening in business lending.

John Edmond is a partner at Allens Arthur Robinson. He began his career in London on Lloyd’s matters, emigrated in 1998 and now acts for clients in the Australian, Asian, London and US insurance and reinsurance markets. He is one of Legal Media Group’s World Leading Insurance and Reinsurance Lawyers and his deep industry knowledge is recognised by clients in the current Chambers & Partners guide. Mr Edmond has been a partner since 2004. He can be contacted on +61 2 9230 4287 or by email: John.Edmond@aar.com.au.

Michael Herron is the Chartis Regional Manager Australasia, Commercial Management Liability & Crime, Financial Lines, based in Sydney. At Chartis he has worked as Regional Financial Institutions Manager, Regional Chief Underwriting Officer, in Legal & Product Development and in M&A insurance. He has also previously worked as a professional and financial risks insurance broker and in legal practice in a corporate insurance team. Mr Herron can be contacted on +61 2 9240 1859 or by email: michael.herron@chartisinsurance.com.

Louise Cantrill is a special counsel in Henry Davis York’s Commercial Disputes Group. She is an insurance law expert specialising in insurance claims and advice. Ms Cantrill is a trusted adviser to insurers, insureds and self-insureds on a wide range of insurance issues. Her substantial expertise in claims work includes acting in multi-party company/directors and officers claims and professional indemnity actions. She also has extensive insurance advisory experience, including the review of complex corporate insurance programs, policy drafting and advising on issues of co-insurance, re-insurance and excess insurance. Ms Cantrill can be contacted on +61 2 9947 6511 or by email: louise_cantrill@hdy.com.au.

THE PANELLISTS

John Edmond

Allens Arthur Robinson

Michael Herron

Chartis

Louise Cantrill

Henry Davis York