Directors and Officers Insurance and Criminal Conduct

Friday, August 31, 2018

One of the main benefits of Directors and Officers (D&O) insurance in practice is the cover that it provides for defence costs in civil, criminal and regulatory proceedings. D&O policies generally exclude coverage where the director’s liability to a third party is found by judgment, award or admission to be based upon criminality or dishonesty, and even in the absence of any such term the common law would imply the limitation that policyholders cannot seek indemnity for the consequences of their own deliberate wrongdoing.

The problem in applying this limitation to defence costs is that, until the proceedings against the director have concluded, there is no way of knowing whether the director has indeed committed a criminal or dishonest act. For that reason, it has become more or less standard for D&O policies to include wording of the type recently considered by the Federal Court of Australia in Onley v Catlin Syndicate Ltd as the Underwriting Member of Lloyd’s Syndicate 2003 [2018] FCAFC 119, namely:

“If a Claim alleges a Wrongful Act or illegal or improper conduct as described in the Dishonest or Criminal Intent/Improper Conduct Exclusion, then We will advance Defence Costs and Representation Expenses in respect of such Claim until it is found by way of an admission by You, judgment or adjudication that such Insured did in fact commit such Wrongful Act or engage in such illegal or improper conduct and any amounts previously advanced shall be repaid to Us by You within thirty (30) days following a request by Us for such repayment.”

By this wording, defence costs are paid as they are incurred, and remain payable up to the point at which the director is found guilty of, or admits to, a crime of dishonesty. Funding at that point ceases and the sums paid to the director are repayable to the insurers.

It has been the experience of insurers that it is frequently impossible to recover sums advanced by way of costs, and that of itself has given rise to a question - yet to be resolved - of whether sums repayable but not recovered go to reduce the aggregate liability of the insurers towards other directors and officers covered by the policy.

However, a more fundamental question has been discussed. Is it possible for an insurer who has agreed to pay defence costs under a clause such as that above to seek to avoid or cancel the policy for the company’s non-disclosure on placement of the very conduct forming the basis of the proceedings against the director?

It is to be noted that D&O policies are taken out by companies for the benefit of their directors, so that the directors are typically not policyholders in their own right but rather third party beneficiaries of the cover. It follows that unless the company was itself aware of the relevant facts, the question of avoidance against the company itself does not arise. That said, New Zealand law recognises a doctrine of imputation whereby the knowledge of the person who is the controlling mind of a company is deemed to be in the possession of the company itself, and in the vast majority of cases the director in question will fall into that category. So, in principle there could be a right of cancellation. The question discussed in Onley was whether the defence costs advance clause is consistent with cancellation.

The facts of Onley are unexceptional. The two claimants were directors of a number of companies. One of the companies had taken out D&O cover for the benefit of the directors. In May 2017 the two directors were charged with tax fraud, and they rapidly notified the charges to the insurers in order to secure cover for the defence costs to be incurred in the trial. The claims were rejected in short order, the insurers purported to set aside the policy by reason of non-disclosure of the fact that one of the applicants had been knowingly misappropriating funds that should have been paid to the Australian Tax Office. The conduct relied upon to avoid the policy was thus precisely that which had given rise to the charges.

The Federal Court, consisting of judges with great experience of the insurance market, held that the insurers were entitled to rely upon their defence of non-disclosure. First, as a matter of construction the defence costs clause did not purport to limit any right of avoidance, and clear words would be required to oust that right. The correct meaning of the clause was that it provided defence costs for alleged criminal and dishonest conduct arising after the policy had incepted, so that there was no issue as to disclosure, but that in respect of pre-inception criminality and dishonesty the right to avoid was unaffected.

The Court was satisfied that this interpretation was business like, in that it conferred substantial benefit on the assured where the alleged conduct was post-contractual and in that it protected an insurer who had been induced by fraud to write cover that would not otherwise have been issued.

Secondly, the House of Lords had decided in HIH Casualty and General Insurance Ltd v Chase Manhattan Bank [2003] 2 Lloyd’s Rep 61 that a clause limiting or excluding the duty of disclosure could not extend to fraud. Thirdly, the defence costs clause did not amount to an implied waiver on the part of insurers to forego their avoidance rights. Finally, the duty of utmost good faith imposed upon insurers was not infringed by reliance on non-disclosure.

The following points in respect of a clause providing for the advancement of defence costs may be taken away from this decision:

  • If the fraudulent or dishonest conduct forming the subject matter of the proceedings against the directors took place after the policy incepted, there is no basis for a non-disclosure defence.
  • If the fraudulent or dishonest conduct forming the subject matter of the proceedings was unrelated to the matters relied upon by the insurers as requiring disclosure, the defence costs clause cannot in any way restrict the right of avoidance.
  • If the fraudulent or dishonest conduct forming the subject matter of the proceedings was known before inception and was not disclosed, then in principle insurers have the right to rely upon non-disclosure. However, the Federal Court warned, based on the duty of utmost good faith, that “an insurer may not escape its obligation to advance defence costs until relevant facts are established by a simple allegation of non-disclosure ... an insurer must have a real or substantial ground for alleging non-disclosure. That does not mean the insurer must then have all necessary proof of the insured’s conduct to establish the ground for the exclusion. However, sufficient grounds must then exist which can be relied upon consistently with the obligation of utmost good faith.”

If you have any questions about this judgment, or would like any further information, please contact a member of our insurance team.

Disclaimer: the content of this article is general in nature and not intended as a substitute for specific professional advice on any matter and should not be relied upon for that purpose.