In the current financial climate, as shareholders and other third parties are more aware of the duties and responsibilities of directors and their rights in relation to bringing errant directors to account, directors may be increasingly exposed to claims for personal liability for their own wrongdoing. With directors and companies becoming subject to increasing regulation, potential liability could arise due to:

  • a director breaching his statutory duties under the Companies Act 2006 (the "Act") or being liable for wrongful or fraudulent trading under the Insolvency Act 1986
  • a director making a misstatement or misrepresentation
  • claims by employees against individual directors for harassment or discrimination under the Equality Act 2010
  • statutory breaches of health and safety and environmental legislation and prosecutions under the Corporate Manslaughter and Corporate Homicide Act 2007 and the Bribery Act 2010 (which comes into force in April 2011)
  • claims under non-UK legislation such as the Sarbanes-Oxley Act 2002, the US-UK Extradition Treaty 2003 and the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act.

As many companies will be renewing their D&O indemnity insurance at the end of this calendar year, this article serves as a reminder of the extent to which companies incorporated in the UK are permitted to indemnify their directors and directors of group companies under the Act.

Directors' indemnity provisions under the Companies Act 2006

The Act generally prohibits a UK company from indemnifying a director against his liability for negligence, default, breach of duty or breach of trust in relation to the company or an associated company (a "claim"). Any provision in the company's articles of association or in any other agreement with the company which purports to exempt its directors or the directors of its associated companies from such liability will not be valid. An associated company includes a company's UK holding company, UK subsidiaries or UK subsidiaries of the same UK holding company.

Exceptions to the general prohibition

The Act provides a number of exceptions to the general prohibition as follows:

  • a company is permitted to indemnify its directors or directors of its associated companies against liability incurred in connection with a claim by third parties other than the company or any associated company (a "qualifying third party indemnity provision" or "QTPIP"), such as by a member, creditor, liquidator, employee or trade or regulatory body (for example, the Financial Services Authority or the US Securities and Exchange Commission). There are, however, limits to the extent of the indemnity that may be given (see below)
  • a company is permitted to indemnify directors of a company which is a trustee of an occupational pension scheme against liability incurred in connection with the company's activities as trustee of the scheme (for example, investment strategy and decisions) (a "qualifying pension scheme indemnity provision" or "QPSIP")
  • a company is permitted, at its own cost, to purchase and maintain insurance for its directors or the directors of its associated companies.

The ability to rely on these exceptions is, however, limited in practice, as a QTPIP or QPSIP must not cover:

  • criminal fines or fines imposed by a regulatory authority which are payable by the director
  • any liability incurred by the director in defending criminal proceedings in which he is convicted
  • any liability incurred by the director in defending civil proceedings brought by the company or an associated company in which judgment is given against him (for example, damages which the director may be required to pay to the company)
  • any liability incurred by the director where he makes an unsuccessful application for relief from liability under section 1157 of the Act[1]
  • derivative actions brought by shareholders.

Failure to limit the QTPIP or QPSIP so that it excludes the above will result in the indemnity being void.

Directors' defence costs in civil, criminal and regulatory proceedings

A company can pay the directors' legal costs on an "as incurred basis" in defending civil or criminal proceedings arising in any jurisdiction in connection with any claim or in connection with a claim for relief from liability under section 1157 of the Act. In the case of civil or criminal proceedings, monies paid by the company are considered to be by way of a loan and unless the costs qualify as a third party indemnity, the loan must be repaid immediately if:

  • the director is convicted in criminal proceedings, or
  • final judgment is given against the director in civil proceedings, or
  • the director's application for relief is unsuccessful.

If the director is cleared of any wrongdoing, the company may indemnify the director and waive the loan or agree terms of repayment.

Similarly, a company is permitted to fund a director's defence costs in proceedings brought by a regulatory authority in connection with a claim, but the Act does not require this to be done by way of a loan. If the director's defence is unsuccessful, the company is not permitted to indemnify the director against the payment of any penalties levied by the regulatory authority.

Provisions in the articles of association

A company's articles of association will usually include a power for the company to grant indemnities to directors to the extent permitted by the Act. Short form default provisions are contained in Table A to the Companies Act 1985 (which applies to companies incorporated before 1 October 2009) and in the Companies (Model Articles) Regulations 2008 (which apply to companies incorporated on or after 1 October 2009). Table A reflects the law on directors' indemnities prior to 6 April 2005, which was more restrictive than the current law. The provisions in the model articles are more up-to-date, as they reflect the current law in the Act and they also extend to former directors. Companies whose articles still incorporate Table A may wish to review and update their indemnity provisions.

The Act does not make specific provision for a company to protect officers other than directors (for example, a company secretary) or auditors from liability and indemnity provisions in the articles can be extended to these persons.

Separate deed of indemnity and key considerations

Even if a provision in the articles obliges the company to indemnify a director, the director will not be able to enforce that provision directly against the company, as the articles are deemed to be a binding commitment between a company and its members (with the director not being a party to this arrangement). Where the director is also a member of the company, he will only be able to enforce those provisions in the articles which confer rights on members as members.[2] For this reason, companies and directors will often enter into separate deeds of indemnities.

When entering into a separate deed of indemnity, a company should consider the following:

whether it is acting in the best interests of the company in giving directors indemnities, especially if the company is indemnifying directors of group companies. Generally such indemnities will be justified on the basis that companies will wish to attract talented directors who will be concerned that they can carry out their duties without risk in certain circumstances

  • to what extent directors of other group companies should be indemnified. It is common for indemnities given to directors of group companies in jurisdictions other than the UK to be wider than is permitted under the Act. However, where an indemnity is given to a director of a company whose equity securities are listed in the UK or any overseas subsidiaries of such a company, there is a risk that, if the indemnity is not in a form permitted by the Act, it will fall within the class test and related party transaction rules, so that shareholder approval will be required before the indemnity is entered into
  • whether it should enter into individual deeds with directors or provide a standard form of indemnity by way of a deed poll. A deed poll will have the benefit of covering existing and future directors without them having to enter into separate, negotiated indemnities with the company, although directors may prefer to have direct undertakings given in their service contracts or in a separate document
  • directors' indemnities usually provide that directors are indemnified to the "fullest extent permitted by law". However, there may be cases where the indemnities should be limited or qualified
  • if persons who are not directors (for example, the company secretary) are to be indemnified, whether the deed should include the same level of protection for those persons, as they are not directors and will owe fewer duties to the company
  • whether directors should be advised to obtain independent advice in relation to the terms of the indemnity.

D&O insurance

The Act specifically allows companies to maintain D&O insurance, which will give directors comfort that they will not be required to fund possibly protracted and expensive litigation from their own personal resources. While the scope of cover under such policies will overlap with the indemnity provisions in the Act, D&O insurance can be more generous than indemnities which a company can provide under the Act. For example, D&O insurance cannot cover criminal penalties but it can cover the costs of defending criminal proceedings up until the point that the director is found guilty.

Discussions around D&O insurance tend to focus on directors and often the most senior directors. However, managers who are not directors are often exposed to individual categories of claim, so any insurance obtained by a company should also cover its managers.

D&O insurance is typically structured into Side A and Side B cover. Side A cover pays for a director's legal costs in defending a claim for a wrongful act which cannot be indemnified by the company. Side B cover compensates the company if it is permitted to indemnify its directors.

D&O insurance policies will often state that, for the purposes of the policy, the company indemnifies its directors and officers "to the fullest extent permitted by law", which means that the insurance cover will only extend to liabilities which the company itself is not permitted to indemnify. Companies sometimes adopt a strategy of having the D&O insurance cover as their primary protection for directors but this is generally not viable, as most D&O insurance policies include substantial retentions in the Side B cover, which is intended to (and does) have the effect of making the indemnity the main source of protection for directors, as opposed to the D&O insurance cover itself.

A company renewing its D&O insurance should consider how the indemnity provisions in the Act tie in with the insurance cover and, as the wording and conditions of D&O insurance policies can vary, it should ensure that the cover is as broad as possible. The level of cover will, in fact, depend on the type of industry in which it operates, the level of regulatory oversight of that industry, whether the company is publicly quoted, the board's attitude to risk and market conditions at the time the policy is renewed.

Considerations include:

  • what liabilities over and above those provided by the Act should be covered? For example, D&O insurance can cover defence costs if the director is unsuccessful or damages awarded against a director in favour of the company
  • which group companies should the insurance cover? It is common in the UK for directors of a holding company and its existing subsidiaries at the policy inception date to be covered, although some policies will automatically cover future acquisitions of subsidiaries. Acquisitions of subsidiaries in particular jurisdictions are often excluded
  • what level of cover and excess should apply? The level of cover needs to contemplate the possibility of claims being brought against the entire board of directors and all directors needing separate legal advice. All too often the level of cover acquired appears to be appropriate for one director but when it is split among the number of directors against whom claims might be brought at the same time, the level of cover could be substantially inadequate. There may also be limits per claim and/or in aggregate and separate limits for different classes of directors. Some policies automatically include bail bonds for all senior management including non-executive directors
  • should there be a period of run-off cover to cover any claim made after a director's appointment is terminated but in respect of actions which occurred while he was a director? A company should ensure that cover continues for a sufficient period after the director retires (normally at least six years). In addition, D&O policies may not cover "outside directors", namely directors of companies outside the insured group who are directors of the company at the request of the group
  • what exclusions apply? While D&O insurance can cover all defence costs and damages arising from claims, it will not usually cover deliberate, wilful, fraudulent or illegal acts, criminal liabilities, regulatory fines, loss of earnings, liabilities which are covered by other insurance and known claims or circumstances at the policy inception date. The exclusions should be reviewed carefully, as there may be significant variations in the wording of the exclusions in the policies of different providers.

Companies may consider changing insurers to obtain the best level of D&O cover possible. However, a change of insurer causes problems because of the "claims made" form of wording. The new insurer may be unwilling to provide cover for claims arising from wrongful acts or omissions committed before inception of the policy and the previous insurer may offer limited run-off cover for such claims.

Copies and inspection of indemnities

Any QTPIP or QPSIP given to directors will need to be disclosed in the directors' report. The company must also keep a copy of the QTPIP or QPSIP (or a written memorandum of its terms where the indemnity is not in writing) for a period of one year after it is made at its registered office or any alternative location which the company has specified as the place for inspecting its records. During such period, any member can inspect the QTPIP or QPSIP without charge and, on payment of a fee, can obtain a copy of it.