It is important to understand the basic components of Directors’ and Officers’ liability policy (“D&O policies”) because D&O policies are significantly different from comprehensive general liability policies (“CGL policies”).
Before examining the various parts of D&O policies, we will examine who they are designed for and why. In other words, who are directors and officers and why do they need insurance? It is the aim of this paper to review the basic components and then outline some coverage issues raised by D&O policies.
WHO ARE DIRECTORS AND OFFICERS?
(i) Business Structures
To understand the role of officers and directors, some understanding of corporate law is necessary. People can run businesses in three basic ways. The first way is a sole proprietorship in which the individual is the business. The second way is to work with others in partnership. The third way is to create a corporation so that the company is the business. A corporation is owned by its shareholders.
(ii) Separate Legal Entity
A corporation is an independent legal entity. A corporation has the legal ability to do anything a natural person can do. The shareholders are not the business and are distinct from the corporation. As set out below, the fact that the corporation is a separate legal entity is of critical significance in analyzing coverage provided by D&O policies and explains why D&O policies raise coverage issues that differ from CGL policies.
(iii) Limited Liability
A corporation is separate from its shareholders and the liability of the shareholders is limited. If a sole proprietorship or partnership cause damage to someone, the owners are liable for the entire loss. If a corporation causes damage to someone, only the corporation is liable. The shareholders are liable to lose only the value of their shares if the business fails.
(iv) Corporate Governance
Corporate governance is the regulation of the relationship between a company and shareholders. Since management by many shareholders is ineffective, shareholders normally delegate their power of management by electing or appointing directors and officers of the corporation. The Board of Directors act subject to limits imposed by the memorandum and articles of the corporation. As discussed below, the directors and officers are also subject to the Company Act, various other statutes, and the common law when managing the corporation.
Who is a Director?
A director is a person duly elected by the shareholders or appointed in accordance with the articles of the corporation.
What Do Directors Do?The directors must manage, or supervise the management of, the affairs and business of the corporation. In a larger corporation, the board of directors will delegate some of its management powers to selected employees (“management employees”) to assist the directors in overseeing the affairs and business of the corporation. In smaller businesses, the directors will likely be the management employees and the workers. It is important to identify an individual’s corporate responsibilities to determine if coverage under a D&O policy applies.
What are Officers?
For our purposes, officers are directors given specific tasks under the Company Act. Each corporation must have a president and a secretary. The tasks of the president, secretary and other officers, if any, are set out in the corporation’s articles. Generally, the president chairs the board of directors meeting and the annual general meeting where shareholders have the opportunity to question the directors about the corporation and the board of directors’ decisions. The secretary must keep the records, ensure all filings are made with the registrar of companies, file certain resolutions with the registrar and perform other duties prescribed by the articles. For the rest of this paper reference will be made only to directors.
WHAT ARE THE DUTIES OF A DIRECTOR?
The Company Act sets out the director’s general duties. Every director of a company, in exercising director’s powers and performing director’s functions, must:
(a) act honestly and in good faith and in the best interests of the company (the “Fiduciary Duty”), and
(b) exercise the care, diligence and skill of a reasonably prudent person (the “Negligence Duty”).
These duties are owed to the corporation.
(i) Fiduciary Duty
The law of fiduciary duties is complex. However, the underlying concept is quite simple. A fiduciary is someone who must put his or her self-interest aside and consider the interests of another first. In the corporate context, a director must put aside his or her own interest as a shareholder and act in the best interests of the corporation. This is necessary and appropriate because the shareholders have entrusted the director with the power to make decisions on their behalf. Because the shareholders are vulnerable to the director’s use of that power, the law says that the director must not let his or her interest conflict with that of the shareholders. The director cannot profit because of his or her position at the expense of those who put him or her in that position.
(ii) Negligence Duty
The duty to exercise the care, diligence and skill of a reasonably prudent person is based on the law of negligence. “Care” can be described as prudence based on common sense – acting deliberately and attempting to foresee probable consequences. Diligence is making enquiries that people make managing their own affairs. The director must carry out his or her duties without negligence.
To succeed in negligence, an injured party must show:
(a) that the director owed the injured party a duty of care;
(b) the standard of care appropriate in the circumstances;
(c) a breach of the standard of care; and
(d) the damage caused by the breach to the injured party.
A number of federal and provincial statutes also impose specific duties upon a director. Examples include:
(a) Employment Standards Act – directors are responsible for paying employees in the event that the company fails to do so;
(b) Income Tax Act – directors are responsible for withholding taxes; and
(c) environment legislation – directors can be charged with contamination and pollution offences.
There are directors’ and officers’ liability handbooks which provide checklists which assist in determining what statutory liabilities may arise in a particular industry.
Common Law Duties
It is generally accepted that the directors’ duties prescribed by the Company Act include the common law duties owed by a director.
WHO CAN SUE THE DIRECTORS – STANDING?
If a director breaches a statutory duty, then the statute defines who has the right of action.
Alternatively, if a director breaches a specific duty owed to a third party then that third party can bring an action. For example, if a director makes a misrepresentation about the corporation that induces the third party to buy shares which decline steeply in value, there may be a claim of negligent misrepresentation.
The more difficult case is where the director allegedly breached the Fiduciary Duty or the Negligence Duty in the course of managing the corporation as these are wrongs done to the corporation. According to the rule in the old case of Foss v. Harbottle , if it is alleged that a wrong is done to the corporation, the corporation itself is the proper party to any action against the wrongdoer. Therefore, the following problems arise:
(a) in law, the corporation is treated as a separate legal entity;
(b) it acts through the directors;
(c) the directors owe the Fiduciary Duty and the Negligence Duty to the corporation, not the shareholders (even though the shareholders are the ones who usually suffer);
(d) the directors control management, and therefore litigation;
(e) it is against a director’s self-interest to start an action against himself; and
(f) if the directors start an action against themselves, they are in a conflict of interest.
The Statutory Solution
To get over this problem, the Company Act contains two provisions which allow shareholders to obtain standing to bring claims against the directors for wrongs done to the corporation – the derivative action and the oppression remedy.
(i) Derivative Action
The derivative action allows a shareholder, with the leave of the court, to bring an action in the name of and on behalf of the corporation to enforce the duties owed to the corporation. The threshold to obtain the leave of the court is quite low. Damages can be obtained.
(ii) Oppression Remedy
Any shareholder can apply for a court order that the affairs of the company are being conducted, or the powers of the directors are being exercised, in a manner oppressive to one or more members. The oppression remedy is limited to court regulation of conduct – damages cannot be awarded. The oppression remedy is more likely to be used when an individual shareholder has a specific complaint rather than a general complaint applicable to all shareholders.
Under the new Strata Property Act of British Columbia, the strata corporation is charged with managing and maintaining the common property and common assets of the strata corporation for the benefit of the owners. A strata corporation is very much like a commercial corporation except its “business” is managing a condominium development and as a result of particular issues concerning the management of common property, it is constrained by its own legislation.
Strata Council Members
Each strata title owner is essentially a “shareholder” in the strata corporation. Instead of a board of directors, the strata corporation is managed by a strata council. Membership of the council is determined by the by-laws (articles) of the strata corporation and by an election at an annual general meeting.
The duties of a strata council member are similar to that of a director and include:
(a) acting honestly and in good faith with a view to the best interests of the
strata corporation, and
(b) exercising the care, diligence and skill of a reasonably prudent person in comparable circumstances.
COMPONENTS OF D&O COVERAGE
There are two distinct components to a D&O policy’s insuring agreement because it provides coverage to both the corporation and the directors, unlike a CGL policy.
(i) Indemnification of the Corporation
Since the directors are working on behalf of the corporation and may be sued in their capacity as directors, the Company Act provides for indemnification of the directors by the corporation if sued. This is covered in the insuring agreement by the “corporate reimbursement” clause.
The typical wording of the corporate reimbursement clause is that the insurer will “indemnify the corporation for all loss for which the corporation may be required or permitted by law to indemnify its directors and officers in respect of claims made against them for a wrongful act during the policy period”.
Under the Company Act, in order for a corporation to indemnify a director, there must be:
(a) court approval sought by the company or the director;
(b) proof that the person acted honestly and in good faith with a view to the best interests of the corporation; and
(c) for criminal or administrative actions or proceedings, proof that the person had reasonable grounds for believing that the person’s conduct was lawful.
Note that there are no indemnification provisions for officers.
(ii) Indemnification of the Directors
The corporation cannot or will not indemnify a director when:
(a) it is financially incapable of doing so;
(b) a new board of directors does not want the corporation to do so; or
(c) the corporation simply has not sought court approval.
The typical wording of the directors’ reimbursement clause is that the insurer will indemnify the directors and officers in respect of losses resulting from any claim made against them for a wrongful act during the policy period, except for loss for which the corporation provides indemnity.
Deductibles and Retentions
D&O policies carry high deductibles compared to CGL policies. Often there will be two deductibles in D&O policies – one for the corporate reimbursement coverage and one for the directors’ indemnification coverage. The deductible under the corporate reimbursement coverage is often higher than under the directors’ indemnification coverage. To avoid situations where the corporation is liable to indemnify the directors, but chooses not to do so to avoid payment of the higher deductible, some insurers mandate that the higher deductible will apply, even if a claim is made under the directors’ indemnification coverage.
There may be an issue about the number of deductibles payable if there is more than one claim arising from the same or a similar set of circumstances.
Some D&O policies contain a provision for a “retention”. In this circumstance, directors and their corporation not only pay a deductible, but are also responsible for a percentage of the actual loss.
What is a “Loss” Under the Policy?
Certain types of losses may be specifically excluded by D&O policies. Most policies only cover compensatory damages and exclude fines, penalties and punitive damages.
Limits of coverage are also a concern and should be reviewed when considering any loss. The policy may limit losses for each occurrence. It may also limit claims on an aggregate basis during the term of the policy. If that is the case, then a number of claims may exceed the policy limits. Review should be made of all prior claims to determine if there may be a limits problem created by a new claim.
It is very important to keep in mind that, unlike CGL policies which indemnify for the loss to the limit of coverage and defence costs over and above the limit, most D&O policies are “eroding” policies where defence costs incurred reduce the stated policy limits.
D&O policies are “claims made” policies. This is considerably different from a CGL policy which is an “occurrence” policy. With an occurrence policy, the act causing the loss must occur in the policy period while the claim against the policy can be made afterwards.
What is a Claim?
A review of the policy wording is necessary to answer this question. The making of a claim by a potential Plaintiff ranges from the commencement of legal action, to notice from a potential Plaintiff that it seeks to hold the director or officer liable, to knowledge of the director or officer of facts that would give rise to a claim. Obviously it is critical to determine whether or not the notice is given in the policy period.
Some policies contain a “discovery period” extension. This effectively extends the policy period. For an additional premium, the right to report a claim may be extended for a defined period if there is a pending expiration or cancellation of the policy.
The most common types of claims are:
(a) failing to look after the interests of the shareholders when the corporation
is being taken over by another corporation, is merging with another
corporation or is acquiring another corporation;
(b) failure to disclose information or making misrepresentations in stock offerings or transactions; and
(c) inducing the corporation to breach a contract.
The definition of wrongful act in the insuring agreement limits the extent of coverage to certain types of acts committed by the director acting as director. Therefore, if the act does not fall within the wording of the insuring agreement or the director was not acting in his capacity as a director, then there will be no coverage.
Typical wording of the wrongful act definition is “any actual or alleged error or misstatement or misleading statement or act or omission or neglect or breach of duty by the directors or officers in the discharge of their duties, individually or collectively, or any other matter not excluded by the terms and conditions of this policy, claimed against them solely by reason of their being directors or officers of the company.” The intent is to cover losses caused by negligent conduct or honest mistakes.
An unanswered issue is whether intentional acts are covered or not. That will depend on the wording of the policy.
Coverage is limited to negligent acts when acting in the capacity of a director or officer. In a small corporation, the person may be acting as a management employee or worker rather than as a director. A director may also be a consultant, such as a lawyer.
Another related issue is whether the person had been properly elected or appointed as a director or officer since some policies require this.
The intent of D&O policies is to cover negligent conduct in the management of corporations. Consequently, these policies will frequently exclude breaches of what has been identified above as the Fiduciary Duty.
Such exclusions include claims based on:
(a) the director taking personal profit or advantage from the corporation;
(b) the director dealing with the corporation;
(c) the director obtaining illegal remuneration; and
(d) insider trading or other securities violations by the director.
Where there is an attempted take-over of a corporation by another corporation, the directors of the target corporation are placed in an immediate conflict of interest. If the take-over succeeds it is likely that the directors will be replaced. However, with a take-over bid, there is usually a premium paid for the stock above the normal stock price and it may be in the shareholder’s interest to accept the take-over bid. Often the directors will recommend to the shareholders whether to accept the bid or not. Some D&O policies exclude claims arising from such activity because of the potential conflict of interest. Other D&O policies include terms in the exclusion to ensure that the directors acted in the best interest of the shareholders and corporation by seeking independent legal and financial advice.
The issue of whether a director acted dishonestly raises difficult coverage questions. Is intentional conduct covered? For example, a director may steal money. Does a D&O policy respond to such an intentional act or is that type of loss intended to be covered by fidelity insurance?
Other D&O Coverage Policies / Related Claims exclusions
Specific wording may render the policy an excess D&O policy when there is coverage overlap with another D&O policy. The limits of the first policy must be exhausted before payments are made under the second policy.
The related claim exclusion excludes claims that may be addressed by a previous policy through a related claim based on similar facts or from issues raised in prior litigation. It may also exclude potential claims of which the insured had notice before the inception of the policy.
Failure to Place Insurance / Personal Injury and Property Damage Exclusions
CGL policies cover losses arising from personal injuries or damage to property. D&O policies are not intended to cover such losses. The failure to place insurance exclusion prevents coverage for situations where the corporation did not obtain CGL insurance and claims that it, through its directors, was negligent in not doing so.
Specific Statutory Exclusions
Some policies contain exclusions against the liability imposed by specific statutes. For instance, most D&O policies contain exclusions against liability for past wages under the Employment Standards Act, withholding taxes under the Income Tax Act, and liability for various pollution related statutory offences.
IS THE POLICY VOID OR VOIDABLE?
The insured must not make a material misrepresentation or fail to disclose a material fact when applying for coverage. A review of the circumstances of the claim and the application submitted by the insured or its broker is necessary to make a determination if coverage has been vitiated by a material misrepresentation.
In British Columbia, the courts tend to view the contract of insurance as severable, so that a misrepresentation or nondisclosure by one of the insureds does not void coverage for the others.
CONDUCT AND COST OF DEFENCE
The D&O policy is very different from a CGL policy when it comes to the conduct and costs of defence. Typically, with a CGL policy, the insurer has complete control of the defence and is responsible for all defence costs. Often the insured has very little involvement in the claim.
Reasons for Insured’s Involvement
With a D&O policy, the insured will be directly involved with the claim. D&O policies’ exclusions often act to limit coverage with the result that directors and corporations face more uninsured risks in a claim than an insured is likely to encounter under a CGL policy.
As indicated above, with D&O policies there is more than one insured. The insureds include the corporation and the directors. There may be conflicts in positions between the corporation and the directors, and among the various directors themselves. For instance, a derivative action usually includes a claim that some of the directors acted against the interests of the corporation.
In that case, the corporation would likely appoint an independent board to manage the litigation. That board’s interests include the defence of the action on behalf of the corporation and whether the D&O policy will respond to the loss under the corporate reimbursement clause. The innocent directors may also have their own interests and positions to protect. Because of these coverage issues, under a D&O policy the insureds must have a greater role in the defence of a D&O claim.
D&O policies vary in their defence provisions. Usually the insured is given the right to select counsel and control the conduct of the litigation with the insurer simply paying the defence costs. The insurer’s duty to pay defence costs may start when the claim is commenced or once there is a determination of the claim against the insured. Some policies contain a provision that the insurer can, at its option, fund a portion of the defence while other policies may contain a provision that the insured cannot commence action for indemnification until the liability of the insured is determined.
Costs of Defence
Problems will arise with respect to the costs where there are claims that are covered by the policy and claims that are not. Some policies contain specific provisions which allocate defence costs between the insurer and insured, or provide a dispute resolution mechanism, for claims which are not covered. In cases where there is no allocation clause, it is unclear if an insurer who exercises its option to pay defence costs, and indicates that it reserves the right to claim back that portion of defence costs which relate to uncovered claims is able to do so. The law appears to be that an allocation can be made after all of the issues against the insureds have been determined. It is important to consider whether an insurer will make interim payments with the risk that there may not be a right to recover these funds later.
Insurers frequently consult coverage counsel to advise on defence obligations under a D&O policy.
What happens when there are covered and non-covered allegations, the matter is eventually settled, and defence costs have not eroded policy limits?
The British Columbia courts appear to be adopting the “larger settlement” rule. If the company’s exposure is the same as that of the directors and officers, the settlement will come entirely from the D&O policy. However, if the liability against the corporation is not entirely the same as that of the directors, then an allocation may be considered by the court as an implied term in the contract of insurance.
D&O policies are not CGL policies. D&O policies give the insureds far greater rights in the control and conduct of the litigation than an insured under a CGL policy. More importantly, D&O policies frequently raise difficult coverage issues that may require legal analysis assistance. Use of coverage counsel to provide policy advice and to oversee the defence of an action often proves beneficial for D&O underwriters.
Prepared by Ryan Darby and former Director, Gregory Blanchard.