A directors and officers (D&O) liability insurance policy typically serves two purposes. It insures directors for losses arising out of their wrongful acts, and it pays directors their defence costs in defending any claims to which the insurance applies. But what happens when a third party claimant sues the directors for an indemnifiable loss under the policy, and the directors also seek the payment of their defence costs under the policy? Whose claim has priority?

The High Court ruled last week that third party claimants have a charge under section 9 of the Law Reform Act 1936 over all insurance money payable under a D&O policy, and that the charge has priority over any claim by the directors to defence costs under the policy.

The ruling is a reminder to all directors to check that they have sufficient insurance coverage for their defence costs, in addition to any other cover that they have under a D&O policy.

Background

The case1 concerned the Bridgecorp group, which collapsed in July 2007 owing investors nearly $500 million. Five of the directors have been charged under the Securities Act with making false statements in prospectuses and other documents, with a criminal trial currently scheduled to begin on 10 October 2011. The receivers of Bridgecorp have advised the directors that they intend to bring a proceeding against the directors, seeking orders requiring the directors to pay Bridgecorp in excess of $450 million.

Bridgecorp holds a D&O policy with a $20 million limit of indemnity. The D&O policy indemnifies the directors for any liability they may incur as a result of their acts or omissions as directors. It also provides cover for costs incurred in defending civil or criminal proceedings seeking to establish the directors' liability. In addition, Bridgecorp has a statutory liability policy with a $2 million limit of indemnity. That policy covers directors' defence costs, but does not cover directors for any liability to third party claimants.

By August 2011, all but one of the directors had exhausted their entitlements under the statutory liability policy. The directors estimated that they would incur another $3 million in costs to defend the criminal trial (which does not include costs on appeals or in defending any civil proceedings that may be brought against them). The directors therefore sought to claim their criminal defence costs under the D&O policy.

This created a problem for Bridgecorp, because it meant that there would be less insurance money available for it under the D&O policy. Bridgecorp therefore asserted a charge under section 9 of the Law Reform Act, and claimed that as a result, it had a priority claim to the insurance money. The directors disagreed, and sought a ruling from the High Court.

The court's decision

Justice Lang described section 9 as "reformatory", because it allows a third party claimant to gain direct access to insurance money in circumstances where proceedings against the insured cannot be maintained. The section has particular application where the insured is insolvent, because in the absence of the section, the insured's general creditors – and not the third party claimant – would receive the benefit of an insurance payout.

Section 9 gives a charge over any liability of the insured to pay damages or compensation. This includes the Bridgecorp directors' potential liability to pay damages to Bridgecorp for breaches of duty, but does not include the directors' claim for defence costs. The charge has effect over all insurance money that is or may become payable in respect of that liability. His Honour observed that the reference to "all insurance money" includes the entire amount of cover under the policy, without exception.

Justice Lang also cited long-standing authority from Chief Justice Myers that the payment of defence costs should not reduce the pool of funds that would otherwise have been available to meet claims in respect of which a charge has arisen.2 His Honour further noted that Parliament may not have envisaged all of the consequences that the Act would produce, but concluded that if it had foreseen the outcome of this case "it is almost certain that Parliament would have viewed it as being consistent with the type of outcome that it intended s 9 to produce".

Finally, Justice Lang accepted that the result may be harsh for the directors. They cannot rely on the D&O policy to defend the criminal or civil claims against them. However, the judge said that the outcome is partly a consequence of the fact that Bridgecorp took out a D&O policy that provided cover for both defence costs and claims for damages and compensation. This left the directors vulnerable once they began to face large civil claims. The directors could have taken out a statutory liability policy providing greater cover for defence costs than the $2 million policy they chose, but decided not to. The insurance money payable under the statutory liability policy does not cover claims for damages and compensation, and therefore is not subject to any charge under s 9 of the Law Reform Act.

Practical implications for directors

Directors need to ensure that they have the right cover for defence costs in the event that they face civil or criminal liability.

A D&O policy that covers both defence costs and liability to third party claimants may preclude the directors from relying on the policy to pay their defence costs in the event of a significant civil claim in excess of the policy's limit of liability.

One way for directors to avoid this problem is for the company to take out a separate policy – such as a statutory liability policy – that contains sufficient cover for defence costs but does not cover claims for damages and compensation. Insurance money under such a policy will not be subject to a charge in favour of a third party claimant under the Law Reform Act. Alternatively, directors should ensure that they have sufficient cover under their D&O policy for all likely claims and defence costs.