Directors’ Liabilities, Indemnities and D&O Insurance

1. Directors’ Liabilities, Indemnities and D&O Insurance Jane Harte-Lovelace and Sarah Turpin

2. Programme Overview • D&O in context – hot topics for your boardroom agenda • Director indemnification – the new regime and the implications for D&O cover • D&O insurance – is your board properly insured for claims and investigations? • Responding to a claim • Potential pitfalls • Necessary steps to minimise coverage disputes

3. Director indemnificationThe new regime and the implications for D&O cover Sarah Turpin, Senior Associate

4. Director indemnification – the law prior to 6 April 2005 • Any provision which exempted or indemnified any director of the company against any liability for negligence, default, breach of duty or breach of trust in relation to the company would be VOID(Section 310 Companies Act 1985) • EXCEPTION – limited “after the event” indemnity for any liability incurred in successfully defending civil or criminal proceedings • PROBLEM – too late and too little comfort!

5. Director indemnification – the law since 6 April 2005 • The Companies (Audit, Investigations and Community Enterprise) Act 2004 relaxed the prohibition on indemnities (from 6 April 2005) • The existing prohibition on any provision which purports to exempt directors from liability or provide an indemnity against any liability remains (Section 309A) BUT • Companies are now permitted (but not obliged) to grant a “qualifying third party indemnity provision”(Section 309B) • Companies are also permitted to advance defence costs as they are incurred (Section 337A)

6. What is a “qualifying third party indemnity provision”? • A “qualifying third party indemnity provision” (QTPIP) is a provision which covers any liabilities incurred by directors, except any liability: • to the company or any associated company • to pay any fines imposed in criminal proceedings • to pay any regulatory penalties • incurred in defending any criminal proceedings in which the director is convicted • incurred in defending any civil proceedings brought by the company or an associated company in which the director is found liable • in relation to any application to the court for relief (where such relief has been refused)

7. So what does this mean in practice? • Companies are now permitted to indemnify directors (and directors of associated companies) for: • damages and defence costs arising from third party proceedings • defence costs relating to criminal proceedings (but not criminal fines and defence costs subject to “claw back” in the event of conviction) • defence costs relating to regulatory proceedings (but not regulatory penalties) • costs relating to any application to the court for relief (unless court refuses to grant relief)

8. So what does this mean in practice? (Cont.) • Companies are also permitted to advance defence costs as they are incurred, even if the action is brought by the company (but not in respect of any damages payable to the company and defence costs subject to “claw back” if director found liable to the company)

9. Some practical considerations • Most companies include an indemnification provision in their articles of association which may need updating in light of recent changes • Consider the need for express incorporation in directors’ service contract or separate deed of indemnity • Important to ensure obligation to indemnify survives directors’ retirement (many claims against directors arise after they have left company) • Disclosure requirements – any “qualifying third party indemnity provision” (QTPIP) must be available for inspection at the company’s registered office and disclosed in the directors’ report with the statutory accounts for the relevant financial year

10. Companies Act 2006 – further changes from1 October 2007 • Introduction of “qualifying pensions scheme indemnity provision” (QPSIP) allowing companies which are trustees of an occupational pensions scheme to indemnify their directors against liabilities incurred in connection with company’s role as trustee • Such provision cannot cover any liability of the director for: • Criminal fines or regulatory penalties • Any liability arising from criminal proceedings where the director has been convicted • Creation of a right for shareholders to request a copy of any QTPIP or QPSIP

11. Director indemnification – implications for D&O cover • D&O cover normally taken out by company as policyholder • Structured around indemnification provided by company to its directors and officers

12. 3 Types of D&O cover • Side A • D&O Liabilities • No indemnification by company • Side B (Company reimbursement) • D&O Liabilities • Company indemnifies • Side C (Entity cover) • Liabilities of Company • Often limited to securities claims

13. So why is D&O insurance still needed? • For Directors (Side A): • Company insolvency - company indemnification only as good as the company’s ability to pay • Legal restrictions - Side A may provide broader indemnification than company permitted by law to indemnify • Criminal defence costs even if director convicted(but check fraud/dishonesty/criminal acts exclusions) • Damages and defence costs relating to claims by the company(but check “insured v insured” exclusion) • Company refusal - Side A may even respond if company refuses to indemnify but essential to check policy wording

14. So why is D&O insurance still needed? (cont.) • For the Company (Side A and Side B) • Side A – to attract high calibre directors (particularly non-executives) • Side B – balance sheet protection • Combined code – “the company should arrange appropriate insurance cover in respect of legal action against directors” • D&O insurance is not a legal requirement but many companies now regard it as essential

15. D&O InsuranceIs your board properly insured for claims and investigations? Sarah Turpin, Senior Associate

16. Is your board properly insured for claims and investigations? • D&O policy wordings vary enormously • “Devil is in the detail” • Minor variations can have significant impact on scope of cover available • Directors should have clear understanding of what is and is not covered and who can benefit and share the cover

17. What are the policy limits? • Lessons learned from Equitable Life • Combined D&O cover for all directors believed to be £5m • Civil claim against 15 former directors • Each director faced £1.7 bn claim • No finding of liability against directors but total legal costs estimated at over £20m • Conditional fee agreements/litigants in person

18. How do the policy limits apply? • “Claims made” cover = claims made against director or officer (and reported to insurers) during policy period • “Per claim” with separate “sub-limits” for certain types of claim • “Series” provision may seek to limit number of policy limits in event of multiple claims • Insurance claims arising from 9/11 terrorist attacks on World Trade Centre

19. How do the policy limits apply? (cont.) • “Per year” whereby policy limit applies in the aggregate i.e. to all claims against any insured during policy period • Can prove problematic where number of insureds covered by same policy • Scope for insured making first claim to exhaust policy limits • Care needed on mixed policies e.g. PI plus D&O

20. Who is covered? • Past, present and future directors and officers of company and any subsidiaries • Should also expressly include: • De facto directors • Shadow directors • Directors who act as shadow directors of any other company • Directors appointed to “outside entity” (subject to specific terms) • Lawful spouse of director (only for “wrongful acts” of director) • Executors of deceased directors’ estate • Consider also: • Employee acting in managerial or supervisory capacity • Employee named as party in claims against directors

21. What types of claim? • “Claim” should be expressly defined to include: • Written demand (monetary and non-monetary relief) • Civil proceedings • Criminal proceedings • Administrative or regulatory proceedings • May not include regulatory investigations/enquiries e.g. FSA, SEC (Sir Philip Watts/Shell), OFT (British Airways), DTI (Farepak), HSE (important such investigations covered) • “Claim” must arise from “wrongful act” by the D&O – should be widely defined to include any actual or alleged breach of duty, breach of trust etc or any matter claimed against director or officer by reason of their status as such

22. What losses are covered? • Loss should include defence costs, damages and settlement payments • Punitive, exemplary and multiple damages may be excluded • Fines and regulatory penalties excluded • Defence costs • Usually require advance written consent • Advancement preferable to reimbursement • Extensions of cover e.g. investigation costs, emergency defence costs, crisis management costs, mitigation costs, regulatory investigation costs

23. The Long Arm of US Jurisdiction – do you need cover for extradition costs?

24. The Long Arm of US Jurisdiction – do you need cover for extradition costs? • The publicity surrounding the “Nat West Three” fuelled concerns over the risk of extradition to the US • UK/US Extradition Treaty 2003 (implemented by Extradition Act 2003 with effect from January 2004) heavily criticised for non-reciprocal evidence requirements: • No requirement for US (and other ‘category 2 territories’) to show prima facie evidence of criminal offence • The perceived creative approach taken by the US authorities in relation to the “double criminality” requirement • Offences of wire fraud/mail fraud used to extend jurisdiction

25. Do you need cover for extradition costs? (cont.) • Nat West Three – extradited on charges of “wire fraud” - alleged misconduct took place outside US but connection with Enron clearly an important factor • Nigel Potter (former MD of Wembley leisure group) – alleged “conspiracy to bribe” also took place outside the US and “bonus” never actually paid – avoided extradition by agreeing to co-operate with US authorities (currently serving 3 year prison sentence in US) • Ian Norris (former CEO of Morgan Crucible) attempting to resist extradition on basis alleged cartel activity only made criminal offence for individuals by Enterprise Act 2002 (i.e. prior to alleged offence)

26. Do you need cover for extradition costs? (cont.) • Up to half the extradition requests under the Extradition Act have related to white collar crime offences • The scope of the Act is very broad provided the authorities can satisfy the “double criminality” requirement • Examples of relevant offences include bribery, corruption, fraud, insider trading, tax evasion, cartels and health & safety offences leading to fatal accidents • Directors of any business with US presence or dealings with US may face extradition/prosecution in US

27. Do you need cover for extradition costs? (cont.) • “Claim” should be defined to include criminal claims and investigations • “Defence costs” should therefore include the costs of fighting extradition • In the light of concerns over the “Nat West Three”, some D&O Insurers now provide express cover for “extradition costs” BUT beware US exclusions and consider a “carve out” for extradition costs if such an exclusion applies

28. Do you need cover for claims and investigations in the US?

29. Do you need cover for claims and investigations in the US? • Cover for US claims/investigations likely to result in significant premium increase • Need to assess directors’ potential exposure to such claims/investigations (defence costs for US regulatory investigations can be significant) • Even if no US operations/shareholdings need to consider: - relaxation of extradition requirements - long arm of US jurisdiction/offences of wire fraud/mail fraud

30. U.S. Regulatory Investigations of non-US Companies • Directors of companies with shares registered in US may face investigations by the following: • SEC (Securities and Exchange Commission) In relation to disclosure violations, accounting violations and internal control deficiencies e.g. Shell (Netherlands), Vivendi (France), Royal Ahold (Netherlands) • CFTC (Commodity Futures Trading Commission) currently investigating BP (Lord Browne) for possible price manipulation of the U.S. propane and crude oil markets • PCAOB (Public Company Accounting Oversight Board) Created by Sarbanes-Oxley to oversee accounting firms – both foreign and domestic – that audit companies issuing securities. Requires an inspection of each firm every three years

31. Sarbanes-Oxley – another hurdle for non-US companies with U.S. securities • Among other things, Sarbanes-Oxley (“SOX”) requires: • Officers of companies to take personal responsibility for financial disclosures and prohibiting conflicts of interest • An assessment of the effectiveness of internal controls by management, to be audited and approved by the company’s independent accountants • September 2006 – Directors of TV Azteca became first international D&Os to settle enforcement action under SOX • Liable D&Os agreed to establish a “Fair Fund” to compensate investors • Chairman Ricardo Salinas Pilego - $7.4 million • Former CEO Pedro Padilla Longorio - $1 million

32. U.S. Securities Class Actions involving Non-U.S. Companies • In past two years, almost 10% of securities class actions filed in the U.S. involved a European company • Overall number of class actions is decreasing, but settlement amounts are on the rise (exceeded $9.6 billion in 2005) • Foreign issuers are paying out large settlements • In 2005, two of the ten largest class actions settlement involved foreign issuers: • Deutsche Telekom AG ($125 million) • Royal Ahold NV ($1.1 billion). • In 2006 Canadian Nortel Networks settled for nearly $2.5 billion

33. U.S. Securities class actions - U.S. opening courtroom doors to foreign investors • Some courts allowing non-U.S. investors to maintain suits against foreign issuers • In re Vivendi (New York 2004) • Royal Ahold (Maryland 2004) • Royal Dutch/Shell (New Jersey 2005) • Not all foreign investors maintain claims successfully • In re Bayer AG (New York 2005) • Daimler Chrysler (Delaware 2006)

34. In re Royal Dutch/Shell Transport Securities Litigation • Shareholder class action arose from Shell overstating its oil reserves, which led to massive dip in stock price once alleged fraud discovered • Putative class included both U.S. and non-U.S. shareholders • Shell filed a motion to dismiss for lack of subject matter jurisdiction, arguing that the court had no jurisdiction over the claims made by non-U.S. shareholders

35. In re Royal Dutch/Shell Transport Securities Litigation(cont.) • Court allowed non-U.S. shareholders to remain part of putative class: • Misstatements by Shell representatives to analysts and investors in the U.S. (the acts that allowed for subject matter jurisdiction) affected both domestic AND foreign investors – U.S. market activity “has become an example for foreign investors and exchanges” • Court dismissed argument that there was no guarantee U.S. judgment would be enforced in investors’ home countries (and could therefore lead to duplicative litigation) as merely “speculative”

36. U.S. Securities class actions – directors’ contributions to settlements • WorldCom • Former CEO Bernard Ebbers -- $5.6 million cash and other assets valued at over $18 million • Former Chairman Bert Roberts -- $4.5 million out of pocket • 10 former outside directors -- $18 million (collectively) out of pocket • Enron • 10 directors to pay $13 million from profits selling Enron stock

37. D&O insurance - what is not covered? • Essential for directors to understand not only what is covered but what is expressly excluded • Number, wording and extent of policy exclusions varies enormously • Preamble to exclusions section may extend application of exclusions to claims arising from other people’s actions • Generally speaking, the longer the preamble, the greater the scope for the exclusion to apply

38. Reasonable exclusions – liabilities likely to be covered by other policies • Death or bodily injury (request carve out for defence costs relating to corporate manslaughter claims) • Physical damage or destruction of property • Pollution and environmental claims (request carve out for defence costs) • Product liability • Pension trustee liabilities

39. Exclusions commonly found but worth negotiating Most D&O policies expressly exclude claims involving: • Dishonest or fraudulent acts/illegal personal profit or gain • Should not include “criminal or wilful acts” • Requirement for judgment or final adjudication • Repayment of defence costs (if established) • Importance of severability provision

40. Exclusions commonly found but worth negotiating (cont.) • Insured –v- insured e.g. Equitable Life (carve outs essential) • Outside directorships • Professional services (possible carve out) • Known claims and circumstances • Prior and pending litigation (could include claims against company) • Material changes in risk/changes in securities listing

41. Unreasonable exclusions • Depends upon nature of business but following should be avoided: • Actual or alleged failure to maintain insurance • Major shareholder exclusion • Blanket or absolute professional indemnity exclusion • Blanket or absolute bodily injury or property damage exclusion (preceded by widely drawn preamble) • Blanket or absolute pollution exclusion

42. Will “dishonest” directors forfeit D&O cover for “innocent” directors? Avoidance of policy • D&O policy (like all insurance contracts) is contract of utmost good faith = insured under duty to disclose all material facts • Scope for Insurers to seek to avoid policy on grounds of material non-disclosure or misrepresentation prior to inception • Typically arises in D&O context where there are errors, or even intentional misstatements, in the financial statements accompanying the proposal form (e.g. Enron/Worldcom) • Importance of severability provision

43. Will “dishonest” directors forfeit D&O cover for “innocent” directors? (cont.) “Basis of contract” clause = converts statements in proposal form into warranties • Breach of warranty automatically discharges insurers from liability • No need to demonstrate ‘materiality’ • Policyholders should aim to delete clause • Important to limit definition of proposal/documents relied upon Exclusion of dishonest/fraudulent acts • Importance of severability provision/final adjudication

44. D&O InsuranceResponding to a Claim Jane Harte-Lovelace and Sarah Turpin

45. Responding to a claim

46. Potential pitfalls relating to claims notification • The D&O policy, being written on a “claims made” basis, will normally provide for notification of claims and circumstances likely to give rise to a claim • Notification of claims: • Within a specific time limit or “promptly” or “as soon as practicable” • Often conditionprecedent to insurers’ liability • Breach enables insurer to deny cover even if no prejudice suffered

47. Potential pitfalls relating to claims notification • Notification of circumstances which may/are likely to give rise to a claim: • Within a specific time limit or simply within policy period • May need to specifyclaimspredicted • Potential problems if not accepted • Importance of early notification • ensure compliance with claims notification provisions • obtain consent in relation to defence costs

48. Potential pitfalls relating to claims co-operation • Insured has duty to defend • BUT • May be no express right to chose own lawyers • May be no express right to appoint separate lawyers (in case of actual or potential conflicts) • May be required to give full co-operation and information to insurers • No defence costs/settlements without consent of insurers • May be conditionsprecedent to policy cover • Scope for conflicts of interest (QC/Hammer clause)

49. Necessary steps to minimise coverage disputes • Ensure full disclosure of material facts at pre-contract stage • Review policy wording and negotiate improvements, particularly to any ambiguous or unduly onerous terms and conditions • Notify any material changes of risk during policy period eg acquisition of subsidiary/offering of securities (in accordance with policy terms) • Notify claims and circumstances promptly and in accordance with policy terms

50. Necessary steps to minimise coverage disputes • Ensure D&Os aware of notification requirements • Obtain insurers’ consent to any defence costs incurred in advance • Seek to comply with any defence costs guidelines insurers may seek to impose • Ideally request improvements to costs guidelines at pre-contract stage • Ensure lawyers aware of guidelines and keep adequate records (particularly for “mixed” claims) • Keep insurers informed of material developments and consult with insurers in relation to any proposed settlements