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Corporate insolvencies set to be the main driver of D&O risk

  • Market Insight 8 July 2020 8 July 2020
  • UK & Europe

  • Insurance & Reinsurance

Even before the advent of Covid-19, insolvency-related D&O claims already made up a large part of the management risk landscape.

Corporate insolvencies set to be the main driver of D&O risk

Corporate insolvencies are on the rise. 2019 saw the highest level of underlying insolvencies since 2013, with the retail, hospitality and construction industries particularly affected. As the ongoing uncertainty of the pandemic further increases the risk that companies will run into financial difficulties, insolvency can only continue to make up a large source of directors’ and officers’ (D&O) claims.

When insolvencies occur, management decisions in the “twilight zone” (somewhere between the point when the company’s financial condition becomes difficult and the commencement of insolvency proceedings) are closely scrutinised. Insolvency practitioners (IPs) are required to investigate and submit reports about the directors to the Secretary of State within three months of the insolvency.

IPs will need to determine whether directors, within the three years before the insolvency, breached any fiduciary duties, insolvency laws (primarily under the Insolvency Act 1986) or company legislation. If the company is listed, directors may also be exposed to actions for breaches of the Market Abuse Regulation, the Listing Rules, AIM Rules, Prospectus Regulation Rules as well as the Financial Services legislation, in particular the provisions on misleading the market.

As a company’s pension fund is often one of the largest creditors, there may also be claims from the Pensions Regulator and/or the pension trustees if the conduct of the directors negatively affected the fund. The regulator has extensive investigatory and enforcement powers and legislation is being drafted to bring in severe criminal sanctions for those that mishandle pension schemes.

Despite many businesses being “mothballed” or “hibernating” at the moment, companies will continue to incur liabilities that could lead to a worsening of the creditors’ position. Further, companies may file for insolvency prematurely because of directors being fearful that if they failed to do so, they might face personal liability for wrongful trading should the company become insolvent.

However, to alleviate directors’ concerns about their potential personal liabilities in such unprecedented times, the UK Government recently enacted the Corporate Insolvency and Governance Act 2020, which, among other things, suspends wrongful trading laws temporarily as a response to Covid-19. It should enable directors to be able to make commercial decisions, which ordinarily would be difficult when the company is in financial distress, with the aim that companies can recover once the worst is over.

However, while this measure may bring some relief to directors, it is unclear if it applies to companies that may have already been in financial difficulty before the retroactive date of the measure (March 1, 2020) and it does not alter the fact that IPs will be required to undertake a full investigation into the directors, should the company become insolvent, whereupon directors may face claims (e.g. for breaches of other insolvency laws which have not been suspended) and, possibly, disqualification and/or compensation orders.

Insurance implications

While the suspension of the wrongful trading laws means insurers should not expect claims in relation to wrongful trading, claims risks against directors remain, and D&O insurers should expect an increase generally in claims notifications and common coverage disputes over which policy responds, whether the terms of the notification clause have been complied with and whether claims aggregate.

 Wordings have broadened in recent years so, when assessing coverage, questions could arise in relation to the capacity in which the person is being investigated and whether the investigation costs cover will pick up the various potential investigations that may be brought. For example, would inquiries before parliamentary select committees be covered? If the director is a member of a regulated profession, such as a solicitor or accountant, there may also be calls to cover Solicitors Regulation Authority and Financial Reporting Council investigations.

Against this backdrop, some insurers are stepping back from D&O or from covering D&Os in certain industries. Others are imposing more restrictive terms or requesting more information at the proposal stage.

The UK is not alone in experiencing an increase in insolvency-related D&O claims. Even before the current crisis such claims already made up a large part of D&Os’ risk landscape in the US, Australia and Germany, for example. Similarly, a number of jurisdictions have sought to lessen the risks of companies becoming insolvent, with most European countries and some other jurisdictions, such as Australia, enacting measures.

Germany, France and Spain, for example, have suspended the obligation to file for insolvency (a company usually has a short period to file after suffering a liquidity risk or becoming over-indebted) and Australia has created a safe harbour from personal liability for insolvent trading.

Whatever accommodation governments and regulators have made, however, it is clear this is a challenging time for all. We do not yet know the full impact the crisis will have on companies, their D&Os and their insurers.

This article first appeared in Insurance Day.

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