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Mitigating Directors' Risk

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central Legal recommends you seek professional advice before taking any action based on the content of this Bulletin.

31/10/2018

By Law Central Legal

As a director of a company, you may be at personal risk for decisions made in the best interests of the company unless your company indemnifies you. A director’s indemnity involves a company undertaking to protect its directors against liabilities that they may incur in the course of performing their company duties. A director’s indemnity may be required (as in some instances by ASIC) or a company can choose to indemnify their directors.

Whether your company is a small business or an entrepreneurial juggernaut - a director’s indemnity is vital. A director’s indemnity protects corporate directors in the event they are personally sued. Contrary to popular belief, a company does not need to have an action launched by its shareholders for its directors to be made personally liable. Often when a company is sued, directors are brought into legal proceedings by investors, employees, vendors, competitors and customers just to name a few.

There are multiple ways in which a director can be indemnified when acting as an officer of the company. The director may be indemnified by: the company constitution, an indemnity agreement, or Directors & Officers Insurance (D&O Insurance). Each approach comes with its own advantages and disadvantages.

Indemnities in Company Constitution
The company constitution may have provisions which indemnify the director’s personal liability when acting on behalf of the company. The company constitution may also have provisions which grant company officers and directors the right to D&O Insurance. Though indemnity clauses contained in the company constitution are effective, often they do not have the same level of legal protection that an indemnity agreement can offer. There are several reasons why an indemnity agreement is a more secure option.

Firstly, the protection will cease when that person stops being a director. Someone who has ceased to be a director will remain liable for actions taken while they were a director. The company constitution operates as a quasi-contract between various parties to the company. Once the director leaves the position, they cease to be a party to the constitution and can no longer legally enforce it against another party. Thus they may become personally liable but be unable to enforce the indemnity protections that were granted in the constitution.

Secondly, the company constitution can be amended without the consent of the directors. Often the general meeting will hold the power to amend the constitution by a special resolution. The general meeting may amend the constitution and remove any indemnity which is given to the directors. If this occurs, the director will be left with no protection and very little legal recourse to re-implement the indemnity.

Thirdly, the scope of the indemnity provisions contained in the company constitution may not be sufficient. The company constitution covers a large range of issues; indemnities form only a small part of the constitution’s operation. For this reason, indemnities may not have been given the attention they would have received in an indemnity agreement. The constitution may only make an allowance for director’s indemnity, as opposed to actually granting an indemnity. Or it may grant indemnity but with insufficient detail to adequately protect the directors in certain situations. Any director who may seek to rely upon indemnity provisions in a company constitution should be careful to check the protection that is actually granted by the provisions. 

Indemnity Agreement
An indemnity agreement is an agreement entered into between the directors and the company. The agreement will set out the extent of the indemnity and in what circumstances it will apply. It is generally considered to provide superior protection for a director or officer of a company.

An indemnity agreement will operate as a pure contract as opposed to a quasi-contract like the company constitution. This means the director may be able to enforce the indemnity against the company even once they are no longer a director of that company. A director remains a party to the indemnity agreement even once they have left the company. Though they can enforce the agreement, whether an indemnity is still granted will depend on the content of the agreement. If the agreement grants indemnity after the director leaves, the director will be able to rely upon that indemnity.

Unlike the company constitution, the indemnity cannot be amended without the director’s consent. As the agreement will operate as a contract, it can only be varied by agreement of all the parties to the agreement. Thus the indemnity can only be amended with the consent of both the director and the company. This can provide additional protection where the company may wish to modify or remove the indemnity it grants to the director but the director wants the indemnity to remain unchanged.

Finally, the indemnity agreement is likely to be much more comprehensive than the company constitution. As the agreement is for a single purpose, as opposed to many purposes, it will be drafted with that single purpose in mind. It will often grant greater protection, with greater specificity, which can be advantageous to a director who is seeking to rely upon it.

If a company or director is looking at implementing an indemnity agreement, consideration should be given to the content of the company constitution. Any indemnity agreement should be consistent with the provisions of the company constitution. There is the potential for lengthy and expensive litigation if a director seeks to rely on an indemnity agreement which is inconsistent with the company constitution.

Directors & Officers Insurance
D&O Insurance will often operate in addition to an indemnity agreement or indemnity clauses in the company constitution. It is an insurance policy taken out by the company which will cover any indemnity claims made by directors. The content of these policies differs between providers but they generally have the same key features. The insurance will indemnify the officers for personal liabilities and it will reimburse the organisation for the indemnity of its directors.

When the company indemnifies the directors, it is only able to cover the director’s liability with any funds it actually possesses. This means that if the company has limited assets and funds, it may be limited in how much indemnity it can offer. Having D&O Insurance can allow for greater indemnities to be offered and can protect the company assets if those indemnities are claimed. This can provide security to employees and people looking to invest in the company.

If a director or company is seeking to rely on D&O Insurance, consideration should be given to the specifics of each policy. There are often limitations and restrictions which can affect the application of the policy.         

To insure or not to insure?
Law Central offers 2 types of Director’s Indemnity Agreements. The Director's Indemnity Agreement - No Insurance document for when no D & O Insurance is taken, and the Director's Indemnity Agreement - Compulsory Insurance document for circumstances where the company agrees to hold D & O Insurance. Law Central’s Director’s Indemnity Agreements offer protection to directors for up to 7 years after they resign from office. This ensures that company directors are protected from actions brought within the limitation period and any tax audits that may be conducted. However, there are some limitations of a director’s indemnity that may warrant additional cover.

Director’s indemnity will only go so far…
There are limitations as to how much a director’s indemnity can cover. For reasons of public policy and accountability, the government is not willing to absolve directors of all personal liability. It certain situations the directors are to remain personally liable.

Directors and officers may be personally liable for breaching the Corporations Act 2001 (Cth) (Corporations Act) or the Competition and Consumer Act 2010 (Cth) (CCA). Under section 229 of Schedule 2 of the CCA, a company is not allowed to indemnify directors and officers against liability for these breaches or against legal defence costs if such liability is established. Any attempt to indemnify these personal liabilities will be declared void under section 230 of Schedule 2 of the CCA.

However, companies are not prohibited by the CCA or the Corporations Act from arranging D & O insurance for directors and officers. Depending on the insurance policy, directors and officers can be covered against liabilities for these breaches and the associated legal defence costs. As well as protecting corporate directors and officers, D & O insurance may offer added security to future investors.

Under section 199B of the Corporations Act companies are prohibited from paying a premium for an indemnity which seeks to indemnify the director in relation to a wilful breach against the company or a breach of certain director’s duties. The director’s duties that cannot be indemnified are: the duty to not improperly use their position to gain an advantage for themselves or someone else or cause detriment to the corporation; and the duty to not improperly use information obtained as a director to gain an advantage for themselves or someone else or cause detriment to the corporation.

Section 199A of the Corporations Act covers situations where an indemnity for a liability is not allowed. Sub section (2) states, amongst other things, that a company must not indemnify a person against any of the following liabilities incurred as an officer or auditor of the company - “(a) a liability owed to the company or a related body corporate”.

Section 199A(3) covers situations where an indemnity for legal costs are not allowed. In particular under sub section (b) a company must not indemnify a person against legal costs incurred in defending an action for a liability incurred as an officer or auditor of the company if the costs are incurred “in defending or resisting criminal proceedings in which the person is found guilty”. The Court of Appeal of the Supreme Court of Victoria in the case of Note Printing Australia Ltd v Leckenby [2015] VSCA 105 considered the application of this section of the Corporations Act. Gold and Platinum members read on for a summary of this case.

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Final Considerations
It should be a very wary director that operates without any form of indemnification from their company. If your company has chosen to indemnify or insure its directors and officers, make sure it is done correctly. Law Central’s Director’s Indemnity Agreements are a clear and simple way of ensuring that the director is properly protected.

Disclaimer: The content of this Bulletin is general information only. It is not legal advice. Law Central Legal recommends you seek professional advice before taking any action based on the content of this Bulletin.

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