Photo of Joe BrennanBy Joe BrennanOctober 22 2015
Business Law

Directors and Officers – Take Steps to Reduce Your Risk of Personal Liability

Before considering becoming, or continuing to serve as, a director or officer of a corporation you should consider if the corporation has an adequate indemnification and insurance program in place to reduce your risk of being exposed to personal liability.  Take the following steps to protect yourself:

1. Corporate Legislation

Ensure that the governing corporate legislation allows the corporation to indemnify its directors and officers. Most corporate legislation in Canada provides that a corporation may do so provided certain tests are met. However, note that the language is generally “permissive” (i.e. the corporation “may” indemnify) rather than mandatory (i.e. the corporation “shall” indemnify).

2. Constating Documents

Review the indemnification provisions, if any, in the corporation’s articles and by-laws. It would be unusual for the articles or by-laws to restrict indemnification.  But ideally they will be more proactive and state that the corporation must indemnify the directors and officers of the corporation to the fullest extent permitted by law (i.e. this puts a positive obligation on the corporation to indemnify rather than a passive ability to indemnify).  But if they are silent, you should still be okay so long as you also receive an indemnification agreement from the corporation.

3. Indemnification Agreement

Even if the articles or by-laws do contain the aforementioned indemnification obligation, it is prudent for directors and officers of a corporation to also obtain an indemnification agreement that contractually obligates the corporation to indemnify the director or officer to the fullest extent permitted by law.  The indemnification agreement should further specify the procedural rights and responsibilities of each of the corporation and the affected director or officer. For example, an indemnification agreement will typically obligate the corporation to pay, in advance, defence costs as such expenses are incurred so that the director or officer is never out of pocket for such expenses.  Having an indemnification agreement in place that sets out these rights and responsibilities will be make it easier for the affected director or officer to enforce the indemnification obligation against the corporation in a court of law, if necessary.

4. D&O Insurance Coverage

Notwithstanding the foregoing, there are many circumstances where the corporation’s indemnification obligations under corporate law or under an indemnification agreement are inadequate, difficult to access or unavailable.  For example:

  1. The corporation may become insolvent and unable to honour its indemnification obligations.
  2. The corporation may have a board that is hostile to the indemnified party and therefore refuses to honour its indemnification obligations.
  3. Indemnification may simply be unavailable if a court finds that the indemnified party’s conduct was not in the best interests of the corporation or that the indemnified party had no reasonable grounds for believing his or her conduct was lawful.

As such, it is prudent to ensure that the corporation also has in place adequate D&O insurance coverage.

Indemnification Agreements

The following concepts should be appropriately reflected in an indemnification agreement:

  1. Agreement to Serve: The individual shall agree to serve as a director or officer of the corporation.
  2. Agreement to Indemnify: The corporation shall agree to indemnify the individual to the fullest extent permitted by law.
  3. Conditions Precedent to Indemnification: Include the following basic conditions precedent to indemnification:
    1. The indemnified party shall have acted honestly and in good faith with a view to the best interests of the corporation, and
    2. In the case of a criminal or administrative action or proceeding that is enforced by a monetary penalty, the indemnified party shall have had reasonable grounds for believing that the indemnified party’s conduct was lawful.
  4. Application for Court Approval: The corporation shall be obligated, at its expense, to make application for, and to use its best efforts to obtain, the Court’s approval to such indemnification, if required.
  5. Advancement of Expenses: The corporation shall be obligated to pay, in advance, all costs, charges and expenses reasonably incurred by the indemnified party in connection with investigating, defending or appealing any civil, criminal or administrative action or proceeding, actual or threatened, as may be appropriate to enable the indemnified party to properly investigate, defend or appeal such action or proceeding.
  6. Repayment of Defense Costs if Not Successful: The indemnified party shall be obligated to repay any such advanced funds referred to in item 5 above if the indemnified party does not meet the conditions precedent in item 3 above or is not substantially successful on the merits in the indemnified party’s defence of the action or proceeding. [However, even if the indemnified party is not substantially successful on the merits of the defence but does otherwise meet the conditions precedent to indemnification in item 3 above, the indemnified party will still be entitled to indemnification for such costs from the corporation.]
  7. Loan by Corporation: If the indemnified party is required to repay the costs advanced pursuant to item 5, the corporation shall agree to provide an interest free loan to the indemnified party in an amount equal to the amount required to be repaid by the indemnified party, such loan repayable within 3-5 years of the final determination of the action, claim, demand or proceeding and expiry of all rights of appeal in relation thereto. Note that some companies agree to loan an amount equal to the full amount that the indemnified party would have otherwise been entitled to be indemnified for but for lack of meeting the conditions precedent set forth in item 3 above , not just the costs advanced.]
  8. Retention of Counsel: The corporation shall be obligated to promptly retain counsel reasonably satisfactory to the indemnified party to represent such person.
  9. Right to Separate Counsel: The indemnified party shall have the right to obtain other counsel to act at its own expense provided that the corporation shall pay the costs of such counsel if: (i) the corporation has not taken up the defence and employed counsel within ten days; or (ii) either party is advised by its counsel that representation of both parties by the same counsel would be inappropriate due to actual or potential differing interests between them (including the availability of different defences).
  10. D&O Insurance: The corporation shall be obligated to: (i) obtain and maintain a reasonable amount of D&O insurance coverage for the benefit of the indemnified party; and (ii) maintain that D&O insurance coverage for a period of 2-6 years from the date that the indemnified party ceases to be a director or officer of the corporation.
  11. Tax Gross Up: The corporation shall agree to reimburse the indemnified party for all taxes payable by the indemnified party should indemnification under the indemnification agreement constitute a taxable benefit to the indemnified party.

D&O Insurance

D&O insurance policies are negotiable and the terms can vary greatly from policy to policy.  The discussion below highlights certain key provisions that you should consider when obtaining or evaluating a corporation’s D&O insurance coverage.

1. What types of loss are included in the policy?

D&O insurance may include some or all of the following coverages:

  • Side A – Personal Asset Protection for Directors and Officers: Generally speaking, this covers directors and officers personally for covered claims for which they are not indemnified by the insured corporation. This may include circumstances where: (i) the corporation is insolvent; (ii) the corporation refuses to pay; or (iii) the corporation is not required to indemnify.  Note that there should be no deductible payable for Side A claims.
  • Side B – Corporate Asset Protection for Indemnification Claims: This reimburses the insured corporation for the costs of indemnifying directors and officers.
  • Side C -- Corporate Asset Protection for Other Claims: This covers the corporation for other claims made against the corporation itself such as claims for breaching securities laws.

If the directors or officers are worried about the insolvency of the corporation, they should obtain some form of run-off insurance that will commence upon the conclusion of the policy and continue for 2-6 years.

2. If Side C coverage is included, what additional protections are in place for D&O?

In a “shared policy” with both Side A coverage and Side C coverage, the coverage limits under the policy may be exhausted before the directors and officers are fully reimbursed for their losses.  Suggestions to avoid this problem include the following:

  • Purchase “Side A Only” insurance as a separate policy.
  • Purchase “Side A Difference in Condition (DIC)” excess coverage. This excess coverage provides additional coverage for directors and officers only when the underlying limits on the policy are exhausted.
  • Include a “priority of payments” clause in favour of directors and officers.
3. Who is covered under the policy?

The policy needs to be reviewed to determine if it provides coverage for the following individuals:

  • All persons that may be directors and officers of the corporation during the term of the policy including those that cease to act as a director or officer during the term and those that are appointed after the policy commences.
  • All persons that may be directors and officers of any subsidiary or affiliate of the corporation during the term of the policy, including any subsidiaries disposed of during the term of the policy and any subsidiaries acquired during the term of the policy [Note: review how these terms are defined to ensure they include non-incorporated entities such as partnerships.]
  • Spouses and common law partners of each of the foregoing.
  • Heirs, legal representatives, estates and legal assigns of each of the foregoing.

Also review the policy to determine if coverage applies to directors and officers only in those capacities or if it extends to such people for activities in their capacities as advisors or consultants to the corporation (typically not).

4. What is the term of the policy, when must claims arise and when must claims be reported?

Most D&O policies are issued for one year terms. They are also typically issued on a “claims-made and reported” basis meaning the policy only covers claims made and reported during the policy period, regardless of when the actions giving rise to the claim occurred (i.e. claims arising prior to the term will not be covered and claims arising after the term will not be covered even if the actions giving rise to the claim occurred during the term). Notwithstanding the foregoing, some policies may have grace period (i.e. 60-90 days) after the term of the policy to report a claim that arose during the term of the policy.  Further, for policies that are not renewed, it may be possible to obtain “extended discovery period” coverage (i.e. 12 months) providing coverage for claims arising during the term of the policy but not discovered until after the term of the policy.

5. Can the insurer terminate coverage early?

Many D&O insurance policies allow the insurer to cancel coverage on 60-90 days’ notice. It is possible that circumstances could arise that lead to a potential claim being made, the insurer then cancelling coverage on such short notice, the corporation being left without D&O insurance and the claim being made after the termination of the coverage.  As such, the D&O policy should stipulate that the insurer may only terminate coverage for non-payment and after giving the corporation a reasonable opportunity to cure that non-payment.

6. What constitutes a covered “claim”?

Under most D&O policies a claim does not typically occur until a specified formal action is initiated against the directors or officers, such as (i) receipt of a written demand for monetary damages; or (ii) the formal commencement of civil, criminal or regulatory proceedings. For clarity, be aware that these policies do not typically consider informal investigations or inquiries to be a covered claim.

7. What types of claims are included in the coverage?

The policy will specify the types of claims that are covered. Consequently, you will want to ask the following questions:

  • Is coverage limited to claims based on negligence?
  • Or does it extend to intentional and deliberate conduct later found to be wrongful (excluding insider trading, fraud and other crimes)?
  • Are regulatory investigations and enforcement proceedings covered?
  • Are administrative, civil and arbitration proceedings covered?
  • Are securities law based claims covered?
8. What types of claims are excluded from coverage?

Listed below are examples of the types of claims that are typically excluded from coverage:

  • Claims arising from matters that are uninsurable at law such as insider trading, fraud and other crimes.  [Note that defense costs should nonetheless be covered until a final, non-appealable determination by an adjudicator has been made that such uninsurable actions have occurred.]
  • Claims arising from bodily injury, mental or emotional distress or property damage.
  • Claims arising from environmental damage [Note: I strongly suggest this exclusion should be resisted unless D&O coverage for this matter is included in another policy.]
  • Claims arising from allegations made by one insured against another insured, subject to certain carve outs; and
  • Claims arising from violations of pension legislation or a breach of fiduciary duty with respect to any pension, profit sharing or other employee benefit plan or trust [Note: I also strongly suggest this exclusion should be resisted unless D&O coverage for this matter is included in another policy.]

If you want coverage for one or more of these types of claims (with the exception of matters that are uninsurable), you will need to negotiate that into the policy.

9. What types of losses or damages are covered?

The policy will include a comprehensive definition of “loss” (i.e. for which a person will be insured) and potentially an extensive list of exclusions to the definition of “loss”.  You will want to review that definition and those exclusions closely to ensure that you are comfortable that you are obtaining the protection you need.  Consider whether the following losses are covered:

  • Statutory liabilities (i.e. unpaid employee wages and vacation pay; unremitted employee source deductions, pension plan and employment insurance premiums; income taxes withheld on payments to non-residents; sales tax; etc.).
  • Fines and penalties.
  • Judgments, including pre-judgement and post-judgement interest.
  • Punitive, exemplary or multiplied damages.
  • Settlements.
  • Defences costs, or settlement costs, including full legal, accounting, and investigative costs.
10. Who controls the defence of the action?

Typically the insurer controls the defence and has the right to appoint legal counsel, approve defense costs (where the insured maintains control of the defence), and approve any settlements or compromises.  Note that the insurer should not be able to admit guilt on behalf of the insured, or obligate the insured to make any payments, without the consent of the insured such consent not to be unreasonably withheld. Also consider if the policy addresses how defence costs will be allocated among the different insured parties, or among both insured and non-insured matters, or among both insured and non-insured parties.  Another related, but important, question is whether the defence costs are included within, and therefore applied to, the policy limit.

Invitation for Discussion:

If you would like to discuss the topics raised herein or any other business law matter, please do not hesitate to contact one of the lawyers in the Business Law group at Shea Nerland LLP.

Disclaimer:

Note that the foregoing is for general discussion purposes only and should not be construed as legal advice to any one person or company. If the issues discussed herein affect you or your company, you are encouraged to seek proper legal advice.

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