The directors of any corporation have important duties and obligations which, in certain cases, can entail their personal liability. As in any area of human activity, allegations of fault can be made against directors, and the latter must defend themselves in order to show that the allegations are either baseless or that the director acted with due diligence. These defence initiatives most often require that the director being sued, or targeted by a demand letter or a regulatory investigation, be assisted by a lawyer or other experts. This can lead to very considerable costs for an individual, in addition to the amount he or she may be ordered to pay as damages to an injured third party or as a penal fine to the government, not to mention the associated reputational risks. It is therefore essential that directors who are or risk being sued or prosecuted have adequate means to defend themselves. Whence the importance of indemnification and insurance plans.
In this bulletin we will point out the fundamental distinction between an indemnification plan and D&O (Directors and Officers) liability insurance and then briefly describe the primary characteristics of each.
Distinction between indemnification and liability insurance
An indemnification plan and a liability insurance policy have the same purpose: to cover a director’s legal costs in order to allow him or her to face allegations of fault in a civil suit or penal prosecution and to defray any amounts he or she may be ordered to pay or which could result from a settlement out-of-court. The primary distinction between them lies in the source of these amounts, i.e. the corporation in the case of an indemnification plan, or an insurer if liability insurance coverage applies.
The two main incorporating statutes applicable to Quebec corporations contain specific provisions on the indemnification protection offered to their directors. These provisions are substantially similar from one statute to the next. The major distinction is that the QBCA obliges Quebec corporations to indemnify their directors while the federal statute makes this optional.
These two statutes essentially provide that the indemnification must cover all reasonable costs and expenses that may be incurred, including those paid to settle the matter out of court or to satisfy the requirements imposed by a judgment. In order for coverage to apply, however, the director must have “acted with honesty and loyalty in the interest of the corporation”. In the case of penal or administrative proceedings that culminate in having to pay a fine (pursuant to statutory liabilities) the coverage criterion is that the director must have had reasonable grounds for believing that his or her conduct was lawful”. These incorporating statutes also provide that the corporation must advance the funds necessary for the payment of such costs. In the event that the corporation sues one of its directors (which can happen, particularly in a derivative action), court approval is required for the director’s indemnification. Without enumerating all the situations provided for in the incorporating statutes, we note that several indemnification plans merely reproduce the legislative provisions. However, this has proven inadequate to deal with several concrete situations that are increasingly recurring with the heightened frequency of civil suits and penal prosecutions against directors. By way of example, consider the following situations:
- choice of lawyer or other professional counsel;
- oversight right with respect to settlement negotiations or legal strategy;
- right to coverage where director’s role is exercised within a subsidiary of the corporation;
- timing of payment of advances and how to determine what is reasonable in terms of costs and expenses; etc.
That being the case, it is important for corporate directors, or those considering becoming one, to ensure that the corporation provides them with an indemnification plan that meets their needs (including with respect to the risks to which they may be exposed). Such a plan can be included in the corporation’s bylaws, but it is preferable that it be part of an agreement to which each director is a party, such that the consent of each of them is required in order to amend it and so they can each take part in negotiating its terms.
While an indemnification plan does not stipulate a maximum amount of coverage or a deductible, it requires that the corporation be solvent or holds sufficient liability insurance to allow it to meet its indemnification obligations. Otherwise the directors could find themselves without any protection or coverage, the consequences of which could be catastrophic.
For its part, D&O liability insurance applies regardless of the corporation’s financial situation; of course, as long as the insurance premiums are paid. Thus, to the extent that its applicability conditions are satisfied, the directors are covered up to the coverage limit stipulated in the policy, and subject to the applicable deductible.
There are various kinds of D&O insurance policies, the terms and conditions of which can vary from one insurer to the next. A director should thus ensure not only that such a policy exists, but that the coverage it affords is adequate for the type of corporation involved and the nature of the challenges to which he or she is exposed.
It should be borne in mind that the primary purpose of liability insurance is as follows:
The insurer is bound to take up the interest of any person entitled to the benefit of the insurance and assume his defence in any action brought against him.
Legal costs and expenses resulting from actions against the insured, including those of the defence, and interest on the proceeds of the insurance are borne by the insurer over and above the proceeds of the insurance.
Those essential provisions should be supplemented by specific clauses in the D&O policy, the primary purpose of which is to afford insurance coverage to the directors and assume their defence with respect to claims made against them personally in connection with the performance of their duties.
It should also be borne in mind that most D&O policies contain a number of applicability conditions, such as (i) initial disclosure of all known facts that are likely to influence the insured risk, and (ii) disclosure of any circumstances that arise during the coverage period that could aggravate the risk.
Directors must also ensure that they fully understand the exclusions set out in the policy, in order to determine the extent of their coverage. It will come as no surprise that fraudulent and criminal acts, insider trading and realizing illicit gains are frequently, if not always, excluded from coverage under this type of policy. Moreover, in no event will coverage apply where an intentional fault has been committed by the director.
That being said, there are policy endorsements available where a specific exclusion is sought to be covered. For example, while coverage for damages associated with cyber-risks is increasingly provided by D&O insurance policies, it would be advisable to ensure that the policy does cover damages of this kind.
The best protection consists of a combination of an indemnification plan and a liability insurance policy, which will complement each other in accordance with the circumstances.
Thus, before agreeing to sit on a board of directors, even that of a not-for-profit organization, prospective directors should ensure that the organization or corporation has an indemnification plan, as well as a liability insurance policy, adequately covering the risks associated with the office and duties of a director.
It would also be prudent to review such programs and policies annually to ensure that they adequately cover the corporation’s business activities and the associated risks, which can evolve over time. Consider for example that a mere five years ago, corporations were generally unaware of the risk of cyber-attacks, whereas today they are at the forefront of corporate concerns, as is the need to prevent sexual harassment in the workplace. Organizations and their directors would be well advised to seek the advice of experts in this area in order to ensure that their coverage is appropriate and in keeping with best practices. Such experts can determine if specific types of coverage are advisable in light of the types of business activities involved.