Strategy & Operations » Governance » Director’s liability: In too deep

As is well reported, Equitable Life has pursued through the courts both its
former auditors, Ernst & Young, and 15 former directors – six executives and
nine non-executives (NEDs). The sums involved are terrifying – Equitable
initially claiming damages of £1.7bn against the directors alone.

At the time of writing, Equitable had reached ‘drop hands’ settlements with E
&Y and six former directors, but still had negligence and breach of duty
claims continuing against two former executives and seven NEDs.

Under drop hands deals, both sides agree to pay their own costs – a fact that
must influence willingness to settle. Legal costs can mount rapidly in such
cases. “If you want the best lawyers, you are talking hundreds of pounds an
hour,” says Graham Simkin, senior litigation partner at international law firm
Fulbright & Jaworski.

“It’s painful to have to put your hands in your pockets and pay sums
equivalent to buying a house and walking away. Even if you have made £10m, do
you want to spend £3m defending yourself?”

Costs can rapidly outstrip the cover provided by directors and officers (D
&O) insurance. The Equitable directors had £5m of cover to share between
them, compared with pre-trial estimated costs of around £15m. Former NED David
Wilson (who built the Wilson Bowden construction group) employed a full legal
team; his estimated pre-trial legal costs exceeded £8m. Even so, he has now
settled in a drop hands deal.

One way to minimise legal costs is to represent yourself as a
litigant-in-person – a route chosen by one of the Equitable NEDs (Peter Martin,
a lawyer). Similarly, Alan Nash and Shaun Kinnis, two of the former executives
to have settled, opted for modest legal representation, bringing their
solicitors and barristers into court only when really necessary.

Among those directors battling on were six NEDs represented by Allen &
Overy under a conditional fee arrangement, essentially a no win, no fee deal.
Such agreements may encourage lawyers to want to keep fighting a case in order
to recoup fees. Furthermore, conditional fee agreements do not mean the
defendants pay nothing if a case is dropped. “You still have to pay something to
the lawyers,” he says.

“You have to pay their disbursements. Imagine, for example, the cost of the
photocopying bills.” Another problem with drop hands deals is that directors do
not have the satisfaction of clearing their names.

As the Equitable Life example makes clear, just like their executive
colleagues, NEDs can be sued when things go wrong. So are the risks attached to
NED life now making the role unattractive? This is an issue being considered by
the Financial Reporting Council in its current review of companies’ progress in
implementing the revised Combined Code of Corporate Governance. The FRC’s
findings are, as yet, unknown.

There is, however, a logical reason why NEDs could be targets for damages
claims – they could be the ones most likely to generate a return. Ed Smerdon, a
partner at law firm Reynolds Porter Chamberlain, paints the scenario of a
company that has suffered some calamitous event, such as a major fraud, leading
to a change of board directors and even insolvency. Given that D&O insurance
wouldn’t cover the executives who perpetrated the fraud, but would cover the
NEDs who failed to spot it, NEDs could find themselves on the wrong end of a
damages claim. “It’s not just about proving a point, but about recovering
money,” Smerdon says, adding that FTSE-100 companies these days may have D&
O cover of around £100m or more.

On the other hand, the fact that cases are brought against NEDs doesn’t mean
they are easy to win. Proving that NEDs should have known a fraud was taking
place is difficult to do. But that is only a limited comfort. “You could still
incur a few million pounds defending yourself, and a few years of misery,”
Smerdon says.

The best protection for NEDs against claims is to do their job as set out in
the engagement letter. “If you act according to your job description, you will
find yourself less likely to lose a claim,” Smerdon says. “The engagement letter
will be very important in setting the standard of care.” NEDs should also follow
the Combined Code. “They have to be clear in their own minds that they are
qualified for the role and that they have the time to spend on the issues of the
company,” Smerdon stresses.

“By joining the company, they have effectively said they have the experience
and the time to do the job.” When trying to protect their own interests, NEDs
must also be prepared to resign. “If non-executives think there is something
going on, which isn’t being addressed, the Combined Code says they must draw it
to the attention of the board,” Smerdon says. “If it’s not dealt with
adequately, you must resign. If you don’t resign, you are held accountable.” One
new cause for concern – or at least debate about whether directors should be
concerned – is the company law reform bill, published in November. The Bill is
proposing to make it easier for shareholders to bring legal claims against
directors. At present, most actions (as in the Equitable Life case) are brought
by the company. “There are some circumstances in which shareholders can bring
actions in the company’s name, but they are very difficult circumstances to
establish,” explains Michelle de Kluyver, litigation lawyer at Allen &
Overy. To bring such a common law derivative action, it must be established that
there has been a ‘fraud on the minority’ (for example, where the directors have
expropriated assets), and that the wrongdoers are in control. “That’s a very
high hurdle to get over,” says de Kluyver.

Under proposals in the company law reform bill, a statutory derivative action
is to be introduced. This will enable shareholders to bring an action in cases
of negligence, default, breach of duty or breach of trust – in effect, creating
a much lower hurdle for shareholders seeking to start a claim. “It’s going to be
relatively easy to commence a claim, but shareholders will need the court’s
permission to continue a claim,” de Kluyver says. “The court has to refuse
permission if the conduct has been ratified.” For example, if directors have
acted negligently, but a majority of shareholders have supported them, then the
court must refuse permission to continue the claim.

Not all conduct is ratifiable, though, such as breach of duty. “If directors
breach listing rules, or health and safety obligations, that can’t be made good
by the shareholders,” de Kluyver explains. There are then other issues the court
will consider in deciding whether to allow a claim to continue, such as whether
the shareholders are acting in good faith, and whether the action is going to
promote the success of the company. Any damages secured as a result of such
actions would have to flow back to the business, not to the shareholders who
brought the claim.

“I think this will play to the fears of directors,” de Kluyver says, “in that
they will feel more exposed. It’s one thing to know you are exposed for fraud on
the minority, and another thing to be exposed for negligence or breach of duty.”
What advice does de Kluyver have for directors? “Establishing and maintaining
relationships with shareholders is very important,” she says, “and companies
have to make sure their D&O cover is as comprehensive as it can be.”
Derivative claims can sometimes be carved out from D&O cover, so it’s worth
checking the details carefully.

As to whether the proposals in the company law reform bill, if enacted in
their present form, will increase claims, de Kluyver says: “There are signs of
more shareholder activism in the market, and that is why directors feel more
exposed. There may be shareholders out there who may use it [the change] to
their advantage. But we will have to see the courts’ approach to giving
permission. If they take a very strict line, that will act as a deterrent to cl
aims. If they are more liberal, things could be different.”

OFR liability fears

Earlier this year CIMA sought a legal opinion from Allen & Overy on
director liability for forward-looking statements in the Operating and Financial
Review, which became mandatory for listed companies for financial years
beginning on or after 1 April 2005.

Although the regulations for the OFR do not include the provision of a ‘safe
harbour’ (or exemption from liability for directors for certain elements of the
OFR), Allen & Overy found that directors could minimise the risks of
criminal and civil liability when making forwardlooking statements if they take
certain steps:

  • Consider the process for agreeing the content and preparation of the OFR so
    as to exercise, and be seen to exercise, the requisite degree of skill and care;
  •  Comply with the Accounting Standards Board’s Reporting Standard 1 on the
  •  Make it clear that the OFR is addressed to shareholders;
  •  Ensure that forwardlooking statements are appropriately couched and
    qualified in order to clarify the level of reliance shareholders should place on

The full legal opinion is can be found on the CIMA website

Corporate liability fears

Research by international law firm Fulbright & Jaworski has found that UK
companies are facing an increasingly litigious environment. Almost half (48%) of
UK companies expect to face more litigation during 2006 than this year,
according to its 2005 Litigation Trends Survey. Two-thirds of UK businesses had
faced court actions in the past 12 months and were particularly concerned about
the increasing frequency of product liability cases.

UK companies are, however, still under less pressure than US businesses,
where three-quarters of respondents had faced at least one court action filed
against them over the past year. The survey also found that UK companies (23%)
are much more likely than US companies (13%) to settle before court proceedings