The April 2005 changes to UK directors' indemnification law generally broaden the circumstances in which companies can indemnify their directors, if they are faced with liability suits But how far can

The new UK regime, introduced by the Companies (Audit, Investigations and Community Enterprise) Act 2004, sections 19-20, features new Companies Act 1985 sections 309A-C and 337A. One effect is that companies are no longer prohibited from giving indemnities in respect of the liabilities of directors to third parties, including US shareholder class action claims.

A recent client seminar held by Marsh looked at the implications of this and other changes. Michael Brown, Insurance Group, Allen & Overy, set the scene, saying that the world of directors' and officers' liability (D&O) insurance changed about four years ago when the cost and scope of D&O cover became more problematic and more visible in board rooms. Linked to that has been a change in the way that directors have to operate because of a broadening in the scope of corporate governance responsibilities.

Many directors are now focusing on their liability exposures, particularly in terms of US class action claims.

Under the old law - section 310 of the Companies Act 1985 - it was not possible for a company to give indemnity to a director or officer in respect of liabilities owed in relation to the company. A company could only reimburse its directors or officers for their defence costs after the event and then only if they had been exonerated. That left the director with the burden and responsibility of funding his own defence in the absence of any D&O insurance cover.

The old law did permit companies to indemnify directors of subsidiaries.

However, indemnities could not be given by a subsidiary to directors of holding or sister companies. It was unclear whether a company could give an indemnity to a director in respect of the liability he owed to third parties, for example shareholders in a US class action claim. This has become a significant risk for European companies with US listings or business.

As a result, directors were heavily dependent on D&O cover, not least to fund their defence costs.

The changes to the Companies Act mean that s310 now only applies to the scope of indemnity that a company can give its external auditors. The new regulatory structure came into effect on 6 April 2005. It is effective retrospectively to 28 October 2004, although any indemnity arrangements which companies at that time had established under s310 remain valid.

In the light of these changes in the Companies Act, the UK Listings Authority (UKLA) is amending its listing rules on related party transactions as they apply to indemnity contracts between companies and their directors.

Director indemnities remain exempt from the requirement to obtain shareholder approval. The new listing rules will preclude overseas subsidiaries of listed companies (which are not subject to the Companies Act regime) from granting broader indemnities to directors than a UK listed company can do under the new law unless they have public shareholder approval to do so. This may cause a number of practical problems for listed companies.

Some principles have not changed under the new regime. Directors still owe their duties to the company rather than to individual shareholders, creditors or employees. As a result, with very few exceptions, English law requires breach of duty claims against directors to be brought by, or in the name of, the company.

Companies remain prohibited from exonerating directors from, or indemnifying them against, their liability 'in connection with any negligence, breach of duty or breach of trust in relation to the company'. This rule is based on the public policy principle that it would be self-defeating if a company that has suffered loss as a result of a breach of duty by a director had to fund the cost of remedying that breach out of its own assets.

The ability of a UK company to provide indemnities downwards to directors of UK subsidiaries has now been removed. However, since the Companies Act does not regulate non-UK companies, this does not restrict the scope of indemnities that can be given by non-UK companies in the group to directors of group companies - though for UK listed companies there may now be the UKLA rules problem mentioned earlier.

Under the new legal regime, a UK company is allowed to give indemnities via the so-called qualifying third party indemnity provision (QTPIP) against liabilities owed by a director to third parties, subject to the corporate benefit test, except that directors may not be indemnified against criminal or regulatory fines or penalties.

A further significant change is that companies will be free for the first time to fund a director's defence costs if he is sued for breach of duty, and in relation to a relief application under s727 (an application to the court for discretionary relief from a liability where the court considers that relief would be reasonable). However, the QTPIP contract must provide for the funding to be subject to claw back in most cases if the director is not exonerated.

Any indemnities granted under the new legal regime will be subject to disclosure obligations, and boards who grant an indemnity to a director will therefore be publicly accountable for that decision.

Companies should check that the director indemnity and lending powers in their existing Articles of Association work under the new legislation, and be prepared to make any necessary changes. There is likely to be renewed pressure from directors for indemnity provisions to be included in a service contract. Judging the position from a corporate benefit standpoint and balancing that with personal ambition will create inevitable conflicts.

Many companies may conclude that it will be appropriate to offer directors the comfort of a fall-back indemnity against the cost of defending themselves against claims by the company or third parties, subject to repayment if the director is held to have acted in breach of duty. However, it remains to be seen whether many companies will decide that it is appropriate to expose company assets to indemnify a director who has breached a duty to a third party, beyond paying for D&O insurance for the director against that exposure.

The need for D&O insurance remains as powerful as ever. The scope of indemnity that a company can grant is not as wide as that provided by D&O insurance, and directors will want to have access to a source of funding independent of the company that might be the entity suing them. Also the availability of D&O cover is important for a company in deciding to fund directors' defence costs because of the claw back provision and the possibility that a director may not be in a position to repay possibly substantial defence costs. So D&O cover remains critical.

Opting for higher retentions?

Nick Foord-Kelsey, D&O practice leader for Europe, Marsh, looked at the impact of the changes on D&O insurance programmes. He said that the new indemnification law increases the significance of retentions in D&O insurance programmes. While retentions do not apply to so-called Side A cover which deals with non-indemnifiable loss and protects directors' personal assets, they normally apply for Side B insurance (losses which the company is permitted to indemnify) and Side C cover (which relates to securities claims) where a company's own assets are at risk.

Historically, retentions have been imposed by insurers, who have offered little incentive in terms of discounted premium for companies to increase them, because they considered the company's opportunity to indemnify its directors was remote. Now with the improved ability for companies to indemnify directors, companies may be able to obtain higher premium discounts, which may help to justify decisions to indemnify directors to their shareholders.

So companies should review their retention levels and consider the availability of premium savings.

In some circumstances, it may be possible for a company to use its captive insurer to underwrite its retention level. However, putting the corporate risk covered by Side B and Side C insurance into a captive may not be economically attractive. Captives are suited to underwriting high frequency, low severity risks, and D&O liability is a low frequency, high severity risk.

There might also be a problem in transferring Side A cover - that related to directors' losses that are not indemnifiable by the company - into a captive. Usually a captive insurer is an associated company, and the UK law provides that associated companies cannot provide an indemnity where the company itself is prohibited from doing so. However, the Companies Act only applies to companies registered in the UK so this prohibition does not apply to an offshore captive. Nevertheless, the decision to transfer Side A cover to the captive requires careful consideration at the highest level. If a large claim had to be settled by the captive, how comfortable would the chairman feel about telling shareholders that their money had been spent in circumstances where the UK parent company was prohibited from indemnifying under English law?

Companies should also consider the possible impact on current claims of changing their Articles of Association to reflect the new law. Since the provisions apply to liabilities arising before 6 April, a current claim which was previously not indemnifiable might become so before its conclusion if a company changes its indemnity provisions. In such a case, insurers might seek to apply the indemnifiable loss retention at that point.

Nick Foord-Kelsey uttered a word of warning as regards some of the standard policy wordings currently in use in the market. He said these were badly drafted, suggesting that indemnification should be made wherever legally permissible. Where a company had not changed its Articles of Association to provide indemnification, this could mean that a director would be left personally liable for the amount of the retention.

Introducing indemnity provisions coupled with increasing corporate retentions will lower the cost of D&O insurance. However, D&O cover does have exclusions, for example relating to directors' fraud and dishonesty.

A US case highlights the importance of directors being able to demonstrate that they give proper consideration to the issues when considering indemnification.

Here the company indemnified its directors, as it was permitted to do, when they were being prosecuted. The defence costs totalled $5m, but the directors concerned were found guilty, went to gaol and became bankrupt, so the company could not recover its money. The shareholders then sued those directors who had allowed the money to be advanced. They were found in breach of their fiduciary duties because they had not considered the possibility that the company might not be able to reclaim its money.

What advice should risk managers be giving their boards? The most sensible course, outlined by the seminar speakers, might be to amend the Articles of Association to provide that indemnification may be made - and then to consider each individual situation to assess whether indemnification is in the best interests of the company.

- Sue Copeman is editor, StrategicRISK.