Is D&O the last line of defence on insolvency?

Insolvency filings are increasing across Australia. In the 2022 financial year, there were 6,555 external administration and controller appointments, a 7.9% increase over 2021. Hospitality, retail and construction were sectors of particular concern, increasing 28.4%, 34.7% and 26.1% respectively in the past year.

While safe harbour provisions gave Australian directors and executives protection over insolvent trading during the COVID-19 pandemic, these have ended, as have government assistance programs relied upon to mitigate cash management issues and reduced business inflows. Combined with rising inflation and the prevalence of fixed cost contracts, pressures across a range of organisations continue to mount and Australia has already seen several high-profile collapses. So, for organisations facing insolvency, will Directors’ and Officers’ (D&O) cover now provide the last line of defence?

Pre vs post COVID appointments

Although the appointment of external administrators is increasing, numbers are still far below pre-COVID levels. However, the challenges for Australian companies finding themselves in trouble are manifold. Where corporate indemnification protections are limited, D&O coverage may be the only defence to which directors and executives can turn.

Companies entering external administration and controller appointments Quarterly 2017 to June 2022

Source: ASIC¹

As insolvencies continue to increase, understanding the coverage available under a D&O policy will assist risk professionals during internal conversations with their boards and executives. Close focus is particularly needed when D&O programs are due for renewal, ensuring coverage remains as broad as possible, limit adequacy modelled and considered to meet risk strategy requirements and any restrictions negotiated.

What can you expect from your D&O cover?

Broad coverage for insolvency-related claims is generally contemplated within the D&O policy. Direct or derivative claims may be filed by creditors and/or administrators who may allege breaches of fiduciary duty, corporate waste and/or deepening the insolvency.

In those cases, defence costs, compensatory damages, and settlements are generally subject to coverage; however, other policy provisions may be relevant, depending on the scope and nature of any given matter. Those may include:

• Insolvency exclusion
  Outside of Securities Class Actions claims, insolvency-related claims represent the largest losses in the Australian D&O market. Articulation of an entity’s operations and financial health remains vital in the negotiation of this exclusion. These exclusions can exclude all claims arising from or attributable to insolvency-related matters and can further extend to the failure to pay any debts as and when they fall due. Removal of this exclusion should be always sought and, where removal is unavailable, endorsement language should be limited to insolvency events only.
• Entity vs. Insured/Insured vs. Insured exclusion
  In the context of insolvency, claims may be asserted against directors and officers by trustees, receivers, and other insolvency constituencies. To protect against application of the exclusion, companies should seek to exempt such claims from the exclusion. Additional exclusion carve backs should be considered and sought.
• Side A
  Coverage for non-indemnifiable D&O losses could be impacted to the extent restrictions in law may impede the company’s ability to advance or indemnify losses. Side A is a D&O coverage tool that can yield different results depending on the breadth and levels of coverage, coverage enhancements, and program structure. To the extent companies maintain Side A only policies in their programs, it is less likely that any court would attempt to assert control over their cover.
• Side A Difference In Conditions (DIC)
  Where underlying insurance has excluded insolvency claims, Side A DIC can provide important umbrella protection. Side A DIC may drop down to cover any insolvency-related exclusions within the underlying program.
• Withdrawal of Support exclusion
  In the context of insolvency, claims may arise from the withdrawal of support from certain parties, which may include parent companies, shareholders, financial institutions or governments. Exclusionary language can extend beyond insolvency and restrict coverage around to any failure to pay debt. Removal of these exclusions should be sought and consideration of carve backs where available.
• Order of payments
  A properly worded “order of payments,” or “priority of payments” provision should specify that the insurer is bound to prioritise claim payments under Side A before paying losses under Side B or C. In some cases, the clause may authorise the organisation to advise the insurer to delay payments under Sides B and C in favour of future Side A payments.
• Fraud and deliberate conduct exclusion
  Claims may be excluded where the alleged wrongdoing is proven in a final, non-appealable adjudication. Policy wording specialists can strengthen the exclusion’s conditions to ensure its limitations do not inadvertently and prematurely trigger.
• Definition of Loss
  Coverage may be limited with respect to some forms of non-compensatory relief (such as disgorgement of ill-gotten gain), as well as certain civil fines, penalties, and taxes. The definition of Loss varies between policies and organisations should be aware of the variance in policy language.
• Definition of Transaction
  If a Transaction is trigged, Changes/Alteration in Risk provisions apply and the policy will cease to respond to any acts or investigations occurring or arising after the Transaction date. The definition of Transaction varies between policies and it is imperative the Transaction language is clearly understood. Certain Transaction provisions explicitly include insolvency events. Policy wording specialists should advise of the difference within available policy wordings.

D&O insurance is a policy designed to cover third party liability exposures. Nevertheless, the policy often includes first party coverages that could be beneficial to companies that are insolvent or in the zone of insolvency.

Crisis management

First party coverage may be available in certain instances for crisis management expenses to the extent a company has experienced a “crisis”, as defined in the policy. Events that may trigger coverage include negative earnings announcements, key executive resignations, employee layoffs, product recalls, and elimination or suspension of dividends, among others. The coverage is customarily subject to a sub-limit of liability.

Reputational risk

Similar to crisis management coverage, some policies may include first party coverage for a director’s or officer’s “reputation crisis”. Also, traditionally sub-limited, the coverage may be applicable to individuals to the extent their reputations are adversely impacted in crisis events. The triggers may be narrow and could require the act of an enforcement authority.

Understanding what your D&O policy offers and making informed decisions at executive and board level is crucial ahead of any renewal process. WTW’s expert Financial, Executive and Professional Risks (FINEX) team and dedicated insolvency practice can help evaluate your organisation’s cover, design appropriate risk mitigation and transfer solutions and secure the best possible terms.

Footnote

¹ https://asic.gov.au/regulatory-resources/find-a-document/statistics/insolvency-statistics/insolvency-statistics-series-1-companies-entering-external-administration-and-controller-appointments/?mc_cid=b371648ebc&mc_eid=95f16a64b1