Class actions that impact financial lines are now a fixture of the Australian litigation landscape. Presently there are at least 35 class actions being litigated in Australia, with most actions taking place in Melbourne and Sydney, with close to equal distribution between the Federal and Supreme Courts. The nature of these actions is also starting to take a similar shape from case to case. There is usually a market event – a company being placed into liquidation or receivership, or significant disruption to the share price of a listed company – that initiates a considerable amount of legal activity as ASIC issues notices for production of documents, plaintiff firms rush to be the first to issue to bind a class and liquidators/ receivers initiate public examinations to investigate why the company failed.

Pity the board members of a public company that have to consider whether or not the company should be placed into receivership or administration. A decision to do so will show the “mindset of scarcity” at its worst. The mindset where all risk is to be avoided, all losses are an error and greed, fear and mistrust take over. The fact that a healthy economy necessarily involves investment and occasional failure is long forgotten, and risk aversion dominates. Each director will endure years of regulatory attention and litigation in a market where reputation is everything. They will need legal support, and lots of it.

The D&O policy is sold to directors that may need this support. Should the day come when a director is facing the combined attention of a regulator, liquidator/receiver and class action lawyer, the policy can be the difference between corporate oblivion and salvation. It is a rare director that is able to match the resources of his or her opposition from their own funds. The insurance coverage is critical and the first question any director will ask is “how much insurance cover do I really have?” That relatively simple question is, unfortunately, very difficult if not impossible to answer in respect of the D&O products currently available in the market.

Traditionally, D&O cover had what was called “side A” and “side B”. Side A provided cover for each director individually, in circumstances where the company was not permitted to or did not indemnify the director for his or her liability for the claim. Side B cover is when the company is obliged to provide that indemnity. The line between Side A and Side B is usually dealt with in a “Deed of Access and Indemnity” that any properly advised company and director will insist on being signed. That document sets out the claims for which the company will indemnify the director and the claims for which it won’t. In most cases, sorting out whether the claim is Side A or Side B is immaterial because the liability lies with the director first. “Side C” cover is different. Side C or “entity cover” is cover for the entity, for a range of wrongful acts covered by the policy that are committed by the company. The difference is significant.

Establishing that a director is personally liable for damages is a difficult task. It usually requires a plaintiff establishing that each director had knowledge of the essential facts constituting the contravention. Proving exactly what a director knew at a particular time is often difficult. The same cannot be said of a company. A corporation is usually attributed the knowledge of its workers. For example, a corporation can be held liable for making a misleading statement that the Board knew nothing about. In those circumstances, litigated claims against the director would fail but the claim against the company would succeed and most importantly, the “Side C” cover would respond to pay the damages claim.

THE PERILS OF SHARED LIMITS

Most D&O policies provide a common limit. Coverage extends to board members and to officers, so a standard class action often involves the board and senior executives who may not hold board positions, such as the CEO, CFO and General Counsel. It is quite common for 10 – 12 people to seek coverage for defence costs under the policy. Each of these people usually share the same limit. So, if D&O cover is AU$10 million, that amount has to be allocated in some way to the numerous directors and officers entitled to that protection. If the limit also covers Side C risks, then the company can “dip into the pot” as well for its defence costs and damages.

This all makes answering the question “how much cover do I have?” quite impossible, because a director can find themselves in a situation where they have plenty of cover one day, but none the next. Take a situation where directors are the subject of a class action and sharing a AU$5 million limit, of which AU$3 million has already been spent. The directors then find out that FOS has ordered the company to pay a series of side C claims that total AU$2 million. As that liability has crystallised to the company, the insurer is obliged to pay it so the valued money set aside for the director’s defence costs, evaporates overnight.

So as a rule, in my view, directors would be foolish to have a policy that shares the limit with “Side C” cover. Brokers should take particular care to avoid that scenario, or at a minimum, point out the risks to each individual director if that is the policy the company wants to go with.

The problem does not end there. Even with a conventional side A scenario, where say eight directors are sharing a limit, how do you fairly allocate access to the limit? The conventional approach taken by insurance lawyers and claims staff, is that each insured is not entitled to know what the other insured has spent; and the limit is eroded on a “first come, first served” basis. The result is that the directors and lawyers are often hoping that they will do work and be paid for it. This can and has resulted in nasty shocks, where directors have discovered prior to or during a trial that the limit has been exhausted. The insurance product has failed at the point it was needed most. This is an industry problem and it needs to be fixed.

SO WHAT ARE THE SOLUTIONS?

Firstly, some common sense goes a long way. It is common for insurers to appoint coverage counsel, that have the role of protecting the insurers’ interests and supervising the work done by the lawyers acting for the directors. Once the “defence team” has been marshalled together, it makes sense for the insurer, via its coverage counsel, to seek the consent of each director to mutual disclosure of cost budgets, as well as regular meetings to avoid duplication of work. The parties should agree to regular reports on the erosion of the costs limit, so that there are no surprises.

Whilst the contract might strictly permit an insured to withhold that information, section 14 of the Insurance Contracts Act makes it clear that all parties to an insurance contract, including an insured, have the following obligation:

If reliance by a part to a contract of insurance on a provision of the contract would be to fail to act with the utmost good faith, the party may not rely on the provision.

Directors defending a suite of regulatory actions and class actions are in a pressure cooker. One director who thinks he or she is entitled to spend the limit as they see fit without regard to their once fellow directors, is in my view, not entitled to rely on any policy term that would produce this outcome as to do so amounts to a lack of good faith. Common sense and good faith simply has to prevail, particularly when the available limit falls short of the claim limit, which is almost always the case as the capacity in the market is a fraction of the potential losses.

Secondly, the insurance product can be altered. Clauses dealing with allocation of the limit as between insureds can be introduced, to ensure joint co-operation between insureds, regular reporting on the erosion of the limit and even QC clauses to resolve disputes between insureds.

Thirdly, the Board can also deal with agreements in the Deeds of Access & Indemnity as to how shared limits are to be dealt with in the event of a claim.

Insurers, lawyers, brokers and insureds need to work together to solve this problem which, in my view, is easily done. Presently D&O policies run the risk of being a car that is going to stop working half way across a desert. Would you start the journey if you knew that was going to happen?