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Directors' lIABILITY AND iNDEMNIFICATION

October 2005

Introduction

In response to the DTI’s consultation paper on directors’ and auditors’ liability, the Government has introduced The Companies (Audit, Investigations and Community Enterprise) Act 2004 (“C(AICE)”) which came into force on 6 April of this year. C(AICE) includes measures to deal with the reform of directors’ and auditors’ liability and is widely thought to introduce the most significant changes to the law relating to directors’ liability for nearly 80 years.

Position Pre C(AICE)

Section 310 of the Companies Act 1985 (the “1985 Act”) prevented directors (and auditors) who were negligent, in default, or in breach of duty or trust from being exempted from liability or indemnified by their company. This prohibition was justified on the basis that directors and auditors owe duties to their company, and it is in the best interests of the shareholders that directors should face the consequences for a breach of those duties.

Although there was a narrow exemption available from the core prohibition contained in section 310, to enable a company to take out insurance and to pay the legal costs of a director where such director proved successful in defending proceedings, it has long been considered unfair that directors should face financial hardship in funding their defence, particularly where they are ultimately successful. There was also a general concern in some quarters that potential liability for negligence may be affecting director recruitment (particularly non-executive directors), and the willingness of directors to take informed and rational risks.

Position Post C(AICE)

The new legislation, whilst restating the core prohibition contained in section 310 of the 1985 Act, introduces two relaxations on the prohibition by amending section 310 to allow, though not require, companies to:

indemnify directors against the legal and financial costs of certain proceedings brought against them by “qualifying third parties”;and
pay directors’ defence costs as they are incurred, in both civil and criminal cases, even where the action is brought by the company itself. The director would still be liable to pay any damages awarded to the company and to repay his defence costs to the company if his defence is unsuccessful (unless the company chooses to indemnify him in respect of his legal costs incurred in civil third party proceedings), but not, incidentally, where proceedings settle.

In order for an indemnity to fall within the new exemptions and be considered a “qualifying third party indemnity”, certain conditions must be satisfied:

the indemnity must not extend to any liability incurred by the director to the company or any associated company;
the indemnity must not cover fines imposed in criminal proceedings or penalties imposed by regulatory bodies such as the FSA; and
the indemnity must not cover the legal costs of unsuccessful defence of criminal proceedings, the unsuccessful defence of civil proceedings where the action is brought by the company or an associated company or the unsuccessful application for relief to the court by the director under certain specific applications under the 1985 Act.

C(AICE) also extends the core prohibition in order to prevent a company in the same group from providing an indemnity to a director of another group company in circumstances where it would be unlawful for that indemnity to be provided by the company of which the person is a director. The limited case law on the old section 310 indicated that it did not apply to downstream indemnities (indemnities from holding companies in favour of directors or their subsidiaries) or upstream indemnities (indemnities given by subsidiaries in favour of directors of their holding companies).

The decision to indemnify a director under the new legislation can be taken by the board of directors; no shareholder approval is required.

The new legislation also restates the provisions which permit a company to purchase and maintain liability insurance for its directors.

Disclosure Requirements

Companies that indemnify directors have to disclose the existence of such indemnities each year in the directors’ report, a document which is generally available to the public in the UK . In practice, many provisions in existing articles of association will give rise to this disclosure obligation. In addition, shareholders will have the right to inspect any indemnification agreement.

Comment

The new legislation will be of interest to all directors of UK companies, but will be of particular interest to investor-appointed directors who will now be able to benefit from the greater comfort and certainty afforded by a comprehensive indemnity. The legislation brings the UK more closely into line with the position in the US and is particularly important in an age where there is an increasing focus on corporate governance and the duties and liabilities of directors.

It should be noted that the benefits outlined in this article did not accrue to directors automatically when C(AICE) came into force in April 2005 and direct action must be taken by the company in order for the directors to obtain the benefit of the protection. However, before doing so, the director should verify that any existing indemnities are not wider in scope.

Directors should consider entering into qualifying indemnities with, and obtaining undertakings to pay appropriate defence costs from, their companies, for example in service agreements or letters of appointment. It remains to be seen how market practice will develop in terms of payment of these costs as companies are likely to be reluctant to give a blank cheque. Investors should consider negotiating the inclusion of provisions in the investment agreement requiring the company to enter into qualifying indemnities and pay defence costs for investor-appointed directors. While many existing articles of association will not need to be changed to provide directors with the additional protection, it is advisable to review the relevant provisions.

The White Paper issued in March 2005 by the DTI states, in relation to directors’ liability, that the Government will continue to consider whether concerns about potential liability for negligence are affecting director recruitment and behaviour and, if so, whether such oncerns are still acute enough to justify a further change in the law and possibly permit shareholders to agree to contractually limit their directors’ liability for negligence.

The text of the relevant provisions of the Companies (Audit, Investigations and Community Enterprise) Act 2004 can be found at:

http://www.opsi.gov.uk/acts/acts2004/40027--d.htm

The new provisions form sections 309A, 309B, 309C and 337A of the 1985 Act.