Directors' indemnities: the new regime

The reform of section 310 of the Companies Act will relax the restrictions on companies' powers to protect their directors from liability – but there is some tightening of the regime, too.

The new regime

The Higgs review of the role and effectiveness of non–executive directors highlighted a shortage of suitable candidates for directorships, and the Department of Trade and Industry concluded after its own consultation that two factors in particular were affecting the recruitment and behaviour of directors: an increase in legal action against directors personally, especially through a sharp rise in class actions in the US; and the cost of lengthy court proceedings. When things go wrong, directors can face financial ruin long before the case comes to trial. As a result of section 310 of the Companies Act 1985, they must rely on their own resources, third party funding or insurance cover to see them through the often long and expensive process of defending themselves.

Chapter 3 of the Companies (Audit, Investigations and Community Enterprise) Act 2004, which is coming into force on 6 April, is designed to alleviate the position by letting companies assist their directors financially while litigation or other proceedings are going on, and by letting them indemnify their directors against certain liabilities to third parties even if the directors are at fault.

The current regime

The legislation from which section 310 derives was introduced because companies had begun to adopt articles relieving their directors from the consequences of breaching their duties. Any provision – in the articles or in any contract with the company or otherwise - that exempts or indemnifies directors guilty of negligence, default, breach of duty or breach of trust in relation to the company is void.

Section 310 permits a company to grant its director an indemnity against his legal costs if he is successful in defending legal proceedings - but he can only enforce the indemnity when he obtains judgment in his favour or is acquitted or granted relief by the court: in other words, at the end of the process. He could therefore face a two-year preparation for trial, punctuated by tactical applications to court, and ongoing legal and experts' costs: all without financial support from the company. The section permits companies to purchase liability insurance (and this will not change under the new regime), and the policy may enable the director to fight on, but what if the cover is not enough? He may, after all, have to share with a number of fellow directors.

The Act will insert new sections 309A, 309B, 309C and 337A into the Companies Act, all dealing exclusively with directors (including de facto directors – in other words, persons who act as directors even if they do not have the formal title). Section 310 will be restricted to auditors, and will no longer affect other officers, such as company secretaries.

The prohibition on exemption

The DTI does not intend to relax the prohibition on exemptions from directors' liabilities, so any article or contractual term stating, for example, that the directors shall not be liable to the company in negligence will be of no legal effect. In fact, the new formulation is more far-reaching than section 310, in that it removes any doubt that exemptions from liabilities arising under statute are within the prohibition.

As with the current regime, if the prohibition is read literally it is wide enough to nullify contractual terms between directors and third parties. Any exemption from any liability attaching to a director in connection with any negligence, default, breach of duty or breach of trust by him in relation to the company is void. It is possible, for example, for a director to be directly liable to a shareholder or creditor for negligence or default in the course of his dealings in the company's affairs. He might be liable to a third party for breach of warranty of authority, in connection with the breach of duty he committed by exceeding his powers as a director. There is nothing to indicate that any exemption the director may have negotiated with the third party could not be challenged under the new section 309A.

Indemnities by associated companies

It has been thought for some time that, despite the very wide wording of section 310, it does not limit the scope of indemnities given by third parties to the directors. This interpretation has had judicial support (and is tacitly admitted in the Explanatory Notes to the new Act), and it has become acceptable for parent companies to protect directors of their subsidiaries with extensive indemnities. The DTI, however, regards this as a loophole that must be closed.

The new section 309A provides that any provision (in the articles or a contract or otherwise) by which a company directly or indirectly indemnifies its own director or a director of its associated company against any liability attaching to him in connection with any negligence, default, breach of duty or breach of trust by him in relation to his company is void. (This is subject to a company's power to grant "qualifying third party indemnity provisions", as described below).

Companies will be treated as associated with each other if they are companies in the same group. On normal principles, as the definition specifies "companies" in the same group, a foreign corporation will be outside the definition.

The statutory instrument (SI 2004/3322) that brings the new regime into force provides that contracts that were permitted under the current regime but would be prohibited under the new one will remain effective if they were made before 29 October 2004. So it is too late to put a parent company indemnity in place, except on an interim basis.

The new formulation leaves no doubt, however, that indemnities provided by other third parties are outside the scope of the prohibition.

Qualifying third party indemnity provisions

Companies and associated companies will be able to grant indemnities if they are "qualifying third party indemnity provisions" (QTPIPs). Careful drafting is needed, because if it exceeds what is permitted in any respect the indemnity will be wholly void, and not merely to the extent that it goes too far.

• A provision will qualify if it indemnifies directors against liabilities (such as damages, costs and interest) in a civil action by a person other than the company or an associated company, and against their defence costs as the action proceeds, even if judgment is given against the directors or the case is settled out of court or otherwise comes to an end without judgment being obtained.
• It can also cover civil actions by the company or an associated company, but it must not indemnify directors against any liability to the company or any associated company (such as for damages, interest and costs, or under an obligation to repay an advance or reimburse expenditure made in accordance with section 337A, as explained below), or cover any costs incurred in defending a civil action by the company or an associated company where judgment is given against the director. In other words, as under the current regime, the indemnity will operate in relation to the directors' costs in successfully defending themselves, and only once the outcome is known. One significant difference is that, unlike the current regime, there will be no question that the indemnity can operate where an action is settled out of court or otherwise comes to an end without judgment being obtained.
• It must not cover any fine in criminal proceedings or any penalty imposed by a regulator, or any costs incurred in defending criminal proceedings where the director is convicted. This means that the company cannot be bound to pay criminal defence costs for him while the trial proceeds (although, as explained below, it will be able to lend the director funds to meet his expenditure before the outcome is known).
• It must not cover the costs of any application to the court for relief under the Companies Act where relief is refused (although, again, the company will be able to lend the director funds to meet his expenditure before the outcome is known).

There is no bar on indemnifying the director against costs as he incurs them in regulatory proceedings, even where his defence fails. An indemnity can also cover costs where a criminal prosecution is dropped without a formal acquittal, or an application for relief is withdrawn without being refused, although in either case only once this has happened.

Funding defence expenditure as it arises

The new section 337A enables companies to fund directors' defence expenditure as the action proceeds. This is distinct from indemnifying the director, where the director has no obligation to refund the money. Instead, the company can pay his costs on the basis that he will reimburse the company in due course, or lend him the money. It makes no difference whether the proceedings are taken by a third party or by the company itself.

The Companies Act contains tight restrictions on loans to directors, and also on transactions of a similar nature or effect, although currently some of the restrictions apply only to a public company or a company in the same group as a public company (termed a "relevant company").

Under the new regime, the normal restrictions will not apply where the company does anything to put the director in funds to meet his expenditure in defending civil or criminal proceedings, or in applying to the court for relief under the Companies Act. Neither will the normal restrictions stop the company from doing anything to enable the director to avoid incurring the expenditure. This presumably covers transactions such as "quasi-loans", in which the same effect as a loan is achieved: for example, if the company pays the costs on the basis that the director will reimburse the company later. The DTI is also understood to regard this provision as enabling the company to assist a director facing non-judicial proceedings – for example, before a regulator such as the FSA – although the reasoning is a little circuitous: by helping him at this stage, the company might prevent his incurring a civil penalty and hence avoid his incurring expenditure for any court proceedings taken to enforce payment of the penalty.

The terms of arrangement must provide at inception that any loan by the company will fall to be repaid or any liability it has undertaken will fall to be discharged on its behalf immediately (after taking account of any appeal periods) if the director loses in the criminal or civil proceedings or the application for relief is refused. Otherwise (including, for example, if a prosecution is dropped, a civil action is settled out of court or a relief application is withdrawn) the parties are free to decide their own terms for reimbursement. The company might waive the debt if it is decided that it is in the company's best interests to let the director off.

If a company is not a "relevant company" and enters into a quasi-loan (for example, by paying the director's costs in the expectation that he will refund the expenditure later), the company will not need to take advantage of section 337A or to comply with it, since it will not be making a loan to the director within the meaning of the restrictions. The DTI is known to be planning to change this.

Disclosure

The directors' report in the company's annual report and accounts will have to disclose the existence of a QTPIP (or, if the QTPIP is provided by an associated company, it must be disclosed in both companies' reports). QTPIPs will have to be open to inspection by the shareholders of the company (and, if applicable, the shareholders of an associated company). But any arrangement to lend money to a director to meet his defence costs will not have to be disclosed.

Things to check

• Does the company have the power, and do the directors have authority, to grant a QTPIP? It will be necessary to check the company's power to give indemnities in its memorandum, and whether the articles enable the directors to enter into the more extensive type of indemnity that will become possible. Most companies' articles reflect regulation 118 of Table A, which authorises only indemnities within the present regime, and they will therefore have to amend their articles if they wish to take advantage of the new regime. The DTI has not taken the opportunity to conform regulation 118 to the new regime – apparently on the grounds that, if Table A authorised the board to make maximum use of the new provisions, that would become the norm and pre-empt any consideration of whether it was appropriate for a particular company.
• Does the company have the power, and do the directors have authority, to make advances as contemplated by section 337A? It may be advisable to make specific provision in the company's objects clause, and a revised indemnities article is likely to include express reference to action taken in accordance with section 337A.
• Should shareholder approval be obtained for QTPIPs and advances? This is not a statutory requirement, but may be advisable in view of the greatly increased exposure of the company that will be possible under the new regime in relation to awards made in third party civil actions and the risk that advances will not be recoverable.
• Should the company review its insurance cover? How does the existing policy interact with the new regime? Does the relaxation for third party claims and advances mean that cover can be reduced?
• Review the terms of existing indemnities? Will they remain valid under the new regime? Should they be amended to pre-ordain the provision of section 337A advances in favour of the director, or is that to be left for negotiation as the need arises?