Strategy & Operations » Leadership & Management » COVER STORY – Directors’ liability: avoiding the potholes

When the chairman of a newly listed technology company died recently, allegedly from Aids, shareholders sued the US company’s directors for failing to disclose his illness. The share price had plunged from $12 to $4 on news of his death and the shareholders were looking for compensation of $45m. To make matters worse, the management had been advised by regulatory authorities that there was no obligation to disclose details of the chairman’s health in its prospectus. At best, the directors hope to settle for $2-3m.

It’s the sort of case that causes knuckles to whiten in US boardrooms but has traditionally created little more than a moment’s anxiety among UK directors. After all, the casebook of successful, high-profile claims against UK directors is a relatively thin volume. The legal system makes it difficult and costly for shareholders to mount class actions and the courts tend to be unsympathetic with investors who do not accept the inherent risks of investing in the stockmarkets.

But there are reasons to suspect that UK directors are becoming more concerned about the risks they face. Recent City scandals such as Morgan Grenfell, Barings and Jardine Fleming raised questions about the adequacy of supervision and level of care by senior management. Proposed European Union legislation could impose increased liability on UK directors and litigation against company directors in countries such as the US, Canada, Australia and Israel is increasing sharply. Directors might well wonder if it is a trend that will catch on here.

Then there is the prospect of new director liability law in California, which, if it wins public support at a vote this month, could have serious implications for UK companies with interests in the US. Concern in the US about the changes is so great that Intel, one of California’s biggest technology companies, said last month it would not publish any further financial projections until the legal situation was clarified.

Roddy Graham, divisional director of Lloyd’s of London insurance broker FirstCity says directors of multinational companies are becoming more exposed to the risk of legal action from shareholders in their overseas markets.

“If you are a director of a UK company which does a lot of trade, or has a subsidiary or is publicly quoted in the US, Australia or Israel then it is time to worry,” he says.

Legal firm Wilde Sapte claims the volume of directors’ and officers’ insurance purchased in the London market has “increased dramatically” since the late 70s. It is now estimated that at least 75% of the FTSE 100 companies and more than half of the leading 500 UK companies have directors’ and officers’ (D&O) liability insurance.

Wilde Sapte attributes the growth in cover to “an increase in legal hostility generally” although it points out that an estimated 15% of companies with D&O policies do not fully understand what their insurance covers.

Nigel Gillott, head of the general insurance practice at Watson Wyatt Partnership, agrees that awareness of the liability risk is on the rise.

A survey by Wyatt (now part of the Watson Wyatt Partnership) in 1993/94 found that 62% of the 132 corporate respondents had D&O cover, which included all respondents from the banking sector. Banks represented 11% of all respondent companies which purchased D&O cover.

“I would guess that in the UK 10 years ago people hardly ever thought about directors’ and officers’ insurance, now its very much more at the top of the agenda,” Gillott says. So much so, that many directors insist on seeing details of a company’s D&O cover before accepting a seat on the board.

D&O insurance cover might be nearing the top of the director’s agenda, but it is still very low on the list of topics freely discussed by directors in public. According to one plc finance director, who asked not to be named, admitting to carrying substantial directors’ liability cover is seen by many as an invitation to be sued. Or could be interpreted to mean that there are skeletons in the closet.

“Few companies own up to having a lot of insurance because the outside market place doesn’t always understand what it means,” he says. “Shareholders may feel directors should take responsibility for their actions and not have insurance.

“But directors have to protect themselves against two types of claims.

First you have the bona fide claims against a director for neglect or whatever. If the individual has been negligent then so be it, it is left for the company to fight as hard as possible to limit the damage.

“The other type of claim comes from the “stick-up artist” who is trying to blackmail the company or cause trouble. Insurers tend to be very tough with these kind of opportunistic claimants. But having said all that, most companies would consider the risk of litigation as remote.”

According to insurers, the pressure to take out D&O cover often comes from the finance director, who is usually heavily involved in managing the company’s risks. But even bullying from within the company can meet resistance.

A former company secretary says many directors believe their best protection against liability claims is to ensure their companies have watertight internal controls in place. Directors who knew they were covered by a comprehensive insurance policy might take risks or be less alert than they would be if their personal wealth was at stake, he says.

“At one of the companies I worked for, we paid u15,000 a year in D&O cover for five years and we never made a single claim. Some might say that is a pretty big outlay for no return.”

Although companies must disclose the purchase of D&O cover in their annual reports, there is no obligation to reveal the premium paid or scope of the cover. This, coupled with a reluctance by insurance underwriters and brokers to disclose the size of their business, means there are no official industry figures on the value of the UK D&O insurance market or the number of claims made against directors.

But the consensus is that the market is still small. Royal Sun Alliance, one of the main players in the UK directors’ liability market, estimates the London market to be worth u100m in premium terms, while the 1993/94 Wyatt UK survey estimated the market to be in the region of 65m-u75m.

This compares with the near u1bn gross premium income of employers’ liability, a compulsory class of commercial liability of insurance which covers injuries sustained by employees.

Even where companies are taking out policies, the amounts indemnified tend to be low. “I’ve always felt the traditional amount of D&O cover taken out by fairly large companies is relatively small when compared to the profession indemnity of accountants and solicitors,” says Michelle George, partner in insurance and reinsurance at Wilde Sapte. “Cover of u5m is not unusual. Yet if a company faced a big case that amount would be consumed by costs pretty quickly.”

While brokers insist the number of companies taking D&O cover is growing, most admit the market is “soft” with increased competition contributing to overcapacity in the market. The good news for UK directors is that this means that, unlike in some other markets, the price of cover has been slipping for several years. Growth in policies will be largely due to companies taking advantage of relatively low premiums.

The UK D&O market has always been dwarfed by the market in the US. The first D&O policy was issued by the Lloyd’s insurance market to an American company in the early 30s. It was a response to the new securities legislation introduced to protect stockmarket investors after the Wall Street crash.

UK companies were probably the next to follow suit, although the UK’s position in the D&O market has been steadily eroded since. “The UK market has been falling behind the rest ever since,” says Roddy Graham. “As yet the number of claims in the UK has been relatively small whereas the US is rife with this sort of litigation.”

Graham says “genuine cultural differences” in the UK go a long way towards explaining why the UK market has lagged behind. For a start, shareholders tend to be reluctant to pursue companies through the courts. “When one buys stocks and shares in this country we fully expect them to go up and down in value,” he says. Shareholders accept that there is accompanying risk.”

Richard Bagley, company affairs executive at the Institute of Directors (IoD), agrees. “We don’t have the same high level of shareholder activists in the UK and it is much more expensive to litigate than in the US where plaintiff lawyers are prepared to take on class actions on a contingency basis,” he says. “There is also a general feeling among British shareholders that ‘we had a good run for our money, we may have lost some money but there we are’.

“Also in the UK up to 70% of equity in listed companies is held by institutions – and I can’t see them wanting to take companies to the cleaners. They will either exit by the time a company goes under or write it off as a loss.”

Another important “cultural” difference is that few claims against directors become public knowledge. The vast majority of claims are settled out of court and usually sealed with a confidentiality agreement.

“Until we get some really sizeable claims that get into the public domain, directors may incorrectly think they have little or no exposure to risk or will continue to be unsure why they are buying D&O cover,” Graham says.

“The huge amount of ignorance stems from the fact there is little claims experience here. Clients are buying cover on the basis that everyone else has it,” he says. “One of the reasons FirstCity is successful is because we use the knowledge we see from our US claims to explain better to clients what they are buying.”

A classic mistake, according to Graham, is the assumption that D&O insurance will cover the liabilities of the corporate entity. “In a simple classic case a shareholder brings a suit on behalf of a class of shareholders against the company and its directors.

“Let’s say the shareholders and their lawyers agree to settle for u5m.

When the directors go to the insurance underwriters and ask for the u5m, they will find that insurers will want to talk about allocation – in other words, how much of the u5m liability is the responsibility of the company and how much is the responsibility of the directors. A D&O policy will only cover the liability of the directors.”

A finance director of a software company says few directors realise they are at risk of losing everything if they are found to be negligent. “Many still think that if things go wrong, the worst thing that will happen is the company will be wound down and that will be the end of it,” he says. “They don’t seem to understand they could be held personally liable.”

These sorts of concerns have prompted the IoD to launch a new directors’ personal indemnity insurance which covers directors whose companies have insufficient or no D&O cover. “Too many people are caught out with no protection,” John Harper, the IoD’s professional development director said when the service was launched last month. “Time and time again we hear stories where the members forget that, as a director, their liability is not limited, they face the prospect of unlimited personal liability.”

Recent cases have also highlighted the risk of liability for non-executive directors. “The demand for D&O cover must be seen against the recent trend of the courts to impose greater liability on both executive and non executives,” says Michelle George.

Last year a UK finance director was found to have been negligent when the company of which he was a non-executive director was discovered to have issued illegal loans. Although the FD was not seen to have behaved dishonestly, the authorities felt that as a non-executive director he should have made sure he was better informed of the company’s activities.

A case in Australia, tried under similar wrongful trading legislation as that in the UK, came to a similar conclusion. A non-executive director was found personally liable to pay more than u41m covering losses incurred by a lending bank as a result of fraudulent conduct by the finance director.

The Australian judge found that although the non-executive had only a very basic grasp of the accounts, this did not excuse his failure to ensure the company was properly run.

The Cadbury Report on corporate governance strongly recommended the appointment of non executive directors “to bring an independent judgement to bear” and to ensure that the boards of companies remain well balanced, says George.

“However, although non executive directors play a smaller role in the running of the company, their personal liability in the event of the company’s failure may be just as great.”

George says it is also worth bearing in mind that a recent Law Commission report considered the possibility of compulsory D&O cover, especially for directors in larger companies. “This is particularly interesting in light of another of the report’s proposals which would enable auditors to limit their liability,” she says.

“If the principle of joint and several liability were to be eroded and auditors able to limit liability, directors could find themselves increasingly the target of litigation.”

Given the lack of public data on D&O claims, it is difficult to identify which companies are most at risk. But it stands to reason that public companies with large workforces and substantial shareholder bases are more likely to be sued than small charitable organisations with few employees and no shareholders. This is reflected in premiums which can be as cheap as u500-u1000 for u1m indemnity for small charitable institutions to u100,000 for large premiums. The Wyatt UK survey found that one respondent was paying as high as u2m a year.

In a report published in 1994, Wilde Sapte noted that the strongest growth of interest in D&O liability insurance had been from companies in the banking and financial services sector. This, it said, reflected an increased awareness of their responsibilities under the 1986 Financial Services Act, including the risk of being considered to be “shadow directors” of companies to which they lend.

It is not only shareholders who can initiate actions against directors.

The list of people who can sue company directors includes past, present and prospective employees, regulators, the Department of Trade and Industry, creditors, clients, consumer groups and customers.

The Wyatt survey found that just under half of claims were made by shareholders.

The next most common claimants were employees (21%) and customers (20%).

Many brokers predict the number of claims from employees will rise. “I believe we are going to see more and more employees pressing suits against company directors in the UK alleging wrongful termination, breach of employment contract, sexual or race discrimination,” says Graham.

The risk of being sued increases when companies undergo substantial transactions: such as listing on a stockmarket, issuing new shares, making an acquisition or disposal, or when their company becomes insolvent.

Research based on US experience by Watson Wyatt suggests that company directors are more likely to be sued over financial disclosure issues than for any other reason. Inadequate or inaccurate financial disclosure was singled out as the most important issue in 16% of reported claims in the nine-year period leading up to 1995.

But it is directors with an exposure to more litigious jurisdictions which may feel most at risk.

The risk of being sued in the US is already relatively high and could soon become higher. Proposed legislation in California, which is to be included on the state ballot paper in this month’s US elections, aims to make it easier for shareholders to bring a case against directors.

The proposals are a backlash against US federal law reform introduced last year to quell rampant “nuisance” claims against companies. In particular, the reforms reduced the risk of directors being sued in the event of growth or profit projections not being met. The Californian proposals would not only reverse but go beyond the recent changes to federal law. Among other changes, the Californian proposals could make directors subject to punitive damages.

“The cost of defending suits is onerous enough when a company is forced to pay compensatory damages,” says US lawyer Andrew Pincus, a partner in Mayer, Brown and Platt. “So when you have punitive damages on top of that the order of magnitude of the risk becomes so much greater.”

According to Pincus, until last year’s reforms the risk of being sued in the US had become so great that premiums on directors’ and officers’ insurance cover were rising exponentially. Fast growing, high-tech companies were targetted for huge jumps in premiums, which threatened to erode both profits and competitive advantage.

“Class actions routinely seek hundreds of millions of dollars and even billions of dollars based on claims of misrepresentation,” he says. Often directors prefer to cut their losses and settle a case, even when they are convinced the claim is unjustified, to avert negative publicity and the drain on the management’s time and resources. “The risk is, if you let the matter go to court, you never know how a jury will react.”

“The federal reforms were designed to prevent abusive law suits which, regardless of a company’s innocence, can be expensive,” says Pincus.

Should the Californian proposals go through, stocks which are traded in California or which have Californian shareholders on their books will be subject to the new laws. The proposals, which are currently the subject of an intense television campaigning blitz from supporters and opponents, have been rejected by both presidential candidates and, surprisingly, by many investor groups.

Pincus explains that many investors fear they will be disadvantaged if new laws reduce the amount of financial information companies are prepared to disclose. They are also concerned that the value of their investment will be diminished if companies are subject to greater litigation, with settlements and legal costs coming out of the company’s resources.

“Investors want a remedy to protect them if there is real fraud but not one that can be abused,” he says.

UK directors will be hoping that the litigation frenzy in the US is one trend that does not cross the Atlantic. But anecdotal evidence suggests there is a gradual increase in the number of disgruntled employees and shareholders turning to litigation to resolve disputes with directors.

It is probably not a bad time for directors to reassess their exposure to risk or the adequacy of existing cover. And where directors do decide to increase cover or to take out new policies, they should make sure they understand exactly what cover they are getting for their money.

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