This article was written by Travis Toemoe, Mandy Tsang, Jason Chow and Astrid Sugden.
Traditionally, many listed companies hold reimbursement insurance cover for claims against directors and officers (Side B Cover) and securities claims cover (Side C Cover) under a directors’ and officers’ (D&O) insurance policy. However, in recent times, many are questioning what value or benefit holding these covers has in light of the difficult D&O market conditions.
The covers are increasingly more expensive and despite increased cost are often narrowing in scope. That together with the perception that companies holding Side C Cover make themselves targets for securities claims (and especially class actions) have seen some companies opt out of buying Side C Cover or it simply being unavailable. Similar issues are beginning to arise for Side B Cover.
In determining whether to take out Side B Cover and/or Side C Cover, a company and its directors need to balance the benefits which may be provided by those covers and the premium payable, with the company’s need for such covers.
In making such a determination, directors must have regard to their duties as imposed by the Corporations Act 2001 (Cth) (Corporations Act) and under general law.
Why do companies take out Side B and/or Side C Cover?
Side B Cover
Side B Cover provides reimbursement cover to the company itself for its liability in providing indemnity to the company’s directors and officers (in other words, balance sheet protection against the company’s indemnity obligations to directors and officers). Side B of a D&O policy allows a company to transfer to an insurer its liability for certain liabilities and costs under a deed of indemnity between the company and director/officer.
The protection provided by Side B and Side C Cover may be particularly relevant given the increasingly complex and challenging environment in which companies are presently operating and boards are required to make decisions. This challenging environment has been exacerbated by the uncertainties brought by COVID-19. In particular, many companies are operating in an environment of frequent regulatory changes and increased regulatory oversight. Additionally, many companies have been the subject of a higher level of scrutiny by the community (consider the “community expectations” approach taken by the Banking Royal Commission).
Such increase in regulatory actions and class actions have seen more claims and investigations brought against directors and officers for which they have sought indemnity from their companies, who have in turn sought indemnity from insurers under their Side B Cover.
Side C Cover
Added to the heightened regulatory and community scrutiny discussed above, there is increasing activity from litigation funders and class action law firms in Australia.
This environment has seen a notable increase in the number of securities claims which are being threatened and brought against companies. These securities claims often include allegations of breaches of continuous disclosure obligations, breaches of fiduciary obligations and/or misleading and deceptive conduct and usually are brought in the form of a class action. These claims are normally covered under the Side C Cover.
Difficulties in obtaining Side B and C cover
There has been a “hardening” of the D&O market in recent times, as premium amounts continue to increase (often considerably year on year). Marsh has stated that “We are in the midst of the most volatile and restrictive D&O Insurance market in the history of the segment.”
This is particularly the case for Side C Cover, which has become increasingly difficult to obtain, with there being more limited coverage available in the market and that coverage becoming more restricted in scope. Even where Side C Cover is offered, such coverage is normally very expensive, has a high retention and/or does not provide coverage for the full limit of liability which the company requires.
Indeed, between 2011 and 2018, ASX200 companies have seen premiums rise on average by a staggering 250%. Companies were also forced to retain more risk, with the companies typically increasing the amount four-fold to over $10 million per loss. During the course of the first quarter of 2020 alone, D&O premiums rose by an average of 225%, with some premiums rising by as much as 400% - 500% for the biggest (securities class actions exposed) ASX listed companies. Insurers also often now require a minimum retention for Side C Cover of between $10 million and $50 million where the relevant company is an ASX-listed entity, with extreme examples reaching up to around $225 million. This effectively means the company funds its legal defence costs and any contribution from D&O insurance only comes where there is a settlement or judgment against the company.
It is likely that these market conditions have arisen as a result of historical under-pricing of D&O Policies and an increase in the number of class actions being brought against companies – in particular, the number of securities claims class actions. In this regard, Marsh has indicated that there has been a “four-fold increase in the average number of securities class action claims per year over the last 10 years” and that this number continues to rise. Further, Marsh has observed that on average, class actions seek compensation of between A$50 million and A$75 million, with a number of ASX shareholder claims having been settled for amounts in excess of $100 million. Unfortunately, in the existing environment, statistics indicate that ASX200 entities stand a one-in-ten chance of being the subject of a class action each year.
Anecdotally, those companies that hold Side C Cover appear more likely to be the subject of a securities class action. This is seemingly because many of the class members remain shareholders so if the class action is not insured, the class action has the effect of reducing or destroying shareholder value for the existing shareholders.
Balance must be sought between the cost of cover and the protection required by the company
As a result of the prevailing market conditions, the need for companies and directors to consider whether the limits of liability under the D&O policy need to be reduced or whether components of the cover provided under the D&O policy should be removed is increasingly common.
These considerations are further complicated by the possibility that claims made by the company under a D&O policy’s Side C Cover could erode the aggregate limit of liability under the policy, which also protects directors (and the company’s indemnity obligations to the directors). Therefore, in a worst-case scenario, a significant securities claim made under the Side C Cover could erode the aggregate limit of liability under the policy in its entirety. In these circumstances, directors and officers, as well as any other insured persons under the policy, may be left uninsured or with reduced amounts of cover. This complication may give rise to an actual, or at the very least to a perceived, conflict of interest on the part of the directors, as the removal of Side C Cover under a D&O Policy would mitigate this risk.
Any determination regarding whether or not to take out Side B or Side C Cover should seek a balance between the respective benefits which may be provided to the company as a whole and the associated amount of premium payable. A company may choose not to take out Side B or Side C Cover if the amount of the associated premium payable is disproportionate to the benefits which may be gained by the company in holding the cover. A further consideration for Side C Cover is whether holding such cover makes the company more of a target for Securities Claims.
Any Board determination regarding whether or not to take out Side B or Side C Cover must be made having regard to the directors’ duties under the Corporations Act and general law. Of particular relevance to such a determination are the duties to act with reasonable care and diligence and to act in good faith in the best interests of the company as a whole.
There are also ways to mitigate the risk that a Side C claim could erode the aggregate limit of liability under the policy. Order of Payment clauses can be included in D&O policy to provide payment first to insured persons before the company. There are also ways of structuring a D&O programme so that that are dedicated cover available only to insured persons.
We have also seen an increase in the use of overseas captive arrangements whereby a company can insure a risk through an overseas entity which in turn reinsures that risk to the reinsurace market. A company may retain more risk in such a structure but there are ways to structure the arrangement such that a company can obtain tax and capital benefits.
These are challenging times and companies are increasingly looking to innovative solutions.
 Public Submission to the Parliamentary Joint Committee on Corporations and Financial Services into the Inquiry into ‘Litigation Funding And The Regulation Of The Class Action Industry’ dated 11 June 2020, by Marsh JLT Specialty
 See above.
 See above.
 See above.
 ‘The D&O Insurance Wave: Staying Above Water’ dated December 2019, by Marsh JLT Specialty.
 See above.
 See above.