The liberalised Chinese economy should indicate great potential for the Directors' & Officers' market, but not before tackling governance issues, says David Walters

A lot has been said recently about new business opportunities in China. In particular there has been an increased focus on developing Directors' & Officers' (D&O) policy liability protection. Since 1991 the number of listed companies in China has surged from 14 to over 1,200. Clearly with such growth and an influx of overseas investment, the stage should now be set for a D&O explosion matching that of the Chinese economy.

However, two interesting trends have occurred in parallel which may offset that explosion. First, the global D&O market has been rocked by corporate scandals in the US and Europe. And second, China has witnessed its own problems - Guangxia (Yinchuan) Industry having been dubbed the "Chinese Enron". Enron and WorldCom happened in the most sophisticated corporate territory in the world and the D&O market will be making payments for these losses, estimated at $191m during 2005.

Whilst the D&O market is keen to look at new territories, insurers have become increasingly cautious as a result of these now infamous accounting scandals. Recent trends show a softening in D&O market rates but this must be tempered by a realisation that large losses do now exist. Therefore a wholesale softening of the market - such as was seen in the early 1990s - is not predicted. To understand the future potential of D&O in China it is necessary to look at current trends in the global D&O market.

Governance and the "Chinese Enron"

Following the post-2001 downturn in the US, several issues have arisen.

American corporate law has been strengthened by the introduction of the Sarbanes-Oxley Act and in particular section 404(a), which requires the CEO/CFO to take direct personal responsibility for internal controls and to sign off on them. In the short term it is predicted that this will lead to a rash of restatements - perhaps leading to further D&O claims - but thereafter, a period of much sought-after stability.

On the 13 July 2005, Bernie Ebbers failed in his appeal attempt against the WorldCom judgement and now faces 25 years in jail with no parole.

Further judgements are due to be handed down on Enron and Tyco later this year.

Compare this to the situation in China, where since 1991 there has been a genuine willingness to address corporate governance.

Regulatory authorities such as the China Securities Regulatory Commission (CSRC) have strived to ensure transparency and efficiency in those companies they police. However there have been several factors that have led to underperformance, including poor IPO governance. In an article in the China Business Review - "Corporate Governance with Chinese Characteristics" - Steven Shi and Drake Weisert explain that, "The prevalent mindset among SOE (State Owned Enterprise) managers is that capital raised from the financial markets is free money that can be squandered with impunity." If this is a true reflection of attitudes then a degree of caution when D&O insurers look to expand in China is understandable.

Other barriers to efficiency include an unfair share ownership system, confusion between state and private investors, underdeveloped capital markets and conflicting and competing regulatory authorities. China has also been hit by several corporate scandals of its own and three of these are detailed below:

Lantian. This ecological agricultural company was listed on the Shanghai Stock Exchange in 1996. Following the IPO the company results outperformed suspiciously and this led to an investigation into its affairs. Banks stopped supporting the company and its creditors filed lawsuits. CSRC has launched an investigation into the company's activities.

Maet Optics and Electronics. The CSRC initiated investigations into this company in 2000. By 2001 it announced that the investigation had uncovered falsified sales revenue of $39m and exaggerated profits of $12m. Senior executives and external auditors have been indicted.

Guangxia (Yinchuan) Industry. This company was investigated in 2001 for fabricating sales figures and inflating net profit by $90m. It is known as the "Chinese Enron".

The parallels between these cases and those in the US are striking. Fundamental to the development of Chinese D&O will be the regulatory response to them.

In the US and elsewhere corporate governance has largely stabilised D&O markets and assuaged insurers' fears. It is likely that any explosive growth in Chinese D&O will be contingent on a similar response domestically.

A new Code of Corporate Governance of listed companies in China was announced in 2002. Accounting procedures were tightened and shareholder rights were strengthened. Shi and Weisert believe that "China would do well to learn from its own experience, and that of the United States, and work to improve public trust in its companies."

The D&O learning curve

But Chinese companies should go further than this by absorbing the valuable lessons that can be taken from the western D&O learning curve, including the following:

Personal contribution and independence. One of the most alarming developments arising from Enron and WorldCom was the personal contributions required from their independent or non-executive directors. In the case of WorldCom their personal settlement was $18m and in Enron the total was $13m. Whilst insurance could not have covered this personal element, a concern remains for the executive members of a board that it will be increasingly difficult to recruit non-executive board members of a sufficient calibre - unless they can maximise the protections offered to them. Appropriate measures will include an overhaul of the company indemnification provisions and the purchase of a specific, but complementary non-executive product that would be firewalled so as to not conflict with the company.

Whose policy is it? The second area of concern relating to independence and also emanating from WorldCom and Enron centres on who should actually benefit from a D&O policy. During the late 1990s it became market practice to include the company as an insured in its own right under D&O policies.

This was done largely for those companies with potential US securities liabilities. As cover was broadened, so brokers and their clients generally welcomed the initiative. However, in their haste to secure this cover, brokers and clients alike forgot who the cover was really designed to protect - the directors.

As WorldCom and Enron were declared bankrupt, their D&O policies, which named them as insured parties, were frozen as a corporate asset leaving the directors with potentially no coverage and a legal fight to secure their rights. In our view the right of directors to independent and guaranteed defence is essential. It is clear that Chinese corporations will require a sophisticated D&O response to their environment and the following elements need to be included:

Severability. It is essential that a D&O liability insurance contract is between each individual director and the insurer(s). This guarantees that insurers cannot rescind the entire policy for all directors if one of them provides false or misleading information to insurers. One scenario where this protection is important is when a finance director has deliberately misled insurers and there is a corporate problem as a result. Cover for the directors not involved in this deception may be rescinded unless the insurance contract is clearly at an individual level.

Fraud and dishonesty. Directors, of course, cannot insure themselves for fraud. However a good D&O policy will provide defence costs to a director where he or she has been accused of fraud or dishonesty. The cover will only cease once the alleged fraud or dishonesty has been proven.

Major shareholders exclusion. Most D&O insurers will exclude claims made by shareholders in a company if they own a significant amount of stock (the figure is usually set at 15%). If a company does have a major shareholder, it is important to negotiate with insurers to explore the possibility of reducing the impact of this potentially damaging clause.

Bodily injury/property damage. This exclusion appears on all D&O policies to clarify the position that insurers will not pay claims which can be insured more effectively by a specific type of insurance (eg public or employers' liability). Great care must be taken when reviewing the policy language used. Whilst any direct claim for bodily injury would rightly be excluded, a good policy will provide cover for a secondary regulatory action against directors - a vital enhancement in an age of greater scrutiny of corporate governance.

The stage is set for an interesting period in Chinese corporate governance and D&O. Their mutual fates are contingent on each other.

- David Walters is director of professional risks at Miller Insurance.

"Corporate Governance with Chinese Characteristics", China Business Review, Vol 29, by Steven Shi, a senior consultant at PricewaterhouseCoopers and Drake Weisert an assistant editor of the CBR.