The Companies Act 2006 has introduced changes to the existing provisions relating to a company’s ability to indemnify its directors and to provide them with upfront funding in relation to defending proceedings against them.

The law in this area was relatively recently amended with effect from April 2005 by The Companies (Audit, Investigations and Community Enterprise) Act 2004. This was done in recognition of increasing concern over directors' exposure to liability arising from legal proceedings brought by third parties. Companies were given the ability to provide their directors with greater protection by allowing them to fund the expenditure of directors in connection with investigations, actions or proceedings relating to alleged negligence, default, breach of duty or breach of trust.

For the most part, the Companies Act 2006 restates existing law in relation to directors' indemnities without substantive amendment. However, the related rules permitting loans for defence funding have been slightly modified with effect from April 2007. The relevant provisions narrow the category of proceedings in relation to which funding can be provided but extend the situations where such funding can be provided to regulatory investigations or actions.

Companies should therefore consider whether they wish to take advantage of the new Companies Act 2006 provisions by reflecting the permitted changes within their articles of association. While the articles in effect form a binding commitment between the company and its members, the directors (unless they happen also to be members of the company) are not party to this arrangement and may not therefore be able to enforce directly any indemnity contained in the articles in their favour. To mitigate against this, directors should consider entering into undertakings directly with the company in order that the relevant indemnity and entitlement to receive funding is enforceable directly by them.

In considering the text of the underlying undertaking to be granted, a range of questions will need to be considered by boards. Such questions will include whether the indemnity should be subject to an upper limit, the form of any conduct of claims provisions and whether there should be any time limit.

It will also be very important to ensure that the terms of any directors and officers liability insurance are carefully considered alongside the text of the articles and also any undertaking entered into pursuant to the articles. In particular, care should be taken to make sure that entering into such an indemnity will not limit the rights of recovery by the director or the company under the policy of insurance. There needs to be a clear understanding of how the relevant policy interacts with the separate indemnification provisions between the director and the company to maximise the protection available for both.

From a director’s personal perspective it is important to ensure that he has an appropriately worded deed of indemnity in place either within his service agreement or as a separate document. From the company’s point of view, it is critical that the wording of the indemnity is checked to make sure that it complements the wording of the relevant D&O policy. If the inter-relationship is not considered, it is possible that the insurance policy may be avoided in the event of a claim. Some policies are in favour of the company and each of its directors and some in favour of the company alone. In the latter case, the policy may rely on the director making a claim against the company under his indemnity and the company then seeking recovery of any payments from the insurer. In such circumstances it is common for the insurance company to require “conduct” of any claim the director may have a right to make in recovering the money from a third party. If the company is not in a position to grant this, it may be unable to claim under the policy.