Apart from the high profile case of the NatWest Three, D&O cases rarely hit the headlines. But the sector remains a hotbed of activity, with the equity market boom and new laws driving current trends, explains Adam Codrington

Directors and officers (D&O) litigation is like an iceberg: a small number of court actions may be visible on the surface, while a much larger number of potential claims lurk beneath. Few headline-grabbing cases appeared last year but insurers nonetheless reported an overall increase in the number of notifications filed by companies under D&O policies. Potential danger, it seems, lies ahead.

The apparent paradox – more notices and fewer claims – is partly driven by booming securities markets. At more than $250bn globally, initial public offerings broke records last year, but the newly-listed companies have yet to be tested by a less benign economic environment. Similarly, in 2006, mergers and acquisitions beat records established in the dotcom boom of the late 1990s, with nearly $4trn of corporate transactions globally and $1.5trn in Europe.

Although investment bankers expect the boom to continue into the first half of 2007, it is worth noting that the current bull market is nearly four years old. This is much longer than the average bull market. When the downturn comes, some of the more positive statements in offer documents may be challenged. Directors should be vigilant in reviewing their insurance cover in the event of shareholder litigation, especially for those companies exposed to US-based investors.

Potentially litigious environment

Aside from a change in macro-economic conditions, UK and European directors must also be wary of recent and prospective changes in legislation. At nearly 900 pages and with over 1,500 clauses, the UK’s Company Law Reform Act is the longest single piece of legislation ever to have passed through the House of Commons. The act widens the concept of stakeholders in a business and will enable third parties and minority shareholders to bring derivative actions against company boards. These are lawsuits where shareholders seek to enforce the company’s rights when directors have allegedly breached their duties.

The government hopes to have limited mischievous impact from this new source of litigation by making litigants responsible for legal costs and making the awards from derivative actions payable to all shareholders (ie the company). But it could well also offer an opportunity for more claims. Directors should note that companies will not be permitted to indemnify them for any recovery in a derivative action. Instead they will have to look to their D&O policy or personal assets.

New European legislation will also continue to affect UK companies in 2007. For example, the EU’s Transparency Directive – implemented in January 2007 – increases the scope of directors’ responsibility for information given in initial public offerings.

The simple fact is that once the bear market returns and litigants return with it, there will be more laws for them to play with. Directors should take a close look at the wording of existing D&O policies to make sure that new responsibilities are within the scope of their policies.

This already seems to be happening. According to a Towers Perrin survey in April 2007, companies received a record number of enquiries in 2006 (up 16% from 2005) from potential board members who were concerned about their current D&O liability insurance. Certainly the appetite for action on the part of aggrieved shareholders is not diminishing. Institutions are increasingly inclined to take an active role on corporate governance issues and to question management performance.

“Directors should take a close look at the wording
of existing D&O policies to make sure that new responsibilities are within the scope of their policies

Think global

Last year’s extradition to the US of the “NatWest Three” illustrates the new perils facing directors as a result of an increasingly global economy, and the risks are not limited to the US. Some countries – including Russia, Brazil, Korea, Japan and France – prohibit indemnification of directors. Therefore, a global policy that appears to offer comfort in a London head office might fall down for a subsidiary in Rio de Janeiro or Moscow.

In some cases, directors may need personal cover with a locally-placed D&O policy that strictly complies with the wording of local law. Generally speaking, directors need to check that their D&O policies explicitly provide cover for extradition proceedings. Some policies may require specific endorsements to confirm this.

The increasing complexity of directors’ liability puts detailed D&O policy analysis and management centre stage in any corporation’s risk management strategy. Buying cover is not simply a box-ticking exercise, and ensuring that policies contain the correct contractual language is essential as insurers become more aggressive in defending claims.

D&O insurers have their work cut out. The price of insurance premiums in the market continues to drift downwards as a result of increasing capacity and appetite for risk. Buyers can also choose from a wider range of products, with some carriers offering non-rescindable cover where other policy limits are exhausted or otherwise compromised. D&O cover, in other words, is not a commodity product and directors should seek out tailored solutions for their specific requirements.

Insurers’ appetite for D&O risk has not been tempered to any great extent by the reinsurance market, which still remains wary of the class and the very attractive terms offered. Despite this, capacity in the reinsurance market has grown, albeit modestly, and without the introduction of significant new players. The market still pays attention to US exposures and the expansion of coverage, such as additional limits for non-executive directors.

By far the most concerning issue for reinsurers is the continuing reduction in premiums for the insurance risk. This reduction appears justified by the performance of the class as a whole in recent years, but cannot continue indefinitely as results are so heavily influenced by both insurance market and economic cycles.

Adam Codrington is executive director of Aon’s professional services group.

The NatWest Three

The “NatWest Three” – also known as the “Enron Three” – are three British bankers, extradited to the US to stand trial on 13 July 2006.

The trio – Giles Darby, David Bermingham and Gary Mulgrew – were accused of advising their former employer, Greenwich NatWest, to sell part of a company owned by Enron for less than it was worth. It was allegedly sold to Enron via a small company owned by Enron chief financial officer Andrew Fastow, with the Three and Fastow pocketing the difference. The Three were issued with arrest warrants shortly after the collapse of the energy giant, and indicted by a grand jury in Houston, Texas in September 2002. They successfully fought extradition for four years, until their appeal was rejected by the High Court in 2006.

Extradition from the UK to the US is ruled by the controversial Extradition Act 2003. The case sparked a major debate on the extent to which directors & officers policies cover the costs of defending and appealing extradition. In the case of the Three, the bankers, who were extradited through a fast-track system, were told to stump up $1m or guarantees, or face jail.

The Three’s trial date has been set to 4 September 2007, until which time they are bound to wear monitoring devices and forbidden to leave the Houston area. They face up to nine years in jail.