Understand your personal liability and how you can protect yourself with D&O insurance.
Duties and obligations as a director
Directors and officers have a number of duties, responsibilities and obligations, including:
- Obligation to exercise your powers and discharge your duties in good faith in the best interests of the corporation and for a proper purpose.
- Common law duty to avoid conflicts of interest and statutory duties to disclose personal interests and not to improperly use position or information.
- Obligation to exercise care and diligence.
- Obligation to prevent insolvent trading.
- Disclosure obligations which differ depending on the nature of the entity, such as the continuous disclosure regime, together with duties of disclosure with respect to prospectuses and Product Disclosure Statements (PDSs) for financial services, and potential liability for providing misleading documents or information.
- Obligations to comply with personal liability provisions under various State and Federal statutes (including occupational health and safety and environmental protection provisions).
If you sit on multiple boards, each board may expose you to a different type and scope of personal liability risk.
Financial risks for directors
If you breach a duty or fail to meet an obligation, you may be required to pay:
- Compensation to an aggrieved party.
- A fine or penalty.
- Legal costs of the other party.
- Your own legal defence costs.
- Interest on any of the above.
Potential claimants
A claim for breach of a duty or failure to meet an obligation may be brought against you by parties such as:
- Your company itself
- Shareholders
- Regulators such as ASIC and APRA
- Employees
- Creditors
- Competitors
- Customers
- Liquidators (or administrators or trustees)
- Other directors on the board.
Case study
You are a director of a small family owned company with a net asset position of $1.4 million and a line of credit for $500,000.
With a downturn in the economy a number of the company's clients started to delay making payments. One major client had continually been seeking an extension to their credit terms and eventually went out of business.
Over a period the company’s cash flow showed a negative trend and the line of credit was fully utilised. Eventually the company went into liquidation.
A claim was lodged by the liquidators alleging that you and the other directors had continued to trade while the company was insolvent.
Ultimately the claim was settled without going to trial for a payment of $1.2 million to the liquidators and $250,000 in legal fees.
The company’s D&O insurance policy covered $1 million of the payment and left you to cover the remaining $450,000.
How would you cover those costs?
Options for treating personal liability risk
There are several mechanisms for treating the personal liability risks associated with your position as a director. For each position you hold as a director or officer, you should consider which mix of the following risk options best suit your individual circumstances.
| Avoid any personal liability risk | Prior to accepting an appointment, you should conduct a careful due diligence on the company and its board. You may decide that accepting a position on a particular board carries too high a risk - that it exceeds your appetite for risk. |
| Reduce your personal liability risk with a deed of indemnity and indemnities provided by the Constitution | Consider the indemnities provided by the company to directors and/or officers by the company's constitution and deed of indemnity, having regard to the legal limits to the indemnities that your company may provide you. These documents should be regularly reviewed, and you should consider obtaining independent advice to assist you to do so. |
| Transfer your personal liability risk using D&O insurance | Identify whether the company has D&O insurance and whether it will be an effective means of transferring risk to the insurer, having regard to the legal limits on D&O insurance. Insurance arrangements should be regularly reviewed and you should consider obtaining independent advice to assist you to do so. |
| Be aware of your residual personal liability risks and consider managing your personal assets carefully | There will always be a residual financial risk – or gap - even when you have a broad indemnity from the company and a D&O policy with an appropriate scope of cover. Many directors seek professional advice on the best way to fund and manage their residual risk. |
What is the role and relationship of deed of indemnity and D&O insurance?
|
Deed of indemnity and company constitution |
D&O insurance |
What does it do? |
Risk reduction. |
Risk transfer from company to insurer. |
How does it work? |
An indemnity from the company to the extent permitted by law. |
Insurance cover for directors and officers to the extent permitted by law. |
What are the limits to protection? |
Cannot cover: some fines, liabilities owed to the company itself, conduct involving a lack of good faith. |
Cannot cover: wilful breach of duty to company, improper use of position or information. |
How long does it work for? |
Usually unlimited in time, although if the company is deregistered and ceases to exist, so too will the deed of indemnity. Usually covers liabilities incurred by directors and officers, regardless of when a claim is made. |
Typically provides 12 months cover. Usually offered on a ‘claims made’ or ‘claims made and notified’ basis. May change from year-to-year depending on availability of product. |
What are the dollar caps on cover? |
Usually none |
Capped at the policy limit (with lower limits for some parts of the cover) |
What is covered? |
May provide broad cover e.g. for a director for all liabilities incurred, to the extent permitted by law. May provide immediate funding for defence costs, irrespective of progress of a claim under D&O insurance. |
Cover for personal liability and associated expenses and costs arising from an actual or alleged wrongful act or omission by an insured director. |
What issues should you watch out for? |
Location of indemnity – generally former directors can only rely on the deed of indemnity, not the constitution. Inconsistencies between constitution and deed of indemnity. Possible restrictions on indemnity and access to information for former directors. |
The insurer may reject individual claims when they are made. Other insured persons may exhaust the limit of indemnity under the policy. The insurer may take time to pay claims. |
Warning: the residual risk 'gap'
There are some risks that cannot be carried by the company, or transferred to an insurance company. These include:
- Loss of reputation. If you are found to be liable in legal proceedings the reputational damage you sustain can be substantially greater than the actual monetary fine or penalty imposed by the court.
- Personal financial losses. If you are found liable, you may suffer related financial losses such as loss of income in the future.
- Fines and penalties for criminal offences, and certain civil pecuniary penalties.
- Fraud, wilful misconduct and criminal conduct. These will usually fall outside the ambit of indemnities and D&O insurance, potentially leaving directors exposed to meet related legal defence costs.
Some directors take steps to manage the residual financial risk and reputation risk with the assistance of professional legal, accounting and /or financial advice.
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