A steady stream of regulation has imposed stringent requirements on European company directors and officers. Sue Copeman looks at the areas that risk professionals believe have implications for manage

Most board members look at overall risks and probably are not too concerned about specific risk transfer arrangements, leaving them to the risk manager. But if there is one area likely to get their blood racing it is directors' and officers' liability (D&O) cover. Without the right programme or adequate reimbursement arrangements in place, they could end up personally liable for a great deal of money. So what is new on the D&O scene?

The issues

In addition to the effects of the US/UK extradition treaty and the implications of the new Companies Act, which are discussed elsewhere in this special report, Paul Hopkin, technical director of AIRMIC (Association of Insurance and Risk Managers) suggests that a narrow, but nonetheless important, issue is the probable introduction of corporate killing during the course of 2007. This was covered in the Queen's Speech last month. Says Hopkin: "It involves not so much a huge change in the law, but a change in priority and perception of health and safety responsibilities, so it may have a significant impact on behaviour." It is unlikely that any additional insurance protection will be required. Lee Lindsay, technical director of legal for the D&O team at Aon, says that Aon believes that D&O policies already provide coverage for corporate manslaughter actions.

Hopkin considers that directors are generally becoming more aware of their responsibilities, with a greater focus on corporate social responsibility (CSR), ethical trading and the environment. "There is a greater focus on CSR issues and I think that will affect directors' behaviour."

Martin Beagley, executive director, FINEX, Willis, warns that there is talk of some US lawyers, either in partnership with UK lawyers or establishing independent practices in the UK, bringing derivative type claims against UK companies following the change in UK company law. "When the flood gates open, they may believe that they could have a field day here, but it remains to be seen whether derivative claims against UK companies will be successful."

Lindsay concurs. "There could possible be an increase in class action law suits - there are certainly attorneys from the US that have come to the UK and are soliciting individuals to join classes to bring law suits against companies in some European countries."

Andre Basile, vice president of financial lines management liability, AIG Europe (UK), considers that compliance with Sarbanes-Oxley 404 is a key issue, which will force some companies to reconsider whether or not they want to be listed in the US. The US Securities and Exchange Commission has recently made it easier for companies to deregister from US exchanges, and a number of European-based companies may take advantage of this.

Basile thinks too that foreign exchange issues could hamper some companies' financial stability, particularly those that have taken an "aggressive approach" to their financial reporting. And he also highlights the implications of the multinational enforcement of US security laws. For example, in respect of the Royal Ahold claim which was settled earlier this year for $1.1bn, the claim was brought in the US, and one of the factors in determining damages in a securities claim is the market capitalisation loss that occurs between the period before the announcement was made and the day the curative announcement is made. That information is used as the basis for damages. Basile explained that before Royal Ahold made its announcement, it had a cap of around $330m. Afterwards it lost $200m of its market capitalisation - over 60% - and the securities loss settlement was more than five times that market cap loss. Non-US shareholders were allowed to participate in that litigation. Says Basile: "It is important for companies to consider not just their exposure but also their conduct in the US. This conduct can be used to bring non-US shareholders into an action, and it is a significant issue for European companies."

John Batch, senior vice president, FINPRO Practice, Marsh Ltd, believes that several issues which have emerged in 2006 will continue to be important next year. First, he cites severability and non-rescission. "Severability, whereby the policy applies as a separate contract for each director, and rescission are interlinked. Regulators are now more likely to push for a finding of guilt than allow out of court settlements without admission of liability, and insurers are taking different approaches to this." Basile agrees that severability continues to be a concern for companies. However, he says, "For the most part the market has responded to it by continuing to offer broader severability clauses than they have in the past."

Batch explains that non-rescission clauses have been available for some time under Side A broad form policies and can now be included within the traditional D&O contract. "But they may take away more cover than they grant, restricting the cover that would be otherwise legally available."

He stresses, however, that there is the ability to build some additional protection against avoidance of contract into the policy. "This needs to be structured carefully, with appropriate advice on how these provisions will work."

Another major issue that Batch highlights is that of local policies. "This is something we are talking to our clients about - whether in certain territories they actually want a local policy to reflect the local legislation or the local insurance regulations."

Lindsay believes that another issue for directors and officers in Europe is addressing the increased costs associated with corporate governance. "Many European companies are going to be faced with ever stricter corporate governance, either self imposed, imposed as a result of shareholder pressure, or imposed by government and regulatory agencies. Along with these increased costs will be increased requirements and a greater need for directors and officers to understand their responsibilities."

Basile says that more companies are buying Side A difference in conditions policies in the UK. Since companies may be prohibited for indemnifying directors and officers in certain jurisdictions, insurers offering broad Side A policies may find that they are faced with an unexpectedly high number of losses relating to claims that the company was not able to indemnify in the jurisdiction where they occurred.

The spread of legislation allowing class actions is also a concern. Says Basile: "One of my biggest concerns is the spread of class action litigation around the world. In Germany there is the Capital Markets Model Case Act, which allows a plaintiff to bring a case and other plaintiffs that have similar actions to follow on its heels. The first case that is heard is considered the model, with the subsequent actions' settlements falling in line with it and all sharing the costs associated with the preceding model. It is not quite as attractive as bringing a US class action funded by the Plaintiffs Bar, as the litigants actually have something to lose.

"In Australia, some litigation funding firms have been established, looking to back cases with potential settlements of A$2m or more. So we are seeing more class type actions in jurisdictions outside the US and a proliferation of enabling legislation around the world. France is now considering this. Although initially it appears to be focusing on consumer litigants, in my opinion that is just the first step before a move to corporate class action litigation."

Costs and claims

Probably the single most significant determining factor in respect of the premium charged for D&O cover is whether or not the company concerned has US exposure. Hopkin stresses that this need not be through a listing on the US stock exchange: "If there are any US activities, there's an exposure." He suggests that other factors that underwriters are likely to take into account include the length of service of the board, how long the CEO and group finance director have held their positions, the quality and standing of non executive directors, corporate stability, historical share price, and acquisition and disposal activities.

"The lowest risk company would probably be one based in the UK, which is not listed and supplies products in the UK only, with a board of directors who are well respected and have not changed very much. The more you deviate from that simple model, the higher the premium is likely to be," he says.

Beagley comments: "Apart from US exposure, other factors that affect the cost of cover include the company's area of operation, industry sector, claims record and its share price performance. Financial institutions are viewed as presenting potentially high losses, particularly in the employment practices liability area - most of the large EPL claims have been against banks and other financial institutions. Pharmaceutical and chemical companies are also regarded as high risk."

While underwriters continue to assess their D&O clients carefully, in fact there has been a general reduction in claims. For example, this year has seen a significant fall in claims relating to US shareholders' class actions against companies. Batch comments: "This may be attributed to changed US corporate behaviour resulting from the Sarbanes-Oxley Act as well as the favourable stock market. In 2007, we will be looking to see if this is a continuing trend or just a one-off reduction." However, he warns that, although such class action claims may be reduced in terms of numbers, there have been some very substantial settlements over the last two or three years. Indeed, introducing a D&O briefing for AIRMIC members last September, Michael Lea, head of JLT Risk Solutions' D&O practice said that the average size of a D&O loss worldwide increased from $7m in 1998 to $36m in 2005.

However, Beagley notes a fall in large UK claims this year. "Many of the current UK claims relate to regulatory or investigation issues, and they don't involve a huge amount of money - most are under £250,000. There are very few current claims exceeding £10m."

Lindsay says that D&O claims in Europe tend to have some element of alleged fraud. "But we haven't yet seen a trend in terms of claims related to securities frauds or trends related to claims where there have been class actions."

Basile considers that there are several claims trends particularly relating to the US. "Stock options litigation is one. There are now tens of stock option derivative claims, and we're probably only getting to the middle of it. We are seeing more companies announcing that they have stock option issues that were unknown before. This dates back to the late 1990s, when a number of companies granted stock options and a trend emerged that certain companies always seemed to have granted them on the day that their stock was at a low point. The statistical probability of that consistently happening accidentally is almost impossible, and a recent report indicates that many companies backdated stock options to allow them to exercise them at a lower strike price. It was perfectly legal to do this, provided the company took an expense for it, reflecting the stock option differential.

"More recently I have seen some asset write down claims centred around failure to disclose. The contention is that some of these companies should have known that assets needed to be written down earlier, and announcing it later rather than sooner has put them in a difficult position."

Current high capacity and a generally reasonable claims record mean that, following the trend that began several years ago, premium rates are still reducing. Says Beagley: "Premium rates are continuing to decline but at a slower rate, so we're expecting to see a decrease of about 5% to 7.5% in the next batch of renewals as opposed to the 10% to 20% that we were seeing two years ago." Batch and Lindsay both confirm that there is a great deal of competition for both primary and excess level covers. Hopkin suggests that perhaps the spectre of huge US failures, such as Enron and WorldCom, has faded somewhat in people's memories.

Basile agrees that premium rates have fallen in the last few years but issues a word of warning. "It seems to me that people used as a proxy for premiums the number of US class action securities claims, but I believe that number is becoming less meaningful in the overall scheme of D&O liability. Although the number of securities claims has dropped, there is an increasing number of derivative claims, particularly with stock option cases, and that is not included in the class action securities claims figures. In addition, although claims have gone down over the last few years and people attribute that to Sarbanes-Oxley and increased regulation, in my experience, the creativity of the Plaintiffs Bar means that new legislation tends to lead to more litigation."

Managing the risks

Most large companies have adopted or enhanced corporate governance processes over the last few years, and clearly managing the D&O risks is very much a matter of making sure that you adhere to corporate governance and keep to the rules. Many claims involve regulatory matters, so it is important to ensure compliance.

Paul Hopkin recommends the corporate governance guide published by the London Stock Exchange. "It sets out the factors which go into making a good corporate governance model for a company. These include clear responsibilities, well defined delegation of authority, a focus on corporate social responsibility, and adequate attention to risk and audit."

Lindsay has some firm views on D&O risk management. "With the current emphasis on corporate governance, directors and officers have to understand their risk in terms of claims and law suits and follow through. A company should start by educating directors and officers about their duties, responsibilities and where risks lie, and then ensure they have strong corporate governance to back up and support their directors and officers."

- Sue Copeman is editor, StrategicRISK

Risks rising for directors?

Recent legislative changes mean that directors are under more pressure than ever before to perform within strict new guidelines, or face the consequences.

The Companies Act of 2006 overhauled the regime which governs companies and their directors, making directors' duties clearer, but arguably more onerous, than previously. By requiring directors to promote the success of the company for the benefit of the members, the Act heightens the need for directors to pay closer attention to the long-term consequences and environmental impact of any decisions. It also paves the way for shareholders to bring a derivative action against directors as a remedy.

The Extradition Act of 2003, under which UK directors can be extradited to the US and most EU member states, also remains a significant concern. As almost all UK financial crimes can be considered extradition offences, businesses with US links must be aware of the need to comply with US law. This was a lesson which the 'NatWest Three' overlooked to their cost, probably because all business was conducted in the UK, barring one meeting in Houston and communication over US computer networks.

These developments - along with heightened interest in the actions of directors from regulators, shareholders and the media - mean that directors and officers must have comprehensive knowledge of their responsibilities and potential liabilities. They must also have the right D&O cover in place to make sure that they are receiving the highest level of guidance and protection available.

- Andre Basile, vice president, financial lines, AIG Europe (UK) Limited.