The recent economic landscape has sharpened the focus on the increasing risks of insolvency to directors & officers and, consequently, to providers of Management Liability Insurance (“ML”). Whilst no underwriter deliberately seeks to insure a risk that enters an insolvency proceeding, as sure as night follows day, this will happen. How the ML policy responds is subject to a range of possibilities and the outcomes and available options can differ materially.
At this point, it is useful to briefly review the types of insolvency events most likely to be a feature in the context of ML and the manner in which they might connect (or not) to policy language. Formal insolvency proceedings generally drop into 3 categories:
- Closure (liquidation);
- Enforcement (receivership); and
- Rescue (administration or company voluntary arrangements (‘CVAs’)).
- Liquidation is a terminal procedure for organisations. It may be initiated by the company on a voluntary basis, either because their activities have come to an end (members voluntary liquidation) or because it is insolvent (creditors voluntary liquidation). In both cases, the shareholders instigate the liquidation. A creditor may also petition the court for a winding up (where it has an unsatisfied demand or judgement) – this is a compulsory liquidation. A compulsory liquidation is often an indication that there has been a ‘stressed’ insolvency. Where an organisation finds itself in this territory, there is a greater risk to directors & officers;
- Receivership is technically an out-of-court enforcement mechanism and happens when a lender who holds security over a debt enforces this. Administrative receivership is a procedure used increasingly less often because the security under which receivers are appointed must have been dated prior to 15th September 2003. The second type of receivership proceeding is also known as the Law of Property Act (or LPA) receivership, as the powers and duties of this type of receiver are still governed by the Law of Property Act 1925. It is used by holders of fixed charges to sell the charged assets and repay the debt.
- Administration is an insolvency procedure that can be initiated by the company itself, the holder of a ‘qualifying charge’, or by the court. Administrators have wide powers, and the process brings a safe area from creditor rights or proceedings. Administration was originally designed to rescue the company, but in practice this rarely happens, with a sale/part sale (arguably a rescue of sorts) the frequent outcome. CVAs happen when agreements are made on payment terms with creditors, although they can be quite complex and often involve administration as a pre-cursor. ‘Pre-pack’ administrations are worth a mention here as well. These happen when the management agree to a sale with administrators shortly before, or on, their appointment. The purchasing party is often connected to the business, so it can sometimes be controversial, as it can lack transparency and often leaves some creditors out of the deal and unpaid.
These insolvency events present varying degrees of risk. It is well established that a good proportion of a director’s duties are to the organisation he or she directs, so a liquidator, receiver or administrator will be able to procure the company to sue a director for breach of these duties on insolvency. Liquidators and administrators also have claims in their own name, principally ‘preferences’ and ‘undervalues’. Unlawful preferences are actions that may have affected creditors in the 6 months prior to the administration or liquidation. They must have involved doing something, or suffering something to be done, which had the effect of putting a creditor into a better position than they would otherwise have been in on an insolvent liquidation. The key feature here is the insolvent organisation must have had a ‘dominant intention’ to put a creditor into that better position. If this merely happened as a side effect of legitimate activity, this cannot be challenged as an unlawful preference. Transactions at undervalue can be almost any disposition of company assets for less than full market value during the 2 years prior to either liquidation or administration. Some defences exist, but even where directors do not receive the benefit of a preference or an undervalue, they can be personally liable for breach of duty in procuring them.
Certain claims are only open to liquidators and these include fraudulent and wrongful trading. Although ‘trading’ may sound like a series of acts, it might actually only be a single one. Whilst fraudulent trading requires actual dishonesty and ‘moral blame’, wrongful trading does not. Much has been made of directors duties in the so called ‘twilight zone’, where the company nears insolvency, between the point where insolvency ought to have been recognised as unavoidable and the commencement of insolvency proceedings, and the recent case of Wright and Rowley, BHS and others -v- Chappell and others – Courts and Tribunals Judiciary drew further attention to this, providing little comfort to those who might find themselves similarly situated.
Insolvency practitioners have powers of investigations under S235 of The Insolvency Act 1986. These apply to anyone who was a director or officer and requires them to provide such information covering the company and its promotion, formation, dealings, affairs or property, as the insolvency officer holder may at any time reasonably require. S236 goes further and allows court orders for examination and production of documents from anyone the court thinks is capable of giving the required information.
Without question, insolvency is a period of intense potential difficulty for directors. In addition to investigation risk (insolvency, regulatory, disciplinary and criminal), potential civil exposure may include that wrongful trading risk, misfeasance, unlawful preference, unlawful distribution of assets, fraudulent trading and transactions at undervalue. The rise in prominence of litigation funders only increases the sensitivity around some of these matters.
It has always been the case that policy architecture differs across the market. Whilst no underwriter willingly puts themselves in a position of providing cover on a risk that enters a procedure, the policy wording, and any endorsed adjustments, will have a huge impact on cover outcomes. In the extreme, insolvency exclusions are often applied and might typically read as follows:
“…it is hereby understood and agreed the Insurer shall not be liable for any Loss or any Investigation Costs in respect of any Claim arising from, based upon, or attributable to the financial failure, liquidation, bankruptcy, insolvency, receivership or administration of the Company.”
At the risk of stating the obvious, insolvency exclusions should be avoided. Nonetheless, other restrictions exist, particularly in the online environment, some of which are hard wired into wordings, such as:
- Transactions on Insolvency Clauses – under normal circumstances, if an organisation enters an insolvency proceeding, ownership does not change, so the ML policy should continue to protect the directors. These clauses have the effect of stopping the cover in its tracks, removing any cover from that date onwards, placing policy restrictions and limiting room to manoeuvre;
- Statements of Fact – most of these contain attestations as to the financial condition of an organisation, such as “the company has sufficient financing to meet projected liabilities as they fall due for the next 12 months”, or “the company/organisation made a profit in the last 12 months”. Quite aside from the vagueness, circumstances can quickly change (part of the reason to buy ML in the first place), but this language potentially opens the door to a retro review of cover. This might involve an insolvency exclusion, particularly amongst those markets with a track record of applying them;
- Insolvency proceedings ‘extensions’ – most often these are actually sublimits, and without them, policy limits would otherwise apply;
- Conversion to aggregate limits of liability on insolvency – these provisions are buried in some wordings and amend the basis of the cover from ‘any one claim’ on an insolvency event;
- Retired insured persons – wordings vary here, but often the assumption is that if they have left the business, they are OK. Sadly, this is not always true from a legal or cover perspective, especially if their former employer ceases trading and the policy stops.
Assuming that any in-force policy makes it to what would have been the renewal date, the question then turns to any extended reporting periods that might be available. What a good wording should do is give the option of an extension if “the Insurer or the Policyholder refuses to renew this Policy for any reason other than non-payment of premium, or because of merger or consolidation”. Cover ought to be available for up to 6 years and the authorisation clause should spell out who can control the policy (some policies do not have these…):
The Policyholder hereby agrees to act on behalf of all Insureds with respect to the giving and receiving of notice of Claims or termination, the payment of premiums and the receiving of any return premiums that may become due under this Policy, the negotiation, agreement to and acceptance of endorsements, and the giving or receiving of any notice provided for in this Policy (except for the Insured Persons’ ability to elect an extended reporting period), and the Insureds agree that the Policyholder shall so act on their behalf.
Of course, having the option to extend the policy is one thing, having the money is quite another. The insolvency officer may sanction the spend out of the estate, but this is unusual (and a bad sign for the underwriter!). Given the nature of ML and D&O policies, if an individual pays the premium, the benefit cannot be ring fenced and cover automatically extends to all previously covered individuals. The remaining insured persons may be unaware of any purchase, but that doesn’t change the facts.
The paradox will always be that those might likely to be affected by insolvency may find the cover hardest to find. Notwithstanding, unforeseen insolvency is a standard feature of the ML risk spectrum and should be priced into the product, so if the worst happens, comfort should exist. As with most areas of ML, language matters, and it is vital to give careful focus to the cover and options that are available.
