Reducing Directors’ Legal Risk

As we pointed out in our previous newsletter, directors and officers are exposed to increased liabilities like never before. Executives are encouraged not to underestimate the risks nor the level of effort required to manage them efficiently. Whilst D&O Liability Insurance is arguably something that should be at the top of directors’ & officers’ list when taking office, it must however be considered for what it is: a last line of defense. Therefore, before we take a deep dive into the details of such a specific insurance product, let us remember the other mechanism of defense available to executives that allow either to limit the liabilities or to transfer their financial consequences to a third party.

Diligence and competence is a prerequisite

Those executives who are concerned about their potential exposure, as they all ought to be, should in the first instance remember that they are expected to act in a diligent and prudent way. Needless to say for example that absenteeism is never a valid excuse, and that sufficient physical meetings should be hold in order to manage a company. Executives are also encouraged to document with evidence all the decisions they take and effectively review & comment meeting minutes, important contracts or prospectuses. In short, they must act with professionalism and competence in all circumstances.

These are important considerations because management errors are usually appreciated “in abstracto”, i.e. in comparison with the behavior of a prudent and diligent director. Thus being able to demonstrate a prudent and diligent attitude certainly is the first line of defense in case of claims.

The truth is however that no one is ever completely protected from imprudent mistakes. Moreover, if executives were to always act safe, they would take up no opportunities at all.

The discharge (quitus)

The “discharge” (or quitus) is the act by which the company releases the directors, either collectively or individually, from contractual liability towards the company. It is granted by the shareholders of the company in the general meeting approving the annual accounts for the previous financial period. The discharge is an important liability mitigation tool given the fact that directors’ duties are mostrly derived from the contract law between directors and the company.

The release is however only valid if the financial statements presented by those directors to the meeting are fair and complete (no relevant omissions or misstatements) and, in respect of actions in breach of the articles of incorporation of the company, only if these were specifically mentioned in the notice convening the meeting. It is also customary to request a discharge when resigning or being removed.

Even though the discharge of liabilities granted by shareholders effectively releases executives from liability to the company and the shareholders (actio mandati), is does not release from liabilities towards third parties (including, in some instances, minority shareholders on the grounds of liability in tort) and is without effect on the right of action of those third parties.

Moreover, shareholders’ decision to discharge directors from liabilities will be void if made in breach of the law or the company’s articles of association, and directors may still be held liable for willful misconduct, fraud or any criminal offences, notwithstanding any discharge of liabilities.

Statute of limitations

Article 157 of the Luxembourg law of 10th August 1915 on commercial companies provides that actions against directors and officers are normally time-barred after five years as from the time of the alleged error or omission. Criminal actions against directors, on the other hand, are submitted to specific limitation periods which in some instances go up to ten years.

Should the liability result from successive and related events, the time limit only begins to run from the date of the last event. In case of fraudulent acts, such as the voluntarily failing to file the annual accounts, the limitation period will begin only when the harmful event is revealed.

Company Indemnification

The company may agree to indemnify the directors and hold them harmless in the case of a pecuniary claim from a third party against them.

Indemnification clauses are commonly used in the financial industry. They are either foreseen in the articles of association, in which case all directors will benefit from it and the intervention of the general meeting will be required, or take the form of a bilateral agreement or a unilateral declaration, usually in the form of a letter.

Indemnification clauses do not preclude third parties from introducing a claim against the directors. It is not about limiting the liability of the directors, but rather shifting the burden from the directors to the company.

Company indemnification is a first and important level of external assurance. It isn’t perfect, however, because the company granting indemnification could be unable (bankruptcy) or even unwilling to pay. Moreover, an indemnification arrangement may be declared void by Luxembourg courts as far as it covers the consequences of an action brought by the company itself against directors. Finally, indemnification arrangement can not cover willful acts or gross negligence.

Insurance

As a complement to the abovementioned indemnification, executives may have their potential liability insured with an insurer. The so called Directors & Officers (D&O) liability insurance is purchased by the company on behalf of its directors, and covers the liability of the executives towards the company and third parties resulting from management errors or omissions in the performance of their duties.

The insurance may be taken out either by the company itself or the sponsor, main shareholder. In the latter case, executives might feel less comfortable as to their real ability to call upon the insurance, given the remoteness between them and the people in charge of the management of such contract.

D&O insurances are today widely distributed in Luxembourg. Although it may seem easy to purchase, it certainly is not easy to find the right product that efficiently fits the particular needs of a given company. Moreover, like any other insurance, specific terms and conditions apply that may exclude particular situations or risk. It is therefore highly advisable to appoint a truly specialized and independent insurance intermediary to negotiate a bespoke insurance wording with the insurers that will fit your particular requirements.

Leave a Reply

Your email address will not be published. Required fields are marked *

This site uses Akismet to reduce spam. Learn how your comment data is processed.