Indemnity and insurance protection for directors

This article is based on UK law as at 1st February 2010, unless otherwise stated.

To what extent can a company protect its directors from some of the liabilities outlined in our guides to directors' duties, including any legal costs that might be involved? There are two possible options:

• giving directors an exemption from any liability to the company and an indemnity against liability to third parties;
• taking out and paying for insurance against any liability incurred by the directors.

The giving of exemptions is banned by the Companies Act, and indemnities are restricted; insurance policies need to be carefully read to ensure they cover the desired risks.

Indemnities

A company can indemnify its directors against personal liability so long as the indemnity does not cover:

• liability to the company in cases where the company sues the director – only liability to third parties can be the subject of an indemnity;
• liability for fines for criminal conduct or fines imposed by a regulator such as the Financial Services Authority (FSA);
• other liabilities (such as legal costs) in criminal cases where the director is convicted, or in civil cases brought by the company where the final judgment goes against the director.

So a company can give an indemnity that will commit it to paying any or all of the following:

• directors’ legal costs in civil claims brought by a third party, even if the judgment goes against them;
• the costs of any damages or other award made against directors if they lose civil claims brought against them by a third party;
• directors’ legal costs if they are acquitted in criminal proceedings;
• directors’ costs in fighting civil proceedings brought by the FSA (for example, for a breach of the Listing Rules).

A company’s articles will usually permit the giving of these indemnities. But it is a mistake to think an indemnity in the articles is all that isn required. A director cannot enforce an indemnity through the articles alone. A separate commitment from the company is needed in a service contract or other document.

The general restrictions on a company making loans to its directors (See: Loans to directors, an OUT-LAW guide) do not prevent a company from funding a director’s ongoing defence costs in either civil or criminal proceedings, provided that the terms on which the funding is advanced require the director to repay the money if they are convicted or final judgment is given against them. This applies even when it is the company itself that is suing the director.

Any indemnities given to directors have to be disclosed each year in the directors’ report that accompanies the audited accounts and their terms have to be available to shareholders at all times. These rules apply also where one company in a group indemnifies the directors of another.

Whether companies should take full advantage of this ability to give indemnities is not a straightforward question. Given the growing burden of their responsibilities and liabilities, and a fear that litigation is on the increase, directors will be keen to have the benefit of every permissible form of protection. But in setting its policy, a board will need to decide whether it believes it is right to give an indemnity in every case – for example, where a director has clearly acted dishonestly or beyond their authority. If money is advanced to a director to meet defence costs in actions brought by the company, it will be necessary to:

• explain the decision carefully to shareholders, who may wonder why the company appears to be helping someone it believes did it harm;
• consider how the costs are going to be recouped from the director if the company wins.

Insurance

A company is allowed to take out and pay for insurance to cover liabilities incurred by its directors. Indeed, doing so can be considered part of best practice. The UK Corporate Governance Code, whose guidelines are followed by a wide range of organisations (see: our Corporate Governance page), states that: ‘The company should arrange appropriate insurance cover in respect of legal action against its directors’.

The question of insurance needs to be looked at in the context of any indemnities given by the company, as discussed above. If the company decides to insure, it may want to take out cover in respect of those risks it cannot indemnify its directors against – or chooses not to do so. The an indemnity to its directors.

Whatever the company decides to do, it is important for the board as a whole, and for individual directors, to appreciate that there is no standard insurance policy that answers all needs. The exact terms of a policy will be interpreted restrictively, and so all concerned must have a clear understanding of what is covered and what is not. A director is taking a big risk if they simply assume that a directors’ and officers’ (D&O) insurance policy is in place and will cover them without taking the time to establish exactly what protection it affords.

A new director should at least establish that the insurer is aware of their appointment and that they will be covered by the policy. And both new and existing directors need to satisfy themselves on the terms of the policy. Some of the key points to consider are listed in the following box.

Like a company indemnity, insurance will not provide a complete safeguard for a director against personal liability. It is only part of the answer. Clarification from the company secretary and, if necessary, from insurance brokers and legal advisers, is advisable where there is any doubt.

Directors' and Officers' insurance policies: questions to ask

• Does the policy cover both past and present directors so that a director remains covered once they leave the company for actions taken during the period of appointment? A claim may not arise for some time after the director has stepped down.
• Who is covered? A policy will usually protect those who sit on the main board and those who are also directors of subsidiary companies. It will not necessarily extend to those who are nominated to be directors of joint venture companies or companies in which the holding company has only a minority stake.
• How does the policy deal with newly acquired businesses? Does cover only start from the date of acquisition, excluding liability for acts committed before then?
• What risks are covered? Few cases go all the way to judgment; most are settled out of court. It is important, therefore, to find out whether claims for sums agreed in out-of-court settlements can be made.
• What are the exclusions? Invariably, the policy will not cover fraud, deliberate dishonesty and illegal acts; nor will fines and penalties imposed by the criminal courts and by regulators such as the FSA be included.
• What legal costs and expenses are covered? Will they be paid on an interim basis during the course of a case? Are they recoverable if the director loses? Legal costs for an appeal against a criminal conviction will usually be excluded – the insurer will not pay for you to fight your case all the way to the Supreme Court.
• Will advisers’ costs (both legal and accountancy) also be paid for government and FSA investigations?
• Will the policy cover claims made outside the United Kingdom? Some jurisdictions may be excluded. For example, a director of a company with operations or subsidiaries in North America may not be covered for actions originating there.
• What about claims made against directors by their own company? Some policies will exclude liability for a claim made by one party against another insured under the same policy. (The precise wording of the policy will be crucial here; establishing what is included and what is not will require careful checking.)
• What are the monetary limits on claims? Many companies are woefully under-insured. A company and its directors could effectively be left uninsured if one or two big claims in the same year have used up the sum insured. The more people insured under the policy, the greater the risk of this happening.
• What about ‘excesses’ or ‘deductibles’? Different risks may carry different excesses. Where they apply, are they payable by the company or by the director?