Hareesh Gupta, Advocate, Gauhati High Court
Introduction
Directors’ and Officers’ Liability Insurance is liability insurance[1] payable to the directors and officers of a company, or to the company itself, to cover damages or defense costs in the event they suffer such losses[2] as a result of a lawsuit for alleged wrongful acts while acting in their capacity as director and officer for the company. In a more simple way, it is an insurance policy bought by companies for the benefit of their directors and officers, insuring them in respect of their potential liabilities as directors and officers. Within the policy limits, the sums for which the insurer takes responsibility are those which the directors and officers are ‘legally liable’ to pay to ‘third parties’. The concept of ‘sums legally payable’ by the director can be illustrated with the help of an illustration, i.e., if the directors are threatened with legal proceedings to prevent them from acting in a particular fashion, and they pay a sum to a third party to allow their intended conduct to go ahead, such payment is not based on legal liability but rather is in the form of business interruption loss, which is not insured by liability cover.
Initially, the directors’ and officers’ liability insurance does not provide any indemnity incurred by the director to the company against any liability incurred by the director to the company itself or to any associated company and it was confined to third party claims only. The said restrictions have been removed by making an amendment in the Companies Act in U.S. and U.K. and the directors and officers need not takeout their own policies as was the case before the removal of the restriction on companies effecting such benefits, but in India the situation is different as the policy has to be taken by the director on their own and the company is legally not authorized to take such policies as per Section 201 of the Companies Act, 1956. Though it does not prohibit directors to take such policies, but the said distinction restricts the scope of directors and officers liability insurance in India to third party claims only.
The Rs 7000-crore scandal at Satyam Computer Services had brought the issue of corporate governance into sharp focus. For years, the senior management of Satyam led by its founder and former chairman cooked the books of the company under the noses of the company’s board, comprising luminaries from the world of academia and business. The Satyam scandal has resulted in more than 500 directors stepping down from boards amid fears they could be held responsible in case of frauds at companies whose boards they sit on even if they are no way responsible. Directors’ and Officers’ liability insurance would help the corporation attract and retain quality board members and ultimately in ensuring good corporate governance as ‘risk management’ is part of corporate governance. Also such policies would ultimately protect shareholders and provide companies with a hedge against uncertain situations. In recent times reports had revealed that in the event of frauds stemming from poor corporate governance practices Capital markets regulator SEBI is looking forward to make it mandatory for all listed companies to buy directors’& officers’ (D&O) liability insurance to shield them from the risk of huge liabilities. The need to make this policy mandatory for every company arises also from the fact that the Companies Bill, 2008 has made a provision for class action lawsuits and once enacted, this could expose directors to expensive litigation. Given the current corporate environment, independent directors would be extremely wary of serving on the boards of companies that do not protect them.
The purpose of this type of insurance is the provision of an indemnity against financial losses arising from claims against directors and officers of companies for actual breach of contract, misstatement, breach of trust, breach of duty, act, neglect, error, omission, breach of warranty of authority, or wrongful trading. Typical sources of claims include shareholders, shareholder-derivative actions, customers, regulators, and competitors (for anti-trust or unfair trade practice allegations). It is not a policy to protect a director or officer against loss of earnings arising from being dismissed, or, for instance being disqualified from being a director. Another common misperception of D&O insurance is that it makes directors or officers able to engage in acts they know to be wrong; this is not the case. Dishonesty, fraud and malicious conduct, fraudulent trading, criminal acts, obtaining any profit or advantage by breach of fiduciary duty, claims for personal injury or material damage, professional negligence, fines and penalties, any liability relating to any kind of pollution, losses covered by previous policies or undisclosed claims, liability under personal guarantees and warranties are not covered in Directors’ and Officers liability insurance; coverage would only extend to “wrongful acts” as defined under the policy, which may include certain acts, omissions, misstatements etc. while acting as a director/officer of the organization. Thus, summarily, four elements must be fulfilled under the cover provided for the directors’ and officers’ liability insurance: there must be a “loss” suffered as a result of “claims” made against the directors’ and officers’ in respect of a “Wrongful Act” committed “in their capacity as Directors’ & Officers”.
Unlike other insurance policies the Directors’ and Officers’ insurance is written on a “claims-made” basis. This means that the indemnity only attaches to claims made against the insured directors and officers during the period of insurance. Furthermore, the indemnity only applies to such claims duly notified to the insurer, provided notification is the subject of a suitable precedent to the insured’s right of recovery under the policy. The indemnity will be limited to losses, as defined in the policy, in respect of which the insured directors and officers have not been provided indemnity by their company. The practice and requirement of insurers vary as to the identification of the insured directors and officers. The policy will usually expressly state that it is severable or composite policy, insuring each director and officer in respect of his own liability. Accordingly, if for any reason one particular director is precluded from recovering, by reason of, e.g. breach of the duty of utmost good faith, breach of policy terms, criminality or fraud, the rights of innocent directors are unaffected.[3]
Rationale behind Directors’ and Officers’ liability Insurance
Directors and Officers liability insurance (D&O) has become the fastest evolving and most dynamic insurance policy in India and is also seen as an alternate means for corporate governance. Though Lloyds Insurers drafted the policy in the 1930s for an American company, its importance was virtually unknown in Asia and particularly in India for a long time. Statistically it is revealed that less than 10% of companies listed on the BSE now have any kind of D&O policies, which typically cover top executives from being held personally liable in the event of misleading financial statements and mismanagement of funds. In U.S. AND U.K. special legislations have been passed to recognize the concept of directors’ and officers’ liability insurance as initially it was unclear that whether corporations would be legally permitted to insure directors and officers against the losses that the corporation could not legally indemnify, but no such legislation or amendment has been passed in India to legalize the said concept.
As to the evolution of the concept of Directors’ and Officer’ liability insurance vis-à-vis fiduciary duties of the Directors it is important to understand that there remains no contradiction to the fact that Directors’ and Officers’ are bound to act in good faith, so as to safeguard the interests of the shareholders of their company; any deviation can have potential liability issues for them and thus it is imperative on their part to operate within absolute legal premise while making a decision. Among the vital functions of the board of directors of a company are the review and sanction of major corporate actions, evaluation, and administering of proper audit procedures to ensure due corporate compliances in accordance with prescribed statutes, regulations and laws. However, there might be instances wherein a stakeholder or any other party concerned with the company, may incur a loss or sustain damages despite utmost diligence. These are circumstances for which directors opt for insurance in the nature of D&O insurance. In a seminar on ‘liability and corporate crime insurance’, Ms. Rajaratnam[4] explaining the nature of the policy said the D&O policy did not belong to a company. It was a personal policy belonging to each and every director and officer of the corporation and its subsidiaries. Explaining the nature and scope of the policy, she further stated that “No other policy presents as complex an array of insurance, indemnification, corporate governance, litigation issues involving liability exposures in virtually every substantive area of the law including securities, mergers, and acquisitions, fiduciary duty, bankruptcy, employment and criminal law”.
Corporate directors are liable for the corporation’s actions as well as their own. Strangely, and by far, the most likely plaintiffs in a lawsuit against corporate directors are the shareholders who appointed them in the first place. As a result, directors often require protection so that their personal wealth is not expropriated in the event of a good faith error. The primary purpose of D&O insurance is to protect individual directors and officers (“D&Os”) from personal financial loss arising from claims against them for alleged “wrongful acts” undertaken in their capacity as directors and officers. The phrase “wrongful act” is a term of art in the D&O insurance industry and is defined by the insurer as part of the policy terms. The definition of “wrongful act” in most policies is two-pronged: the first prong encompasses claims that may be asserted against the D&Os merely by reason of their status as a director or officer. The second, and more frequently litigated, prong specifies certain types of “wrongful” conduct by the D&O in his or her corporate capacity. The wrongful conduct delineated in the majority of D&O policies typically is phrased as any actual or alleged errors or misstatements or misleading statements or acts or omissions or breach of duty by D&Os while acting in their individual or collective capacities.
The Directors’ and Officers’ insurer serves as an intermediary between injured shareholders and the managers who harmed them. Thus, intermediary role has important implications for corporate governance that has been largely overlooked by corporate and securities law scholars. The deterrence goals of corporate and securities liability are achieved indirectly, through an insurance intermediary. The D&O insurer has several means of reintroducing the deterrence function of corporate and securities law. First, D&O insurers may screen their risk pools, rejecting firms with the worst corporate governance practices and increasing the insurance premiums of firms with higher liability risk. Second, D&O insurers may monitor the governance practices of their corporate insureds and seek to improve them by recommending changes, either as a condition to receiving a policy or in exchange for a reduction in premiums. Third, D&O insurers may manage the defense and settlement of shareholder claims, fighting frivolous claims, managing defense costs, and withholding insurance benefits from directors or officers who have engaged in actual fraud.
Recoverable Losses under the Directors’ and Officers’ insurance policy
Directors’ and officers’ cover is, typically, concerned with two forms of loss: that suffered by the directors and officers themselves; and that suffered by the company itself as the result of the conduct of its directors and officers. The first head of coverage provides the directors and officers with an indemnity against loss arising from claims made against them during the period of insurance by reason of any wrongful act committed by them during the period of insurance, in their capacities as directors or officers of the company. Liabilities incurred by directors and officers in their personal capacities, e.g. in respect of guarantees, are excluded. The second head of coverage is for the company itself, and extends to any payment which the company makes arising out of claims against the directors and officers in respect of any wrongful act for which the directors and officers would themselves have been entitled to indemnify under the policy. Therefore, if the company assumes liability to a third party and makes payment on behalf of the wrongdoers themselves, the insurers will pay. As already stated earlier, the company is not permitted to provide an indemnity to directors or officers for breaches of their duties to the company itself or to agree to do so (Section 201 of the Companies Act) and for this reason the second head of coverage will generally be confined to the situation in which the company is legally entitled to indemnify the directors.
Legal constraints in application of the concept of Directors’ and Officers’ liability insurance in India
It is a settled principle of law that a company is a juristic person and it acts through its Directors who are collectively referred to as the Board of Directors. An individual Director has no power to act on behalf of a company of which he is a director unless by some Resolution of the Board of Directors of the company specific power is given to him. The company acts through agents and the directors’ act as agent of the company by virtue of the Resolution of the Board of Directors and provisions in the Articles of Association. Therefore, the directors occupy the position of agents, trustees and representatives of the company and they hold a fiduciary position in respect of all transactions on behalf of the company. The fiduciary capacity within which the directors have to act enjoins upon them a duty to act on behalf of a company with utmost good faith, utmost care and skill and due diligence and in the interest of the company they represent[5] . If company suffers any loss on account of breach of duty on part of a director, he is liable to reimburse company to the extent of such loss. The directors’ and officers’ liability insurance indemnify the directors individually against the third party claims for allegation of breach of fiduciary duty done in good faith by a director. The legal contradiction is that, if the directors’ cannot act individually, can they be indemnified individually for the acts that they have done collectively. Section 291 of the Companies Act, 1956 that deals with general powers of Directors contains the word ‘Board’ means Board of Director and not individual Director. Further, any act or decision by the director under Section 291 is done collectively and not individually. Therefore, a question arises that in case of any breach of fiduciary duty can the liability be severed among individual directors’ or will it be the liability of the Board collectively. The interpretation and reading of the ‘proviso’ clause to section 291 and interrelated sections dealing with the powers of the Board (Section 292 and 293)[6] clarifies the position and reveals that in cases of statutory violation of any of the provisions of the Companies Act and acts ultra vires the Memorandum of Association the Board will be collectively held liable. But where the Board exercises its general powers under Section 291 which does not defines the acts to be performed by the directors in exact terms rather it gives very broad powers to directors to exercise all such powers and to do all such acts and things, as the company is authorized to exercise and do; in such circumstances individual liability needs to be severed and directors as an agent can be indemnified individually against the consequences of acts done in good faith towards third party. Thus, according to this insurance policy, directors of a company though must act collectively as per statutory regulations, but on the contrary when it comes to liability they can be indemnified individually for the acts done collectively in their fiduciary capacity excluding statutory violation and ultra vires acts. In the above context it is important to mention herein that the D&O policy does not indemnify the directors against any liability incurred against the company except the cost of defense proceedings that the director has defended successfully under Section 201 of the Companies Act. Section 201 of the Companies Act, 1956 states that a company cannot indemnify an officer or director against any liability which the officer or director may incur on account of negligence, default, misfeasance, breach of duty or breach of trust of which he may be guilty in relation to the company and any provision contained in the articles of a company or in an agreement with a company or in any other instrument exempting such officer or director from any liability shall be void. However, the proviso clause to Section 201 provides that, a company may indemnify its director or officer only against any liability incurred in defending any proceedings if the judgment is in latter’s favour or in connection with any application under Section 633 in which relief is granted to him by the court.
Secondly, the question as to who should decide the fact whether the act done by the director was done in good faith or not at the time of deciding the bonafideness of the claim. The legal problem is that defining the conditions of indemnity which is usually done to cover the consequences of the wrongful acts of the directors done in good faith may lead to abuse of the said policy as the same can be used a shield by a faulty director. The decision whether a particular act was done in good faith or not is very delicate and subjective. The insurance companies while granting claim under the directors’ and officers’ liability insurance has to adjudicate on bonafideness of the act of the director or depend upon the decision of an adjudicatory body (Company Law Board) to decide the bonafideness of the claim of the director and also to decide whether the act of the director individually actually amounted to breach of fiduciary duty or was done in good faith in the interest of the company. Because under this type of insurance a claim in favour of a director would succeed only if the breach of fiduciary duty or risk insured is unintentional and in good faith; any other situation would rather encourage bad governance. The Supreme Court has in many cases on the question whether a particular act amounts to oppression or not, held that mere breach of fiduciary duty does not entail any liability upon the director. In V.S.Krishnan v. Westfort Hi-Tech Hospital Ltd[7] the Supreme Court held that: “Even if the acts of the parties prima facie indicate an abuse of the fiduciary position but the ultimate object and result of such act is greater good of the company, then such an act will not constitute ‘oppression and mismanagement.” These questions are of utmost controversy and importance and are being a subject matter of number of judicial pronouncements and it would be a very daunting task ahead of the insurance companies to perform their functions in a judicious manner. Though the insurance companies are trying to make the concept of ‘good faith’ objective by defining certain matters of insurance policies, but it is a known fact that the decision as to whether a director of a company has acted in good faith while performing his fiduciary duty as an agent which has incurred liability to the company is highly subjective and there is no any firm guidelines or definitive standard to determine as to when the director has acted in good faith, rather its determination depends upon facts and circumstances of given case. The concept of Directors’ and officers’ liability insurance is no doubt a good step to ensure effective corporate governance in India, but its implementation requires an utmost amount care and caution on the part of the insurance companies and any error in granting claim would make this concept a total failure.
Thirdly, problem that would come up while deciding the claims, is how to distinguish between the allegation of wrongful acts of the directors’ towards the third parties i.e., shareholders, creditors etc., and the allegation of wrongful acts of the directors’ towards the company as they both overlap and there is very thin difference between the two. The distinction between the two is important because the loss caused to the directors against the allegations of wrongful acts which affects the company is not legally insurable as per Section 201 of the Companies Act and it is only the third party claims that are insurable.
Exclusions from cover
D&O policies have three principal exclusions: (1) the “Fraud” exclusion for claims involving actual fraud or personal enrichment, (2) the “Prior Claims” exclusion for claims either noticed or pending prior to the commencement of the policy period, and (3) the “Insured v. Insured” exclusion for litigation between the insured persons. The Fraud exclusion prevents insureds from receiving insurance benefits when they have actually committed a wrongful act, often defined as a “dishonest or fraudulent act or omission or any criminal act or omission or any willful violation of any statute, rule or law.” Whether an act comes within the Fraud exclusion depends upon the wording of the policy, which may require “final adjudication” of the fraudulent act or merely evidence that the fraudulent act has “in fact” occurred. The Prior Claims exclusion carves out any claims noticed or pending prior to the commencement of the current policy, which ordinarily would be covered under a policy. Finally, the Insured v. Insured exclusion withholds insurance proceeds for losses stemming from litigation between insured parties, such as directors suing the corporation or the officers or the corporation suing an officer or director. The followings are excluded from the cover: –
Dishonesty, fraud and malicious conduct
The policy will not provide an indemnity in respect of claims arising from the allegations concerning any dishonest or fraudulent act or omission by an insured director (but will indemnify other directors not concerned with those particular allegations) except in regard to the costs and expenses reasonably incurred by the director in his successful defense of such claims. In Prudential Assurance Co. Ltd v. Newman Industries Ltd (No.2),[8] the directors who were sued for damages on the ground of their conspiracy to deceive the company’s shareholders, would not be indemnified under a directors’ and officers’ liability policy. In Re George Newman & Co.[9] the court held that the blatant and dishonest misuse of directors’ and officers’ powers by dispensing, by way of gratuitous payment to one of the directors, moneys borrowed for the purpose of the company’s business would not be indemnified.
Obtaining any profits or advantage by breach of fiduciary duty
Liability of directors and officers relating to their obtaining of benefit or profit will be expressly excluded from the cover provided by the insurance policy. This effectively excludes all claims for breach of fiduciary duty that might be brought against directors or officers by their company. The main aspect of this duty is that the directors, and indeed company officers, must not allow their personal interest to override their duty to act in the interests of the company and to act intra vires the powers conferred on them. Another aspect of the duty is that the director or other officer must not make any secret profit from his position-if he does, the company may seek an order that he account to them for that secret profit and such claims may well be excluded from the scope of a directors’ and officers’ liability policy. The statutory provisions under the Companies Act, 1956 which prevents directors from making secret profit are: Section 297 deals with ‘Board’s sanction to be required for certain contracts in which particular directors are interested’; Section 299 deals with ‘Disclosure of interest by director’; Section 300 deals with ‘Interested director not to participate or vote in Board’s proceedings. In Regal (Hastings) Ltd. v. Gulliver,[10] a high point was perhaps reached where, to assist their company to buy out other rival companies in the area, the directors formed a new company to buy those other companies. After the rival companies had been bought the directors sold their shares in the new, acquiring company at $2.80 per share, having subscribed for them originally at $1 per share. The claimant company then sued them for the profit they had made, and the House of Lords upheld that claim:
“The directors standing in a fiduciary relationship to the claimant company in regard to the exercise of their powers as director and having obtained these shares by reason and only by reason of the fact that they were directors are accountable for the profits which they have made out of them. The lack of mala fides (bad faith) is irrelevant in these cases. The rule of equity which insists on those, who by use of a fiduciary position make profit, being able to account for that profit, in no way depends upon fraud or absence of bona fide, or upon such questions as whether the profits would or should otherwise have gone to the plaintiff, or whether the profiteer was under a duty to obtain the source of the profit for the plaintiff, or whether he took a risk, or acted as he did for the benefit of the plaintiff. The liability arises from the mere fact of the profit having been made. The profiteer, however honest and well intentioned, cannot escape the risk of being called to account”
Claims for personal injury or material damage
The policy will exclude from its scope claims made for personal injuries or material damage to property. These risks should be covered by appropriate employers’ liability insurance, public liability insurance, and, perhaps, product liability insurance.
Professional Negligence
Any claim that arises from the breach of professional duty to a client or customer of the company, or other third party who relies on the director or officer’s advice, design, specification or other professional services, will generally be excluded. These risks should be covered by appropriate professional negligence insurance policies.
Fines and Penalties
The policy will expressly exclude any fines and penalties imposed on directors and officers in criminal and other proceedings. Such an indemnity would probably be contrary to public policy and thus unenforceable by the insured directors or officers themselves in any event.
Conclusion
In the light of the Satyam fraud the concept of Directors’ and Officers’ liability insurance will give undue protection to dishonest directors who under the said insurance cover may often commit breach of fiduciary duty towards the shareholders and creditors of the company. Further the Indian corporate environment is not best suited for the application of the concept of directors’ and officers’ liability insurance as compared to other developed economies like U.K and U.S.A. The reasoning for introducing the concept of directors’ and officers’ liability insurance must not arise from the fact of mere increase in litigation against directors’ and officers’ of the company, but from the concern of false claims against directors. In India though the shareholders have been provided enough protection in law to protect their rights but it has been found that they are very less aware of their rights as owners and very often go for its enforcement and even when they go for its enforcement the management side often found to influence the outcome of the case on the ground that the acts of the director were done in the interest of the company. The said conclusion can be supported by the fact that analysis of various decisions of the Supreme Court the most recent being V.S.Krishnan v. Westfort Hi-Tech Hospital Ltd reveals the fact that the provision relating to oppression and mismanagement in the Companies Act has become totally redundant and in very few cases the shareholders succeeded in their claims against the management. Further in the wake of the Satyam fraud case which has unveil the failure of corporate governance measures in India and the existing scenario of Corporate Governance it would not be appropriate to introduce the concept of directors’ and officers’ liability insurance in India. Apart from that there are several legal constraints also in the application of the concept of directors’ and officers’ liability insurance i.e., whether the company can take the policy against the director or not in the light of the wordings of Section 201 of the Companies Act, 1956 and if not whether the director can take a policy individually in the light of Section 291 of the Companies Act, 1956 which entrusts all powers, and to do all such acts and things, as the company is authorized to exercise and do on the ‘Board of Directors’ and not individual director. Therefore, if the directors of a company cannot perform individually can they insure themselves against the individual liability? These legal issues needs to considered and necessary amendments have to be made in the Companies Act, 1956 before introducing the concept of Directors’ and Officers’ liability insurance in India. The act of the directors’ which is insured in Directors’ and Officers’ liability insurance is bonafide breach of fiduciary duty and not the malafide breach of fiduciary duty, but what is bonafide breach of fiduciary duty is not easy to define and is very subjective. Concluding though the concept of directors’ and officers’ liability insurance as an alternative means of corporate governance can be very effective but its successful implementation in India will depend upon the Indian Corporate environment and necessary legal amendments in the Companies Act.
References:-
[1] Liability insurance is a part of the general insurance system of risk financing. Liability insurance is designed to offer specific protection against third party claims, i.e., payment is not typically made to the insured, but rather to someone suffering loss who is not a party to the insurance contract. But under the Directors’ and Officers’ liability insurance the payment is made to the insured directors’ and officers’ against the risk of third party claims for the wrongful acts of the directors. The director has insurable interest to the extent of any potential liabilities that may be incurred by way of damages or costs caused while exercising their functions as director subject to certain exclusions. Under this policy it is not possible to pre-determine the extent of interest because there is no way of knowing how often one may incur it and what would be its monetary value and this feature does not meet one of the important factors of insurability i.e., ‘loss must be calculable’. [2] If the insurance policy in question undertook by its express terms to indemnify the plaintiff against damages resulting to him because of his violation of a criminal statute he could not recover. In such a case the contract on its face would be illegal and void and to prove his cause of action the plaintiff would have to prove his contract and that, being void and illegal on its face, could not be enforced, Messermith v. American Fidelity Co., 175 N.Y.S. 169 (N.Y.App.Div. 1919). [3] Arab Bank v Zurich Insurance [1999] Lloyd’s Rep.I.R.262. [4] Managing Director, Financial and Executive Risks (Finex) Asia, of Willis (Singapore) Pte Ltd [5] Dale and Carrington Invt.P.Ltd. v. P.K.Prathapan, (2004) 122 Comp.Cas.161 (SC) [6] Section 292 deals with certain powers to be exercised by Board only at meeting and Section 293 deals with Restrictions on powers of Board. [7] (2008) 83 SCL 44 [8] [1982] Ch.204, CA. [9] [1895] 1 Ch.674, CA. [10] [1942] 1 All E.R.378
