How to Squeeze Blood from a Stone: D&O Insurance and Insolvency

There were 19,077 compulsory and creditors' voluntary liquidations in the UK in 2009, an increase of 22.8% on 2008.¹ The amount of other corporate insolvencies (receiverships, administrations and company voluntary arrangements) also increased. The UK insolvency body, R3, recently warned that company collapses will hit record levels this year (a peak of approximately 28,000) and will stay high in 2011. The main reasons for this spike in insolvency, are, reportedly, aggressive creditors and less forgiving tax authorities.²

Directors' Duties and Liabilities

In light of these alarming statistics, directors and officers of UK companies must be on their guard. In particular, directors must be aware of the duties codified in sections 171-177 of the Companies Act 2006:

• Duty to act within powers (section 171);
• Duty to promote the success of the company (section 172);
• Duty to exercise independent judgment (section 173);
• Duty to exercise reasonable care, skill and diligence (section 174);
• Duty to avoid conflicts of interest (section 175);
• Duty not to accept benefits from third parties (section 176); and
• Duty to declare interest in a proposed transaction or arrangement (section 177).

Section 172(3) is especially relevant in the context of insolvency. It provides that a director's duty to promote the success of the company is subject, in certain circumstances, to a duty to act in the interests of the creditors of the company.

A director who breaches these duties may be subject to claims by the company or its shareholders, which is worth keeping in mind if a company is close to insolvency. However, a director of a company in financial difficulties could also face liabilities imposed under the Insolvency Act 1986 ("the Insolvency Act"):

• Misfeasance or breach of fiduciary duty (section 212);
• Fraudulent trading (section 213); and
• Wrongful trading (section 214).

Under these provisions, the liquidator can, in certain circumstances, apply to the court for an order that forces a director to contribute to the assets of the insolvent company.

For example, in the context of wrongful trading, the court may require a contribution if, at some point before the commencement of the winding up of the company, the director knew or ought to have concluded that there was no reasonable prospect that the company would avoid going into such insolvent liquidation. This means that even though directors may consider they are doing the right thing by continuing to open their doors in order to "save the company", a director can actually be liable for allowing a company to continue to trade when it is on the brink of insolvency.

Additional fraud and misconduct offences

The Insolvency Act also imposes the following offences, which can apply to directors of companies in financial difficulties:

• Fraud in anticipation of winding up ( section 206);
• Transactions in fraud of creditors ( section 207);
• Misconduct in the course of winding up ( section 208);
• Falsification of company's books ( section 209);
• Material omissions from a statement relating to company's affairs ( section 210); and
• False representations to creditors ( section 211).

Each of these provisions sets out further claims that can be made against the directors and officers in the context of insolvency. In light of these potential liabilities, a director who is aware that the company is in financial difficulties should seek immediate external advice from experienced advisors.

D&O Insurance

Once a company has been declared insolvent, directors often find themselves between a rock and a hard place. On one side, they may be facing claims by a liquidator for wrongful trading or other Insolvency Act offences. On the other side, they probably do not have sufficient personal assets to defend these claims. Finally, because the company is insolvent, it will not be in a position to assist the director. As a result, directors are becoming more interested and educated about the directors and officers indemnity insurance policies that a company purchases whilst the company is a going concern.

Depending on its terms, a D&O policy will usually cover the costs of defending claims resulting from insolvency. Importantly, a D&O policy will usually provide that these costs can be advanced to the directors and officers as long as there has been no finding or admission of fraud or dishonesty. As such, the objective of a D&O policy is to provide personal protection to individual directors and officers. However, the policy can also be extended to reimburse the company when it indemnifies the directors, or where it is the subject of a securities claim (which may be the case if the company is publicly listed). A typical policy is broken down into three broad categories of cover:

• Side A (non-indemnifiable loss) provides cover for the individual directors and is designed to pay when the company fails to indemnify the director;
• Side B (indemnifiable loss) provides reimbursement to a company that has indemnified a director; and
• Side C (entity cover) provides protection for the company as an entity and is usually restricted to claims for breaches of securities laws.

Who owns the D&O Policy when the Company is Insolvent?

Although a D&O policy is designed to benefit individual directors and officers, the fact is that the policy is usually purchased by the company. This raises some interesting questions: Who owns the D&O policy when the company is insolvent? Will the directors and officers of an insolvent company be able to access the proceeds of an insolvent company's D&O policy?

Take this example. A company is put into compulsory liquidation, and a liquidator is appointed to collect and distribute the company's assets. The liquidator and creditors of the company argue that the D&O policy (and more importantly, its proceeds) is the asset of the insolvent company and must be distributed by the liquidator in accordance with insolvency laws.

On the other hand, the directors and officers argue that the D&O policy was purchased for their benefit and, is therefore, being held on trust by the company for them. Assets held on trust are usually not considered assets of the insolvent company and would therefore be (theoretically) protected from distribution by the liquidator as long as the formalities for formation of a trust are met.

To date, the point has not been resolved by an English court. Judges in the United States continue to struggle with similar issues in the context of US bankruptcy laws, with some courts finding that the policy proceeds should be distributed as part of the bankruptcy estate and some concluding that the directors and officers have "first dibs" on the proceeds.

The point was most recently highlighted in the Stanford Financial Group ("SFG") case in Texas, where the SFG receiver asserted that the proceeds of SGF's D&O insurance policies were "receivership assets". Eventually, the judge avoided the debate by concluding that he did not need to determine whether or not the proceeds were receivership assets, because he could exercise "equitable discretion" to permit the payment of defense costs "even if the proceeds were part of the receivership estate".³ Judge Godbey also found, "the possibility that the D&O proceeds might one day be paid into the receivership [did] not justify denying the directors' and officers' claims". So, the debate rages on across the Pond.

Additional Protection for D&Os

Until this point is clarified under English law, it is likely that directors and officers will continue in their efforts to protect themselves by ensuring that an appropriate programme of D&O insurance is in place before they are appointed to the board. For example, directors are increasingly demanding separate Side A coverage to respond in an insolvency situation.⁴

Directors should also be mindful of whether the D&O policy has a priority of payments provision, which has become fairly standard in recent years. It generally specifies that payment of loss will first be made under the policy's Side A coverage, thus confirming the parties' intent that the D&O policy serves primarily to protect the individual directors and officers.

Another option for directors and officers to consider is the more recent entrant to the UK market – the Excess Side A/DIC policy. This policy is designed to "drop down" and provide primary cover under certain circumstances, including the company's inability to indemnify due to insolvency. However, the terms of these policies vary widely.

Finally, directors should bear in mind that liquidators or administrators are unlikely to renew D&O cover for former directors of now-insolvent companies. Because the policies operate on a "claims made" basis, former directors may wish to consider "run-off" cover and should ensure all potential claims and circumstances are notified each year prior to renewal, and before a company is declared insolvent.

Conclusion

In these troubled times when directors may find themselves in the middle of an insolvency "squeeze", they should pay close attention to the company's D&O programme. Brokers and underwriters should also ensure that the desired cover is being provided and that the policy is clearly drafted to benefit the directors (rather than the company's creditors) in the context of insolvency.

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¹The Insolvency Service, Policy Directorate: Statistics.
² Financial Times, "Insolvencies to peak as slump ends", 26 January 2010.
³ Securities and Exchange Commission v Stanford International Bank Ltd, et al., No. 3:09-CV-298-N (N. Dist. Texas Oct. 9, 2009).
⁴ Buck, Graham. "Full Circle", Continuity Insurance & Risk Online, October 2009, http://www.cirmagazine.com/cir/full-circle.php