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Corporate governance dangers of deeds of indemnity, access and insurance

Feature Articles

Cite as: (2003) 77(3) LIJ, p.38

Deeds of indemnity, access and insurance need to strike a fair balance between the interests of the directors and those of the company.

By Emilios Kyrou

Most of the recent debate about the excesses of some directors has focused on salaries, bonuses, options and retirement benefits. Deeds of indemnity, access and insurance which are routinely signed by public companies in favour of directors have not received scrutiny. Yet, an overly generous deed has the potential to cause much greater harm to a company than overly generous remuneration, and to raise serious corporate governance issues.[1]

Ironically, the greater the success directors have in forcing their company to agree to generous benefits under a deed, the more they run the risk of not being able to enjoy those benefits. The dramatic changes to the corporate governance and insurance environment since 1 July 2001 mean that it is in the interests of directors, as well as their company, to review deeds executed before that time. If the deeds confer unreasonable benefits on directors, they should be replaced with deeds which strike a fair balance between the interests of the directors and those of the company.

Deeds of indemnity, access and insurance have three components. The indemnity component involves the company agreeing to indemnify the director for liabilities incurred by the director. The access component involves the company agreeing to provide to the director access to the company’s documents while the director holds office and for seven years after ceasing to hold office. The insurance component involves the company agreeing to take out directors’ and officers’ (D&O) insurance to protect the director while the director holds office and for seven years after ceasing to hold office.

These deeds involve a classic conflict of interest scenario for directors. It is in their interest to maximise the benefits to them under the deed, whereas it is in the company’s interest to limit the exposure of the company’s assets to liabilities under the deed.

Since 13 March 2000, there has not been an express prohibition in the Corporations Act on a director participating in board deliberations over execution of a deed in favour of the director or from voting on the deed. Despite the absence of an express prohibition, it is wise for such a director to abstain from any deliberations or voting on the deed. This is because the director is still subject to general duties to the company in relation to the deed, such as the duty of care and diligence (s180 of the Corporations Act (the Act)), the duty to act in good faith and in the best interests of the company (s181 of the Act) and the duty not to improperly use their position (s182 of the Act). In the recent case of Australian Securities and Investments Commission v Adler,[2] it was held that causing a company to enter into an agreement which confers unreasonable personal benefits on a director is in breach of ss180, 181 and 182 of the Act. Further, the key business judgment rule defence for breach of s180 does not apply where the director has a material personal interest in the relevant transaction.

Most deeds provide the maximum indemnity permitted by s199A of the Act. Consequently, they indemnify the director for all liability incurred by the director, other than a liability to the company or a related body corporate, a liability for a pecuniary penalty order or a compensation order, or a liability to a third party that did not arise out of conduct in good faith. All the director’s legal costs are also indemnified, except costs incurred in defending proceedings where the underlying liability cannot be indemnified or for certain other proceedings where the director is unsuccessful.

Subject to the above exceptions, typical indemnities are not limited to particular types of liabilities and there is no monetary cap on the company’s exposure. By entering into such a deed, the company is undertaking contingent liabilities of unknown amounts which may arise in unknown circumstances. Further, many deeds do not reserve a right in the company to revoke or amend the indemnity without the director’s consent. They are thus permanent obligations which will bind the company irrespective of changes in its circumstances. They impose financial obligations which the company may not be able to afford in the future.

In the case of a public company, shareholder approval for a deed is necessary unless the entering into of the deed “would be reasonable in the circumstances of the public company” at the time the deed is made. Ironically, where shareholder approval is not sought, the individuals who decide whether the deed is reasonable are the directors themselves.

The directors’ assessment as to whether the deed is reasonable must be supported by objective facts. If the directors’ assessment is wrong, it means that shareholder approval was legally required and in the absence of shareholder approval, the directors may be liable to a civil penalty and the court may make an order prohibiting any payments being made under the deed.

The current environment of high-profile corporate collapses and high-profile directors being fined and disqualified from being directors lends itself to a dispute over entitlements under a deed coming before the courts.

From the directors’ points of view, now is the worst time for the courts to be looking at these deeds, particularly if the first deed to receive judicial scrutiny involves a disgraced former director.

A factor which would count in favour of the reasonableness of a deed of indemnity, access and insurance is the existence of substantial D&O insurance. If the company is able to pass on the bulk of its liability under a deed of indemnity to a D&O insurer, this would assist in establishing the reasonableness of the deed.

In practice, it is impossible to have a direct match between a company’s liability under a deed of indemnity and the D&O insurer’s liability under the insurance policy. This is because all D&O policies have a cap on cover and various exclusions. Also, D&O policies are usually reviewed, and often amended, on an annual basis whereas deeds of indemnity tend to be permanent.

The utility of access rights under a deed of indemnity, access and insurance has been reduced by the statutory right of access now contained in s198F of the Act. That right, however, is limited to legal proceedings and there is therefore merit in conferring additional rights of access (such as the right to use company documents in a royal commission or in a tax audit) in a deed.

An unresolved issue is whether s198F extends to documents which are protected by legal professional privilege. As a result of the recent High Court decision in Daniels Corporation International Pty Ltd v Australian Competition and Consumer Commission,[3] it is likely that s198F does not abrogate privilege. Often, it is helpful to a former director to have access to privileged documents to assist in defending proceedings that might be taken against him or her. On the other hand, if the company allows a former director to have access to a privileged document, the privilege may be lost and the company may be prejudiced as the result of sensitive information ceasing to have the protection of privilege. Careful drafting is required to make clear the company’s position in relation to privileged documents and to avoid unintentional waiver of privilege.

The insurance component of a deed involves two key issues. The first is the nature of the obligation that a company, acting prudently, should accept. It is unwise, for example, for the company to undertake to purchase insurance covering “all liabilities” incurred by a director, as no D&O policy will cover “all” liabilities. Further, it is dangerous for a company to undertake to ensure that all D&O policies will provide no less cover than the policy in force at the time the deed is signed, as insurers may seek to alter the cover provided once the initial policy expires, may increase premiums to prohibitive levels or may even refuse to provide any further cover at all. It is dangerous for a company to undertake obligations whose performance does not lie entirely within its own control. It is much safer for the company to undertake insurance obligations which are qualified by references to what is reasonably available at reasonable cost.

The other key issue is who pays the premium for the policy. Typically, deeds require the company to pay the entire premium. This is inappropriate, as s199B of the Act prohibits the company from paying a premium for a contract of insurance which provides cover for three prohibited liabilities, namely a liability for conduct involving a wilful breach of duty, a liability for misuse of position or a liability for misuse of information.

Where the prohibition in s199B is infringed, the policy is void insofar as it purports to provide cover for the prohibited liabilities and the company commits a criminal offence of strict liability.

Traditionally, the insurance market has sought to overcome the prohibition in s199B by an endorsement to the policy excluding cover for the prohibited liabilities or, where the policy provides cover for the prohibited liabilities, by allocating 1 per cent of the premium for that cover and requiring the directors to pay that part of the premium.

It is arguable that allocating 1 per cent of the premium to cover for the prohibited liabilities and requiring the directors to pay that part of the premium is not sufficient to overcome the prohibition in s199B. This argument treats the insurance policy as an indivisible contract, so that if the company pays any part of the premium, it is treated as paying a premium for all of the cover provided by the contract, and thus contravenes s199B. Although this argument may be criticised as being too literal, in the absence of judicial guidance on the proper interpretation of s199B, it cannot be ignored. Companies should therefore either require the insurer to exclude cover for the prohibited liabilities and pay the entire premium, or require the insurer to insert an endorsement in the policy which deems the policy to comprise two separate contracts, one in respect of the prohibited liabilities (in which case part of the premium should be allocated to this contract and the directors should pay it) and the other for all remaining liabilities.

It follows from the above discussion that unless new deeds are drafted carefully, and existing deeds reviewed regularly, they may contain time bombs which could cause severe financial or legal difficulties for the company or the directors in the future.

The ideal deed of indemnity, access and insurance should strike a reasonable and fair balance between the interests of the director and those of the company.

Prudent guidelines for negotiating such a deed are:

  • the director and company should be represented by different lawyers;
  • the director should be represented by lawyers who do not usually act for the company;
  • the deed should be prepared by the company’s lawyers, and the onus should be on the director to justify any changes;
  • negotiations should be conducted on an arm’s length basis;
  • the extent to which the company’s obligations under the deed will be picked up under D&O insurance should be taken into account;
  • the director should not participate in any board discussions or voting on the deed; and
  • although shareholder approval is not required, it should be considered in the interests of full disclosure.

EMILIOS KYROU is a partner with Mallesons Stephen Jaques whose practice includes insurance, corporate governance, administrative law and dispute resolution.

The author gratefully acknowledges the research assistance of articled clerk Lachlan Scully.

[1] The Corporations Amendment (Repayment of Directors’ Bonuses) Bill 2002, if enacted in its present form, raises even further corporate governance issues in relation to deeds of indemnity, access and insurance but these are outside the scope of this article.

[2] (2002) 41 ACSR 72 at [458].

[3].(2002) 192 ALR 561.


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