Directors and officers liability insurance

Answer

Directors and officers (D&Os) are the controlling mind of the corporate entity of a company. Their duties include fiduciary and statutory duties, with their core duty being to promote the success of the company. The codified statutory duty is set out in the Companies Act 2006 (the act). D&O liability insurance (D&O policies) typically provide cover for claims against D&Os relating to allegations of breach of fiduciary or statutory duty, or breach of trust by a director.

Under a D&O insurance policy, insurers will sometimes instruct law firms to provide coverage advice – advising on whether the losses incurred are likely to fall within a policy's cover – and in certain circumstances, where legal costs are being incurred, to assume a monitoring role for the defence of the claim against an insured director.

One issue that insurers face in relation to D&O policies is that unfair prejudice petitions under section 994 of the act have become an increasingly common remedy for shareholders to use against both the company and directors given the wide scope of potential remedies. The court's wide discretionary power to consider and offer remedies in favour of a successful petitioner creates heightened risk for insurers from a coverage and monitoring perspective.

What’s an unfair prejudice petition?

Broadly speaking, an unfair prejudice petition is a remedy for shareholders to apply to the court for relief in situations where they consider the company is being conducted which causes prejudice to the petitioning shareholder. A petition may be brought by any member of a company. It should be noted that where a majority shareholder does bring a petition and could have rectified the prejudicial state of affairs using their majority shareholding, they may struggle to demonstrate that the prejudice has been unfair.

There are two limited exceptions where a non-member may be eligible. These are where:

1. a non-member has been transferred shares, but hasn’t yet been entered on the register of members; and
    
2. a non-member has had shares transmitted by operation of law.

Under the act, a petitioner may bring an unfair prejudice petition on two grounds:

1. conduct of company affairs in an unfairly prejudicial manner; and
    
2. an act or omission of the company would be unfairly prejudicial.

It’s important to note that the conduct, act or omission must be unfairly prejudicial to the interests of at least some of the members of the company. However, the conduct in question must either affect the petitioners in their capacity as members or be sufficiently connected with membership.  

What constitutes ‘the company's affairs’?

The court has interpreted the term, ‘the company's affairs’, by reference to commercial reality. As such, the term has a wide scope.

What constitutes unfair prejudice?

To be successful, a petitioner must demonstrate that their interests have been prejudiced and that any prejudice is unfair.

The court in RA Noble & Sons (Clothing) Ltd [1983] BCLC 273 stated that the test for unfair prejudice is an objective one. Therefore, a petitioner must demonstrate that a reasonable person would regard the conduct as having unfairly prejudiced the petitioner's interests.

In regards to prejudice, the authorities demonstrate that prejudice isn’t a narrow concept. Lord Hoffmann stated in O'Neill v Phillips [1999] 1 BCLC 1 that "the requirement that prejudice must be suffered as a member should not be too narrowly or technically construed". A breakdown of a relationship of trust and confidence has been held to constitute prejudice where it arose from the conduct of the affairs of the company (Re Baumler (UK) Ltd [2005] BCC 181).

However, as David Richards J pointed out in Re Coroin Ltd (No. 2) [2012] EWHC 2343, "prejudice will certainly encompass damage to the financial position of a member", that damage may be to the value of the member's shareholding, but it may extend to "other financial damage which is bound up with his position as a member".

With regard to unfairness, it’s accepted that fairness is a flexible concept and is contextual. However, Lord Hoffmann established, as a starting point, in O'Neill that "a member of a company will not ordinarily be entitled to complain of unfairness unless there has been some breach of the terms on which he agreed that the affairs of the company should be conducted [unless there are] equitable considerations that make it unfair for those conducting the affairs of the company to rely upon their strict legal powers".

Previous examples of unfairly prejudicial conduct include breaches of fiduciary duty, serious mismanagement as determined by the scale of financial loss and frequency of conduct constituting mismanagement, failure to pay dividends and diluting the minority's shareholding.

Why’s there a rise in unfair prejudice petitions?

The economic environment has experienced extended periods of relatively high interest rates and uncertain economic growth. Consequently, director decisions have come under greater scrutiny, leading to a rise in internal corporate disagreements.

Given the wide scope of remedies that are available, it’s understandable why minority shareholders are viewing unfair prejudice petitions as a viable route to recover a portion of their financial losses, while securing an exit from their companies.   

Issues that an unfair prejudice petition poses to insurers

From a coverage perspective, unfair prejudice petitions can become quite complicated as insurers try to sort out the parts of the petition that falls within a covered loss. The court's wide discretion in awarding remedies can make the outcomes very hard to predict. For example, even within the context of monetary losses, which are more likely to fall within the definition of a covered loss, the court can choose to ask the respondents to account for any alleged wrongdoing in either their capacity as a shareholder or a director. Consequently, the same type of loss – an order for monetary damages – can both be a covered loss if the order is made against the respondents in their capacity as a director; or an uncovered loss if the order is made against the respondents in their capacity as a shareholder.

Additionally, the costs of defending an unfair prejudice petition can escalate very quickly, and result in unanticipated exposure under a D&O policy.

Given the unpredictability of exposure that can arise from an unfair prejudice petition, law firms can assist insurers in reducing the uncertainty of the financial risk that they face by:

• anticipating potential areas of weaknesses that a respondent may face in defending an unfair prejudice claim during coverage;
   
• monitoring closely the development of an unfair prejudice petition; and
   
• considering any applicable exclusion terms to limit the exposure.

Daniel Goh is a trainee solicitor at RPC.