Directors' and officers' liability insurance in Hong Kong 1

A recent article in the Economist contained a rather unusual revelation: Warren Buffet does not buy D&O insurance for the board of Berkshire Hathaway. Strange, you might think, that a company so extensively interested in the insurance industry should spurn a product which corporate America has widely embraced, but Mr Buffet’s rationale seems to be that the absence of a ‘safety net’ for his board focuses their minds wonderfully on the decisions that face them. Warren Buffet has long been synonymous with successfully being unconventional, but he certainly seems to be swimming against a D&O tide that has not yet reached its high point.

In Hong Kong, the tide has only just started to turn. Awareness of D&O as a product is improving, but we still have a long way to go before we see the kind of market penetration that is evident in the USA, for example. Fewer policies mean lower numbers of claims and less litigation. The fledgling state of the market is reflected by the fact that there are no reported cases dealing with D&O policy issues in Hong Kong.

Directors’ indemnities and section 165 of the Companies Ordinance

D&O liability cover in Hong Kong is inextricably linked to the law on directors’ indemnities derived over the years from the Courts’ evolving perceptions of public policy and the law of agency. The law itself has been codified in section 165 of the Hong Kong Companies Ordinance.

Section 165 has generally been interpreted as permitting the reimbursement by a D&O carrier of any indemnity a company may give to a director, provided judgment is given in the director’s favour or he or she is acquitted. Conversely, it prohibits a carrier from reimbursing a director in respect of any loss caused by proven negligence or breach of duty or trust.

D&O liability cover in Hong Kong is structured in two parts: part A cover providing an indemnity directly to a director, with part B cover providing an indemnity to companies to reimburse them for any payment they may in turn have been permitted by section 165 to make to their director by way of an indemnity. One might ask why part A cover has been provided in D&O policies in Hong Kong, given that it seems to conflict with section 165? The answer may be that section 165 appears to allow a D&O carrier to indemnify a director in relation to a claim by a third party as opposed to a claim by the company. Part A cover might therefore benefit a director in the event that a third party claim, e.g. a representative action brought by a company’s shareholders in their own names against a director without the company’s authority, is made at a time when the company becomes insolvent. If the part A premium (which is generally a nominal figure in comparison to the premium charged for part B cover) has been paid in full before the company becomes insolvent, but the part B premium is paid by instalments, the part A cover is likely to remain intact to respond to the third party claim even if the part B cover lapses because the company is unable to pay the part B premium instalments.

Reform of section 165 of the Companies Ordinance

Although the Standing Committee on Company Law Reform in Hong Kong has been aware of the limitations inherent in section 165 since 1992, its amendment has only recently found its way onto Hong Kong’s legislative agenda. Although a proposed new section 165 retains much of the existing section 165, it seeks to clarify the scope of the indemnity a company may offer to its directors and puts beyond doubt that companies are permitted to purchase wide-ranging D&O liability cover for their directors. The new provision is expected to come into force during the second half of 2003.

The new section 165 should improve the situation for directors and companies in three ways. First, it will allow companies to purchase insurance cover for directors in relation to their liability to the company and third parties. Second, it will no longer be necessary for a claim to be dismissed or for there to be an acquittal before cover is triggered. Given that defence costs are often incurred negotiating settlements and before the outcome of a trial is known, this aspect of the reform of section 165 represents a positive step forward. Third, although it provides clarification that fidelity cover against a director’s fraud is still prohibited, the new section allows cover to be provided for the costs of defending claims involving allegations of fraud.

It seems unlikely that the proposed reforms to section 165 of the Companies Ordinance will trigger an increase in the incidence of D&O policies being issued in Hong Kong, since those who are most likely to purchase such cover already do so. They may, however, lead to more claims because of the wider scope of the indemnity they permit D&O policies to offer. D&O cover is likely to become a more prominent issue in compensation negotiations between directors and their prospective or current employers as a result. Companies might also decide that they can take advantage of the changes to restrict the scope of the indemnities their Articles of Association make available to their boards.

Compensation and penalties

Punitive, aggravated, multiple and exemplary damages, fines and penalties are much like elephants; you know them when you see them but they are difficult to describe. This may explain why D&O policies rarely define such terms, even though they commonly exclude the carrier’s liability for them. Terms such as “exemplary” or “aggravated” probably present few D&O coverage problems in practice because the Courts will usually use those descriptions where they award damages of that nature, but the position is less clear where compensation is awarded for civil liability under a statutory enactment.

Some Ordinances in Hong Kong make an explicit distinction between compensation and penalties, whilst others are not so clear. The point gains practical significance when one considers the variety of circumstances in which the Courts in Hong Kong can order compensation under Ordinances such as the Mandatory Provident Schemes Ordinance, the Securities and Futures Ordinance and the Companies Ordinance.

By way of example, section 295E(1)(a) of the Hong Kong Companies (Corporate Rescue) Bill provides that a person liable for insolvent trading may be ordered to pay “such compensation to the company as the court thinks proper in all the circumstances of the case”. Since the provision places no explicit cap on the amount or type of award that may be made individuals may find that they are held liable for all the consequences of insolvent trading even if they were triggered by only a relatively small insolvent trading debt.

Although the Law Reform Commission in Hong Kong has expressed the view that the proposed section 295E(1)(a) is not intended to be punitive, it does leave open the possibility that compensation might be awarded which is not a genuine reflection of the loss sustained as a result of insolvent trading. Whilst D&O carriers might be encouraged to exclude cover for such awards because they are punitive or exemplary in character, an insured might challenge such a decision by distinguishing the compensatory element of an award from the punitive element. The fine judgement and, no doubt, expert evidence needed to achieve that aim leaves complex insolvency cases potentially vulnerable to expensive D&O coverage litigation.

By way of contrast, the Hong Kong Government’s legislative draftsmen have adopted a much less problematic approach to statutory compensation in the new Securities and Futures Ordinance. The Ordinance not only puts beyond doubt that it provides for compensation in the form of damages, but it also establishes an explicit link between negligent misrepresentation and pecuniary loss sustained as a result. The likely consequence is that that coverage disputes over whether damages awarded under are penal or compensatory are likely to arise only infrequently. Indeed, the Securities and Futures Ordinance appears to have the potential to create significant exposures for D&O carriers.

For further information, please contact Tim Ingham at [email protected] or Steven Dewhurst at [email protected] or on +852 2846 3575.