In brief - Directors must notify their D&O insurer of all "potential claims circumstances"

Directors must be aware of any deterioration in the solvency position of the company and must ensure that they notify their directors' and officers' (D&O) insurer of such changes, otherwise they risk having no cover when a claim arises.

Widespread lack of knowledge of directors' obligations to insurer

Although most people know about directors' and officers' (D&O) liability insurance, too few directors outside the insurance industry have a good understanding of their obligations to their D&O insurer.

Perhaps surprisingly, this can be the case in both small and large, even listed, companies.

If an insurer has not been told something that it should have been told, there may be no cover when a claim arises.

Changing insurers - be sure to notify the outgoing insurer properly

Like most insurances, D&O cover is typically renewed annually. It is common for the insurance broker to be asked to obtain competitive premium quotes. If the broker can find a cheaper quote, especially at a significantly better price, there is a temptation to take it.

But what may be the consequences?

Obviously, the benefits offered by any continuous cover clause that may be in the outgoing insurer's policy will be lost. This can cause problems if a claim later arises and the new insurer denies liability to indemnify on the basis that the claim arises from circumstances which should have been notified to the earlier insurer.

When changing insurers, you should take great care to ensure that the outgoing insurer is properly notified of all "potential claims circumstances".

What are "potential claims circumstances"?

This is not an easy question to answer.

Indeed, it sometimes happens that the notified insurer in effect rejects the notification on the basis of lack of sufficient specificity.

At the least, the notified insurer will likely want to know:

  • What's happened to generate the notification - why are you telling me this now?
  • What are the factual circumstances?
  • Who may be making a claim?

But what is the position where the directors have recognised a set of circumstances, unknown outside of the company, which may, or may not, result in a claim? Does a poor financial result, not yet announced, but likely to give rise to substantial adverse comment, given the unexpected nature of the result, amount to potential claims circumstances?

On those simplistic facts, perhaps not. But almost always there are other factors, known to the careful and inquisitive director, that could dictate that such a result be notified as a potential claims circumstance.

The lesson here is this: look carefully at everything you know, or reasonably believe or suspect, and think. If in doubt, notify.

Discard the rose-tinted spectacles

We are all human. It can be hard to admit that on your own watch, things have deteriorated and "the writing's on the wall".

Try not to delude yourself that "it's a one-off event" or "it'll be better next year". To be fair on yourself, make a brutally honest assessment of the situation.

In particular, think carefully about the question which invariably appears (in some form or another) in a D&O proposal: has there been any material change between the date of the financial statements submitted and the date of this proposal?

Case study in D&O insurance

This case involved a company whose sole business was operating three mines. It went to the NSW Supreme Court and the insurer won.

In September, the directors signed off on the 30 June statements in the annual report.

In November/December there were significant changes in the business.

At the end of December the directors submitted a proposal for D&O cover, stating that since 30 June, there had been no subsequent information not disclosed in the annual report that could affect the financial position, capital structure or operations of the corporation.

On 1 January the D&O cover was renewed, but by March an administrator was appointed who later became the liquidator.

Some time later, the liquidator sued the directors for insolvent trading. The directors claimed indemnity from their D&O insurer and the insurer denied cover on the basis of a false answer to a question in the proposal. The denial was upheld by the NSW Supreme Court.

Company's financial situation deteriorated significantly over six months

In a nutshell, the factual position was that the 30 June statements presented a rosy outlook for the corporate group. However, by December there had been significant changes:

  • A project at a particular mine that had been highlighted in the annual report had been suspended.
  • The alternative project would be likely to produce lower grade ore and would not come into production for at least six months, causing production (and hence income) from that mine to drop significantly in the interim.
  • Reserves at that mine had halved from the figure stated in the annual report.
  • Grades at the second mine had been falling since October and were well below budget.
  • Reserves at this second mine were also falling and would continue to fall.
  • As a result of a falling commodity price, the second mine had become a loss making venture.
  • Grades at the third mine were significantly below forecast and income was thus falling below budget.
  • The third mine would be exhausted in about six months and would have to be closed at significant cost.
  • Cash resources were substantially depleted.
  • Net current assets had fallen from a positive as at 30 June to a negative.
  • Between June and the end of October, a cumulative loss had developed as against the budgeted profit.
  • There were severe liquidity problems. Cheques were being drawn but held back.
  • Falling commodity prices had rendered hedging contracts inoperative.
  • The managing director knew that rights issue proceeds, which had been raised for specific exploration purposes, would inevitably have to be used, to some extent, to pay creditors.

Quite clearly, a prudent and inquisitive director ought to have been aware of all of these factors.

Directors should have been aware of the risk of insolvency

Had the directors thought about the situation of the group, they should have realised that as at November/December, there was a very real risk of insolvency, in which event there could be a claim against them. Had they notified the insurer at that point, they would likely have been covered in the event of a claim, because the expiring policy did not have an insolvency exclusion.

On top of that, an administrator appointed at that time may have been able to rescue the situation - we will never know.

Insurer refuses to indemnify directors

The insurer, however, knew nothing about these matters affecting the business until after the administrator was appointed some three months later and the directors notified the insurer of a "potential claims circumstance".

Not surprisingly, the insurer's approach was this: had you properly answered the question in the proposal, then at the very least, we would have offered terms only on the basis that there was an insolvency exclusion in the D&O policy.

There are several lessons to be learned from this case:

  • Always look critically at the business operations.
  • Understand the implications of what is happening - if you don't, get off the board.
  • Always ask: what if?
  • Quiz the managing director/CEO and make sure you get the whole story.
  • Meet regularly, certainly as often as may be needed to keep a close eye on a deteriorating situation.
  • Abandon your ego: do not be blind to the fact that things may have gone wrong "on your watch".
  • If in doubt, notify.

This is commentary published by Colin Biggers & Paisley for general information purposes only. This should not be relied on as specific advice. You should seek your own legal and other advice for any question, or for any specific situation or proposal, before making any final decision. The content also is subject to change. A person listed may not be admitted as a lawyer in all States and Territories. © Colin Biggers & Paisley, Australia 2024.

Related Articles