BLG Directors´ and Officers´ Liability Review

Article by Francis Kean

The Higgs Review: a very cautious welcome due from D&O Insurers?

"I do not presume a "one size fits all" approach to [corporate] governance is appropriate. … The Review is not a blueprint for box-tickers, but a counsel of best practice that can be intelligently implemented with discretion."

On 20 January 2003, Derek Higgs published his report on the role and effectiveness of non-executive directors (NEDs), commissioned by the Government in April 2002. This coincided with publication of the report of Sir Robert Smith’s group on audit committees, the recommendations of which also emphasise a key role for NEDs, and which are expressly incorporated into Higgs’ recommendations. Those recommendations take the form of a proposed revised Combined Code, which Higgs invited the Financial Reporting Council (FRC) to implement for reporting years starting on or after 1 July 2003. The FRC has now indicated that, following the usual consultation process, it intends to do so with effect from that date (together with implementing certain other changes to the Code taking into account the effect of the Directors’ Remuneration Report Regulations 2002, which are of course now in force).

How then will this affect the liability of NEDs, and therefore their D&O insurers? The answers are far from clear, and indeed, as we explain below, a case can be made that the effect of the Higgs Report, if implemented, might be to increase NEDs’ exposure.

Higgs’ views about the role and effectiveness of NEDs can be summed up in the following two conclusions, from which all of his detailed recommendations flow:

1 The role of NEDs has two principal components: monitoring executive activity, and contributing to the development of strategy and therefore to wealth creation (see paras. 1.12, 6.1-2 and 4.2). Accordingly, to realise both components it is necessary and appropriate to stick with the traditional UK model of the unitary board, that is, a single board of both executives and non-executives (paras. 1.7 and 4.3). Higgs rejects the US model of a board composed largely of "outside" directors with only a few executives, and also the European model of separating legal responsibility for running the company between a management and a supervisory board, on the basis that such models tend to over-emphasise the monitoring role at the possible expense of the strategic and wealth creation aspects (see paras. 1.12 and 4.3).

2 Corporate structures and processes are not sufficient by themselves to deliver good corporate governance, the key to NED effectiveness in Higgs’ view lies as much in fostering appropriate behaviours and relationships (see paras. 1.5, 1.18 and 6.3). Accordingly, many of Higgs’ detailed recommendations are directed to establishing and developing "a spirit of partnership and mutual respect on the unitary board" (para. 6.3). Higgs seeks to achieve this goal through "best practice" recommendations (strengthening both existing structures and introducing new behaviours), and rejecting legislation as the way forward (and therefore adopting, in very general terms, the European rather than the US approach).

Higgs endorses the "comply or explain" approach of the Combined Code as the way to implement his "best practice" ethos. This means however, that the vast majority of Higgs’ recommendations will not apply to non-listed private companies (although Higgs’ non-Code recommendations will of course apply: see 3 below).

Two effects of these conclusions on the liability of NEDs can immediately be noted:

• Higgs expressly endorses the current position that the legal duties of directors (both those owed to the company and to third parties) are the same for both executive and non-executive directors – classically, the law draws no distinction in that regard, and neither, formally, does Higgs. Further, Higgs expressly rejects the idea of putting NEDs into a separate legal category that would protect them in any formal way from the potential of full liability to which any executive director is subject – he rejects, for example, proportional or capped liability, or any form of "business judgment defence" (see para. 14.1).

• At the same time, Higgs recognises that the perceived risks associated with being an NED are continually growing in the current climate. He seems to tackle those risks in accordance with his preference for "best practice" guidelines rather than concrete limitations upon liability.

Higgs’ specific recommendations concerning NEDs’ liability, fall under 3 heads:

1 Amendments to the Combined Code:

The new revised Combined Code contains many provisions intended to strengthen corporate governance, such as provision to NEDs of appropriate information and professional development services, regular board performance evaluation, and requirements relating to the balance of executive and non-executive directors on boards, including the institution of a formal new category of "independent" NEDs. Such provisions might fairly be regarded as prospective liability avoidance or education mechanisms, although plainly their usefulness remains to be tested in practice. To this limited extent, therefore, Higgs’ recommendations are to be welcomed by D&O insurers.

2 A new Schedule to the Combined Code:

This is described as "guidance on liability of non-executive directors: care, skill and diligence". Higgs’ idea here is that notwithstanding that the legal duties of executive and non-executive directors are formally identical, he "would expect that the Court would wish to pay regard to such [guidance] where it might be relevant to the case (for example in the context of determining of what would be reasonably expected of a director in the Defendants’ position)" (para 14.8). Thus, although the legal duties are formally the same, he wishes the courts to reflect the different involvement of NEDs as a matter of fact in assessing the care, skill and diligence reasonably to be expected of an NED. There is a clear focus in this proposed new Schedule on duties owed to the company rather than to third parties, but there is no express limitation to this effect.

The proposed new Schedule to the Combined Code refers expressly to "the contract or letter of appointment of the director" setting out the particular expectations of the individual NED within the company, as being a "particularly relevant" matter for the Court to consider in determining the content of the duty in the particular case. This does not appear to be fully thought out, as it is difficult to see how matters of this kind could have any relevance in determining the content of an NEDs’ duty owed to a third party, which accordingly leaves the NED in that situation without even this modest protection that Higgs has sought to provide.

3 Recommendations that having nothing to do with the Code (and would therefore apply to all companies, not just listed companies) – three noteworthy changes are proposed by Higgs:

(a) Active case management in cases applying to directors. Higgs is concerned, rightly in our view, about the risk of reputational detriment to directors from long drawn out proceedings. Higgs stresses the possibility of dealing more promptly with section 727 applications (where a director may ask the Court for relief in certain circumstances from liability to his company), although whether this would give the "considerable reassurance to directors" that Higgs hopes may be more doubtful – especially as this would not in any event apply to claims by third parties, as opposed to claims by the company.

(b) Consideration of the appropriate role of criminal sanctions. Higgs endorses the key principles proposed by the Company Law Review in Annex D of its final report for determining the appropriateness of different types of sanction, and in particular criminal sanctions, against directors. This is to be welcomed, as, especially in relation to criminal sanctions, Annex D specifically identifies the questions "is the penalty imposed on the right person?" and "are there different degrees of culpability requiring different levels of penalty?" – it is to be hoped that the Government will be sensitive to the imposition of criminal sanctions upon NEDs, as distinct from executive directors, although we must again wait to see the reality.

(c) Corporate indemnification. Higgs proposes amendment to section 310 of the Companies Act 1985 to allow a company to indemnify a director against the reasonable cost of defending proceedings against him, without having first to assess in advance the prospects of success of the case (going in certain respects beyond the more modest amendments to that section recommended by the earlier Company Law Review, considered in our previous review). In addition, Higgs endorses the recommendation that a company should be entitled to indemnify a director against any excess of loss requirement under the policy. The director would, however, be bound to repay any indemnified sums in the event that the case were to be lost. Higgs notes, however, that insurance is preferable to corporate indemnification (see para. 14.19). These proposals should be largely good news for D&O insurers, to the extent that they are implemented and result in greater freedom for the company to indemnify directors up front.

Perhaps the most significant and far reaching recommendation affecting NEDs’ liability is the proposed new Schedule seeking to tailor the content of the directors’ usual duties to the particular circumstances of NEDs. We have reservations both about that concept, and about the way that Higgs has sought to implement it. This approach is very much unchartered territory in UK company law – the same formal duties, but a different content of those duties for different types of director. Although it is nothing new for the courts to look at the circumstances of each individual case, it is a matter of uncertainty how the courts will respond to this more fundamental shift in attitude towards NEDs.

As a matter of general principle, it seems unsatisfactory to leave what are matters of substantive law (namely, the content of the legal duties for different types of director) to the interpretation of the meaning and effect of the Combined Code. It seeks to introduce through the back door a new legal category of NED for the purposes of liability, which could result in a fundamental lack of clarity and certainty.

This attempt at restricting the potential liability of NEDs does not in any event apply to non-listed private companies – this is simply because the Combined Code does not apply to non-listed companies, rather than for any reason of principle differentiating between listed and non-listed companies so far as the reasonable liability of NEDs is concerned.

It seems to us that there is therefore an appreciable risk that, contrary to the result that Higgs appears to seek, the potential liability of NEDs might in fact be expanded as a result of his recommendations rather than reduced – with a greater emphasis on NEDs’ control and monitoring role, but without any reliable protection against executive liability, NEDs may face the worst of both worlds as they become the natural first portof call when corporate governance goes wrong.

What all this means for D&O insurers remains to be seen. The emphasis on education and training among NEDs should help to raise standards. At the same time, however, the likelihood is that as the expectations of NEDs (already high) continue to rise, so the probability of more litigation against them will also increase.

Given the gloomy economic outlook, the English courts have recently served up a timely reminder as to directors' duties in the context of companies which are at risk of insolvency.

In Gwyer and Associates Ltd v London Wharf (Limehouse) Ltd the court stated the duty thus:

Although this may seem straightforward enough, problems often arise in establishing at what point directors ought to regard the company as of "doubtful solvency".

Under the Insolvency Act 1986, a company is regarded as insolvent either if it is unable to pay its debts and liabilities as and when they fall due (the cash-flow test), or whenever its liabilities (including its contingent and prospective liabilities) exceed its assets (the balance-sheet test). The problem with this approach is that these tests are in essence "snapshots" of the financial health of the company. A company which is a going concern might from time to time suffer cash flow difficulties. This does not necessarily mean that for practical purposes it should be viewed as insolvent. It may, for example, be the case that the company is in the process of re-negotiating its loan facilities with its bankers. If the directors believe they have good reason to anticipate a successful outcome to these negotiations, they may have good grounds for believing the company is not insolvent. Arguably, however, they have already entered a twilight zone of "doubtful solvency" which imposes on them the duty to consider the interests of all the creditors.

The wrongful trading legislation under the Insolvency Act 1986 applies to a director who knew or should have realised that at some point in time there was no reasonable prospect of the company avoiding insolvent liquidation. In making such an assessment, the law imposes both an objective and a subjective standard. In other words, the law assumes a minimum standard of skill and care applicable to any director but will also take into account the individual’s particular skills and experience in deciding what can be expected of him or her.

Assuming there is a subsequent insolvent liquidation and the court concludes that at a given time prior to the date of the actual liquidation there was no reasonable prospect of avoiding it, the directors will be liable to contribute to the losses incurred after the date when they should have unless they can show that they did everything to minimise those losses to creditors. One of the difficulties here is that certain actions of the directors may disadvantage one section of creditors but work to the advantage of others. If for example a new facility from the bank enables the company to repay existing trade creditors, this might be of benefit to them but of little comfort either to the bank or to new creditors of the company if it subsequently becomes insolvent.

The fact that directors often have to perform a difficult balancing act in this area has not been lost on the Legislature. The government published a White Paper on 16 July 2002 entitled "Modernising Company Law". This paper recognised that there was a risk if a duty were imposed on directors to take every step with a view to minimising the potential loss to creditors that directors may err on the side of running down or abandoning a going concern at the first hint of insolvency. The Government’s conclusion in the White Paper is that "the weight of argument is against the inclusion of any duties in relation to creditors in a statutory statement." Instead, the paper suggests that mention should be made of the company’s obligation to its creditors as one of the factors a director should take into account when considering his fiduciary duties in general.

This is all very well but offers little practical assistance to a director anxious to know where he stands. A good starting point if he has concerns is the accuracy and quality of the company’s books and records to which the finance director should be able to speak. Generally, a court is likely to be more sympathetic towards a director who has asked the right questions and drawn the wrong conclusions than to a director who has asked no questions at all. If the management and accounting information available to a company is poor it may well prove impossible to determine whether the company is in fact insolvent or not. If the concerns persist, the practical answer may be to seek independent professional help on the legal and accounting issues involved in making any decisions as to whether or not to carry on trading.

As far as the particular point in the case was concerned, the need for Claimants to show this special duty of care had the effect of putting directors into a very different, and much more advantageous, position than any other person behaving in the same way, including agents of other types of principal, or, indeed "mere" employees. For everybody else, but according to the Court of Appeal not directors, loss caused by reliance on a deliberately or recklessly false statement equals liability. This is one of the oldest, and most stringent, forms of civil liability recognised by the law. Why then did the Court of Appeal put directors into a special category, and how has the House of Lords now dealt with this?

The reason the Court of Appeal imposed this duty of care hurdle for Claimants suingcompany directors in deceit (and in fact for any other form of tortious liability) was because of the fallacy of the so called "identification principle", concerning the legal status of the activities of certain agents when acting on behalf of companies. Lord Rogers explained the Court of Appeals’ erroneous reliance on this principle as follows:

‘At the heart of the Court of Appeal’s decision is the view that, because [themdirector] was a director of [the company] and acted as such when cheating [the claimant], his acts must be regarded solely as the acts of [the company] and he should have no personal civil liability for them. …

His fraud might be the fraud of the company but, somehow or other, it was not his own fraud.’ The Court of Appeal arrived at this result by extending the familiar decision of Williams v. Natural Life Health Foods Ltd (1998) from negligent misstatement to all claims in tort against company directors, including claims in deceit. In Williams itself, the claim against the director failed because the claimant could not show that the director – as distinct from the company – had assumed the special duty of care required to give rise to liability for economic loss caused by merely negligent misstatements. In Standard Chartered, the Court of Appeal erroneously assumed that this decision should apply to all tort claims because of the undoubtedly correct principle that a company has a separate legal existence from the directors, and the reluctance of the courts to ‘pierce the corporate veil’ by holding directors liable for the company’s wrongs. However, the House of Lords has now made it clear that:

It will therefore now be easier for Claimants to hold directors liable for fraud in their dealings with third parties, as Claimants now need not trouble to show a special assumption of responsibility to them by the director. Nevertheless, since a Claimant (in reality his legal advisors) will know that D&O insurance will not normally cover liability for deceit, Claimants will in practice tend to prefer framing their claims in negligence even if a claim in deceit might be available, notwithstanding that they will then face the additional hurdle of showing the special assumption of responsibility – the choice will often be to face this additional hurdle or to face potentially insurmountable difficulties in making an effective recovery.

The proposed changes to the law regarding corporate manslaughter have been shelved for the present, after years of consultation and promises on the part of successive governments to enact the legislation. Meanwhile, Transco, the gas supply company, has become the first company to be charged with culpable homicide in Scotland, arising out of an explosion in Lanarkshire in December 1999 which killed four members of the Findlay family. If found guilty, Transco could be ordered to pay an unlimited fine.

Despite another high profile failed prosecution – the Serious Fraud Office failed to secure convictions against the former directors of Wickes – Ros Wright (head of the SFO) maintains that they will press ahead undaunted with other investigations in the pipeline. She reiterated what she called the "mantra" of the organisation, that it is the "directing minds" or "big fish" who are the prime targets for prosecution.

In the case of the Official Receiver -v-Broad and Others [2002] EWHC 2786 (Ch) the Court held that where a director had already given an undertaking not to act as a director some 18 months before proceedings against him for disqualification (under Sections 6 and 7 of the Company Directors Disqualification Act 1986) the disqualification period imposed in those proceedings should be reduced by the period since the undertaking was given, effectively, giving credit for "time served".

The SEC has been introducing detailed rules under the Sarbanes-Oxley Act (see headline article in the D&O Review, issue 31). The rules include some relief for non-US companies, and more has been promised. For example, non-US companies will in some cases be allowed to choose between strict compliance with a rule, and explaining to the SEC why its own procedures are adequate.

The controversial rules which would have required lawyers, including UK lawyers, acting for any company required to make SEC filings to make a "noisy withdrawal" of their services should their client fail to make disclosure of their activities to the SEC, have been postponed for further discussion after intense pressure from the legal profession, concerned at this erosion of legal professional privilege.

The case of Bradford & Bingley Plc -v-Hayes, and Dunphy and Hayes Limited (decided on 25 July 2001 – not reported but reviewed in the Estates Gazette, 1 February 2003) is of interest to directors of professional firms and other service providing companies. Mr Hayes produced and signed a property inspection which was held to be negligent. The Honourable Mr Justice McKinnon, following Williams -v- Natural Life Health Foods Limited [1998] 2 All ER 557 decided that there was no personal liability on the part of Mr Hayes – no direct dealings had taken place between Mr Hayes and the customer, who could not be said to have relied on any assumption of personal liability on the part of Mr Hayes.

This finding is difficult to reconcile with the decision in Merrett -v- Babb [2001] 1 EGLR 145 in which a home buyer complaining about a negligent mortgage valuation was held entitled to sue not only the firm of valuers employed by his building society, but in that case the employee who had carried out the survey.

One can perhaps see sound reasons why Mr Hayes did not incur liability as a director, but he would also arguably have been acting in the capacity of employee. Mr Hayes’ firm was still solvent (unlike Mr Babb’s firm) and although it should not have made any difference to the issue of whether or not the valuer owed or assumed a personal duty of care to the customer, one wonders if the result would have been different had Mr Hayes’ firm no longer existed. The judge stated, significantly that "there is no call to resort to any imposition liability upon the valuer....for the claimant in the instant case has all the rights it could possibly need against the principal defendant, the limited company."

An acrimonious dispute between Kirk Kerkorian, whose company was the biggest shareholder of Chrysler before its 1998 merger with Daimler-Benz, and former Chrysler directors, rumbles on in the US courts. Mr Kerkorian alleges that the Chrysler directors voted for the deal without taking proper advice and undersold the company in what amounted to a takeover by Daimler-Benz. The directors deny that anything has since emerged which would have made them vote against the deal had they known it at the time, and that they got the best price possible. They are trying for a second time to persuade the court to throw the case out, but Mr Kerkorian shows no signs of giving up.

The content of this article does not constitute legal advice and should not be relied upon in that way. Specialist advice should be sought about your specific circumstances.