06 Aug 2020

Five (un)easy pieces: some possible solutions to the D&O dilemma

By Fred Hawke, Lucy Terracall

D&O insurance is becoming costlier and harder to get, so it's time to explore the options.

It's timely now to consider how corporate life might adapt to the conditions of a world without D&O insurance. Adapt it must, or perish, since the tide of corporate officers' personal accountability (600 odd pieces of specific legislation at last count and climbing) shows no sign of receding.

At a time of market failure in the traditional insurance classes of D&O and Managerial Liability, other options for managing the relevant risks need to be explored. What then are the possible alternatives to private-sector insurance in these classes?

In this article we sketch out five possible solutions. None are perfect; the adoption of any will be a matter of regulatory and commercial actions, risk and appetite, but all deserve serious consideration.

What would a possible alternative to D&O and Managerial Liability need to have?

As a first step, let us consider what was the original purpose of D&O insurance, as conceived and developed by the legendary underwriter, C. E. Heath, nearly 100 years ago. It was certainly not intended to be an insurance for the company itself against liability for breach of stock market continuous disclosure obligations, or even against older forms of prospectus-based liability. Its primary purpose was to provide corporate officers with at least partial indemnification, and more importantly, the means to afford a legal defence, in the event lawsuits were brought against them in that capacity, in circumstances where the company itself could not do so by reason either of insolvency or legal prohibition. That purpose remains valid and should inform any examination of alternative protections.

Secondly, any solution proposed to the current D&O insurance availability dilemma, be it in the form of traditional insurance or otherwise, must have as its primary objective the maintenance of effective, functioning Boards and Management. That means separating their liability and legal costs safety nets from those of their companies. This, at bottom, is an issue also of conflict of interest: how can management be expected to decide objectively whether or not the company should make a claim upon its Side C securities coverage in a class action, when they may need to draw upon the limit themselves for a subsequent (or even an unrelated) ASIC investigation?

Option #1: Dump "Side C" (Securities Entity) Coverage

Introduced to the market in the 1990s as an optional extra to the traditional Side A and Side B contracts, Side C coverage pretty soon became mandatory since insurance brokers were loath to advise their clients against purchasing cover that was on offer. At the same time, the undesirability of insuring both the officers' and the company's liabilities under a single, aggregate limit was largely overlooked or discounted on both sides of the market.

Ironically, the original reason for Side C's introduction was to reduce the incidence of directors and officers being sued or joined in US securities litigation, for no better reason than to boost the pot of available insurance. The result has been infelicitous. There is a risk of the policy proceeds upon which directors and officers must rely for their legal defences being either frozen in insolvency or exhausted by prior litigation against the company – a risk prudent insurance purchasers and their brokers can no longer overlook. Whether or not companies can and should buy separate insurance against their own liabilities arising from market disclosure is a separate question.

Some commentators may argue that Side C improves corporate securities governance, by giving Boards an added incentive to avoid continuous disclosure breaches which would present a threat to their own insurance protection – a proposition without proof.  

Option #2: Ditch Side C & Side B as well

Ditching Side C alone will not be enough to abate the D&O crisis, since companies which have done so or have never even bought it are nonetheless facing massive premium increases and drastically reduced coverage terms this renewal season, and some cannot buy the insurance on any terms. What then, of the suggestion to dispense also with Side B (Company Reimbursement) and purchase only a "stand alone" Side A contract on which the insured persons can claim directly? This would respond only to those Claims, costs and liabilities for which indemnification by the company is legally precluded or financially impossible.

While superficially attractive, this measure also is unlikely to reduce substantially the cost of protecting Boards and Management. The original rationale for the development of Side C – the fact that having responsive liability insurance makes you a target for litigation – hasn't gone away and is, if anything, more cogent now than it was when the cover was introduced, some 25 years ago.

Once Side C is removed, the only time the company itself can claim upon D&O insurance is if and to the extent it has indemnified one or more Insured Persons, with respect to Claims against or Investigations concerning them personally. It then has a Side B claim, against which it bears a substantial deductible. From the perspective of a D&O underwriter, that risk has not changed. Should the company choose not to insure against it but retain the obligation to indemnify directors and officers under their Deeds of Access and Indemnity as a contingent liability on its own balance sheet, premium cannot be charged for the Side B component of the overall risk but neither can a corresponding excess be applied to the remaining element of cover under the contract: Side A. The universe of risks to which Side A responds, however  (those categories of Claims, costs and liabilities for which the company cannot indemnify its officers), will have been expanded as to frequency and magnitude as, without Side C, they now represent the only means of access to the proceeds of relevant insurance.

Where this is important is in the context of corporate insolvency, and it is why insolvency exclusions are unlikely to go away. Suppose that a company has dispensed with Side C and is no longer insured for securities-related liability, because the loss experience for that class of cover has driven the cost of it out of reach or made it unavailable on any terms, either as a feature of D&O insurance or a separate class. If that company then becomes insolvent (whether before or as a result of a securities class action), the only way for the class action investors to reap a return is to find someone else with responsive insurance to blame for the company's conduct and/or its situation.

The obvious candidates will be its officers and managerial employees, who will be covered under their Side A contract because the company, by reason of legal prohibition, insolvency or both, cannot indemnify them against the Claim. Auditors and other professional service providers of course may also be invited to the party, but these are all apportionable Claims and so there is no way the directors and officers will be left out.

That Claim will be facilitated by the fact that the old common law rule in Foss v Harbottle is being progressively eroded; courts are now finding that an officer's basic duty of care and diligence, under section 180(1) of the Corporations Act 2001 (Cth), is "normative" in nature and not just a private matter between officers and their companies.

In the meantime, the practical effect of Side A only cover in an insolvency scenario will be to make the director and officers an attractive recovery target for creditors, disgruntled investors and class action lawyers and funders. Moreover, the levels of self-insured retention that have been applied in the past to Side B cover, to try to keep D&O premiums manageable, cannot be imposed on Side A without rendering the insurance unworkable and effectively valueless to the individuals who must claim upon it.

Accordingly, faced with a shift in exposure from Side C to Side A in an insolvency situation, together with inability to impose the sorts of deductibles that normally apply to the Side B component of the risk, underwriters can be expected to impose extensive and rigorous insolvency exclusions even on Side A only renewals. Nor, despite the contraction in cover, are they likely to offer much in the way of premium reductions, given the diabolical claims experience of the D&O class, the class action nirvana that Australian jurisdictions (and especially Victoria) have become, and the resultant withdrawal of reinsurance capacity.

Viability of the insurance?

Pruning back D&O insurance to the point where it covers only risks for which the company is not legally permitted to indemnify its officers, and will not respond anyway in situations where the company would be unable to do so in any case by reason of insolvency, does not leave much value for money. The main selling point of D&O insurance used to be the fact that it provided the company's officers and employees with a safety net, in the form of an independent fund on which they could claim directly, against the possibility that the company became unable to fulfil its contractual and constitutional obligations toward them. If you take that away it becomes increasingly hard to see the point of the product, especially in light of its other legal ambiguities and constraints (such as its unavailability for criminal fines and penalties, and possibly pecuniary penalties too).

So if dumping both Side C and Side B and returning D&O insurance to its paleo roots is not going to solve the problem, what will? Where insurance markets fail, corporate clients must look elsewhere to manage relevant risks and the usual first port of call is Government, as in the case of terrorism for example. At the moment though, it's probably a bit of a stretch to expect the Federal Government to extend the Australian Reinsurance Pool Corporation's remit to include reinsurance of D&O risks. That leaves exploring other alternatives, including the capital markets, to find means of managing the D&O risk class so as to maintain the calibre of applicants for Australian Board and Management positions. So what other choices are there?

Option #3: A captive D&O insurer

A common response of businesses which find themselves unable to buy insurance at a reasonable price is to set up their own insurer, to provide a primary layer of coverage and facilitate access to excess and reinsurance markets. While captives can be of considerable benefit in managing retentions and imposing risk management discipline on business units, in some classes of risk, their utility in Australia for D&O is questionable at best. This is simply from the terms of the prohibition, in section 199A of the Corporations Act 2001 (Cth), on indemnification of officers against prescribed liabilities and legal costs. It is the terms in which the prohibition is expressed that are significant.

In short, indemnity must not be provided "by the company or a related body corporate … (whether by agreement or by making a payment and whether directly or through an interposed entity)". There can be no doubt that a captive insurer fully owned and controlled by the policy holder is a related entity to the latter, within the meaning of that term in section 50 of the Act, irrespective of the jurisdiction in which it is incorporated. Such a captive, therefore, would be precluded from offering Side A coverage to its group directors and officers and could only underwrite the Side B risks for which the group of companies themselves can indemnify them, which is not much use.

A rental captive might be a better option, provided sufficient distance was maintained between its capital sponsor and the companies whose individual Insured Persons might need to claim upon its policies. An industry-available captive established and operated by an independent, arm's length organisation, such as a major insurance broking house, would work best. With separation and divestment of regulatory responsibility, however, comes attenuation of control and security.

The difficulty also arises that, practically speaking, establishing and operating such a facility means that the insurance broker must effectively set up, capitalise and run a mono-line D&O insurance company, or an underwriting pool, and risk becoming the insurer of last resort. While prospective policyholders might contribute the seed capital, given the loss experience of the class and absent significant law reform that is likely to be an even less attractive business proposition from an underwriting perspective than continuing to write D&O as part of a diversified, multi-line insurance book.

Such a rental captive would need to hold capital and charge premiums commensurate with the risk, together with fees sufficient to cover the cost of its required operational resources and expertise, all of which might not leave prospective insureds much better off in terms of net financial impact. It's probably only a serious option, therefore, if there are a critical number of major corporates which cannot buy acceptable Side A cover (acceptable meaning without an insolvency exclusion) from the insurance market at any price, and are willing to support the project.

Of the various captive-related solutions on offer, the one which probably comes closest to meeting the present need would be a protected cell or segregated account arrangement, under which the occupiers of adjacent cells agree to indemnify each other's officers against Side A category risks. Such structures, in which assets and liabilities in each insured's "cell" or "account" with a special purpose insurer are segregated, even in liquidation, from those of all the other participants in their respective cells are facilitated by express legislation, in Bermuda and certain other jurisdictions which have made innovative risk financing a local cottage industry.

The drawbacks of course, as with a straightforward rental captive arrangement but intensified by the arcane structure and regulatory environment, are the requirements to capitalise the cell and provide sufficient assurance to the relevant Insured Persons that they will be able to make effective claims upon it if necessary. Legally the cell would belong to the company and it is by no means certain that Australian law and regulation in an insolvency would respect either the foreign legislation or the purpose of the arrangement. In an insolvency scenario where an Australian company is in liquidation, a liquidator may seek to challenge prior transfers of funds to the cell, particularly if there are concerns regarding the solvency of the company at the time of the transfer and, for example, if it was an uncommercial transaction. The potential outcome is that the funds transferred to the cell can be recouped by the liquidator and become part of the pool of assets available to meet the claims of creditors of the company.

Funds transferred to a segregated account well before any question of the company's ongoing ability to meet its financial obligations arose, and for the legitimate purpose of protecting its Officers and employees against Side A risk, presumably ought to be resistant to recoupment. Nevertheless, the unusual nature of the arrangement – the fact that the funds in question would effectively be impressed with a trust for the benefit of Officers and Employees of an unrelated entity, as consideration for a reciprocal obligation assumed toward those of the company – might raise a question of potential un-commerciality which an administrator or liquidator would feel bound to explore.

The difficulty of ensuring access is compounded, in the case of the protected cell or the segregated account captive structure, by the fact that in order to obviate the risk of the cell being treated as an "interposed entity", within the meaning of section 199A(2) of the Act, each Participant's insured persons would need to rely upon another participant to ensure that the cell upon which they might need to claim for indemnification is kept solvent, operational and honours its obligations to them. In other words, by agreement between the participants, participant A's cell provides Side A cover to the insured persons of participant B, and vice versa. Should either participant become insolvent and the Australian governing regime refuse to recognise the arrangement, there would be a failure of consideration to the other. That would leave both sets of insured persons out in the cold. The likelihood of such an eventuality, and what precautions in advance might be taken against it, require specialist analysis beyond the scope of this paper.

Option #4: A Mutual

Although the D&O crisis seems to be affecting all Australian industries to a greater or lesser degree, some clients, particularly in the financial services and retail sectors, seem to be getting hit especially hard. They might want to give consideration to establishing an industry mutual fund to underwrite the Side A risks for its members, along similar lines to the role which the Bermuda's OIL Insurance Limited plays in the petroleum industry, or the London-based Protection and Indemnity (P&I) Clubs in global shipping.

That could be set up in several ways:

(a) as a straightforward, primary insurance company – effectively an industry-owned captive. Singapore would be a more favourable regulatory jurisdiction for it than Australia, but this option would require a significant investment in time, capital and expertise, and premiums commensurate with the Side A exposure in insolvency would still need to be charged, as with the rental captive option discussed above. There would be no guaranteed return to lower premiums, therefore, even without open-market insurers clipping the ticket, and it would not be a short-term fix but a long-term, industry-wide investment in risk finance. It would, however, be able to manage the insolvency exclusion problem.

(b) As a Discretionary Mutual Fund (DMF) indemnity pool. This could work with a sufficient number of participants to spread the capital burden, and could be set up onshore with less regulatory expenditure than establishing an insurance company would require, on the basis that what was offered to insured persons on entry was not insurance but merely the right to have claims for indemnity duly considered for acceptance by the Trustees of the fund, in accordance with the common terms of traditional Side A cover without an insolvency exclusion. Government self-managed insurance funds such as Comcover come to mind. That very limitation, however – the absence of an enforceable contract of insurance – is likely to make this option less acceptable to prudent, prospective directors and officers who may be considering whether Board appointments are still worth the risk. Moreover, as the collapse of United Medical Protection in 2002 vividly demonstrated, getting the actuarial projections and investment settings right for these sorts of funds can be a fraught exercise.

(c) as a reinsurer, with an APRA-regulated Australian primary insurer issuing the Side A policies to Insured Persons and ceding the risk 100% to the industry's, or the relevant participants', captive reinsurer. That would probably be the most palatable of the captive options for directors and officers and it need not concern them that the reinsurer might be domiciled offshore. It would have to be a proper insurance company, however, not a DMF, and the process of establishing it would involve most of the expenditure identified above with respect to the rental captive option.

Option #5: Alternative Risk Transfer

Of all the beasts currently inhabiting the ART zoo, the one most adaptable to the present purpose may be a contract analogous to a credit default swap, ideally between clients with off-setting or counter-cyclical D&O risk exposures. Instead of hedging against the risk of credit events in respect of a reference exposure, however, in return for specified payments from the fixed party the floating party would have a contractual obligation to make a payment commensurate with Side A indemnification, upon the occurrence of a parametric trigger. That trigger need only be the commencement of an Investigation or the making of a Claim, which exposes the fixed party's Insured Persons. If the risk exposures were correlated, rather than counter-balancing, the two parties could simply exchange such contracts and in the latter scenario there would not even be a need for money to change hands: the respective obligations assumed would represent valuable consideration flowing from both parties.

This could enable the risks to be managed by what amounts to reciprocal swaps, without either party infringing section 199A of the Corporations Act. The company making the payment ought not be considered an "interposed entity" for the purposes of Section 199A (1), any more than are insurance companies that provide traditional D&O cover. Nor should it amount to carrying on a business of insurance without authorisation by the Australian Prudential Regulation Authority, contrary to section 9(1) of the Insurance Act 1973 (Cth), since the payment would not be an indemnity but an amount calculated in accordance with a prescribed formula and the arrangement would be entered into not as part of the company's commercial activities, but to manage a risk by securing the benefit of a corresponding arrangement for its own officers.

Nor should the provision of such a benefit contravene section 199B of the Corporations Act, any more than does the company's customary payment of the premium for Side A insurance cover. Nevertheless, to make doubly sure of that, the arrangement might be structured so as to direct payment of the swap coupon to a third party stakeholder, whose responsibility it would be to ensure that the funds were not disbursed for any purpose that would infringe the mandatory exclusions in section 199B, once the relevant conduct had been established by admission or final adjudication.

The only drawbacks to this idea would seem to be, firstly, the problem of ensuring that the respective groups of Insured Persons would be able to enforce the contractual arrangement for their personal benefit, should the need to do so arise; secondly, the likelihood that it would constitute dealing in a financial product under Chapter 7 of the Corporations Act and require the parties to hold Australian Financial Services Licences, with all that entails. As to the first, it should not be beyond the wit of commercial lawyers to contrive a structure where by the Insured Persons were also privy to the relevant contractual arrangements, in such a way as to enable them to be enforced by the intended beneficiaries under the same principle as the rule in Trident General Insurance Co Ltd v McNiece Bros Pty Ltd (1988) 165 CLR 107. One suggestion might be to include a nominated beneficiaries clause.

Regarding the second, the arrangement certainly looks like a contract by means of which the companies manage risk, albeit a risk to their respective managers and officers, and therefore a financial product for the purposes of Section 763C of the Corporations Act. Dealing in a financial product includes the issuance of one and both parties to a derivatives contract are considered to be issuers, which would make it provision of a financial service. On the face of it, therefore, section 911A (1) would seem to require that they each hold an AFSL, which would scupper the arrangement as far as most companies outside the banking and financial services industry are concerned, unless it could be argued that the arrangement did not really amount to the carrying on of a financial services business, or should be exempted from being treated as such.

There is, however, an exemption (reg 7.6.01(1)(m)) from the requirement that a person who provides a financial service by issuing a derivative must hold an AFSL, where:

  • the service does not involve making a market for derivatives or foreign exchange contracts;
  • the dealing is entered into for the purpose of managing a financial risk that arises in the ordinary course of business;
  • the person does not deal in derivatives or foreign exchange contracts as a significant part of the person's business; and
  • the dealing is entered into on the person's own behalf.

While the immediate financial risk to be managed is to the organisation's Officers and Managerial employees, rather than the organisation itself, it is arguable that the future financial consequences to the company of not being able to arrange Side A cover for them are such that the arrangement can be said to have been entered into on the company's own behalf as well as that of its Insured Persons. These days it also can be argued, sadly, that the risk of Side A claims against Officers and Managers is one which arises in the ordinary course of business. On that basis, a company which does not deal in derivatives or FX contracts as part of its core business ought to be able to rely on the exemption, while one that does, such as a Bank or other financial institution, probably has a suitably endorsed AFSL in any case.

Moreover, sub-section 911A 2)(k) provides that a person is exempt from the requirement to hold an AFSL for a financial service they provide, if the provision of the service is covered by an exemption prescribed by regulation. Sub-section 911A(2)(l) similarly allows for exemptions to be specified by ASIC and published in the Gazette. Rather than try to steer a tortuous path through the densely interwoven thickets of convoluted prose that make up the multilayered definitions in Chapter 7, in search of an argument that they don't apply to the proposed arrangement (which might or might not commend itself to the regulator or a Court), it may be easier and simpler just to apply to ASIC for legislative instrument protection for such derivative arrangements, either on an individual or a general basis.

Such a means of providing security to corporate officers and employees, as an alternative to D&O insurance, has not been tried before to the best of my knowledge. The point, though, is that in desperate times you try whatever might work and if you are unwilling to move out of your comfort zone, then obviously you are not yet desperate enough. That might not be what you want but as Henry Ford famously said, when asked if he understood what his customers wanted, "If I'd asked them what they wanted they'd have said faster horses". You might well prefer cheaper and more comprehensive D&O insurance, but when the market for that fails, you either do without or you innovate.


The contributions of  Sonia Goumenis, Matt Daley and Anthony Burke to this paper are acknowledged. Any mistakes, of course, are the sole responsibility of the authors.

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Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this communication. Persons listed may not be admitted in all States and Territories.