Reform of directors' and auditors' liability: Government written statement

Following responses to the DTI's December 2003 consultation on directors' and auditors' liability, on 7 September 2004 the DTI, through a written statement to the House of Commons, set out its intentions regarding the reform of section 310 CA 1985.

Directors – reforms finally on the way

The existing restrictions on companies indemnifying or exempting their directors from liability will be relaxed in two respects:

• Companies will be able, but not required, to indemnify their directors in respect of proceedings successfully brought by third parties (covering both legal costs and the financial costs of any adverse judgment, except for the legal costs of unsuccessful defence of criminal proceedings, fines imposed in criminal proceedings and penalties imposed by regulatory bodies such as the Financial Services Authority); and
• Companies will be able, but not required, to pay directors' defence costs as they are incurred, even if 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 were unsuccessful (except where the company chooses to indemnify the director in respect of his legal costs in civil proceedings brought by third parties).

To effect these reforms, the Government will table amendments to the Companies (Audit, Investigations and Community Enterprise) Bill which is currently proceeding through the House of Commons. The Bill is expected to become law by the end of November this year.

The two bullet points above reproduce almost exactly the wording of the Government's statement, the full text of which can be found at http://www.dti.gov.uk/consultations/statement.doc. Although the detailed implications will only be clearer when amendments are actually tabled to the Bill, various things are apparent from a closer inspection of the statement.

Current position

The prohibition in section 310 on companies "indemnifying" their directors covers both arrangements by the company to pay directors' legal costs as and when they are incurred and also arrangements for the company to reimburse a director after the event for any such costs and any damages awarded or fines imposed on him. Although companies can reimburse a director for his legal costs once judgment is given in his favour or he is acquitted, this may be too late - a director without the benefit of sufficient D & O insurance may already have been bankrupted or forced to give up his defence.

'Unpacking' the proposals

The proposed reforms distinguish between claims made against directors by third parties - such as creditors, investors, employees, shareholders, regulators and Government agencies – and claims made by the company itself. A company may consider taking action against a director in one of four circumstances: the director has left office (perhaps following the company's sale); the director has fallen out with the rest of the board; the company has gone insolvent and proceedings have been instigated by a liquidator; or minority shareholders have brought a successful 'derivative action' in the name of the company.

Claims made by third parties

Companies will be able to pay directors' defence costs as and when they are incurred ('up front'), without having to wait until judgment is given in the director's favour. They will be able to choose whether or not to require a director to repay such costs if his defence is unsuccessful.

Companies will also be able to reimburse a director for damages, interest and costs awarded against him in any judgment. But for reasons of public policy, companies may not reimburse directors in respect of any fines imposed in criminal proceedings or penalties imposed by regulatory bodies such as the FSA or HSE.

Claims made by the company itself

Companies will be able to pay directors' defence costs up front, without having to wait until judgment is given in the director's favour. This could leave the company having to foot the bill for a QC and legal team to defend a current or former director against a claim that he acted negligently or misapplied the company's property.

A director will have to repay his defence costs to the company if his defence is unsuccessful.

But of course companies will not be allowed to reimburse a director for any damages, interest and costs awarded against him in favour of the company, as this would effectively make such claims impossible.

Disclosure of reimbursement arrangements

Such an arrangement will have to be disclosed in the directors' report, and shareholders will have a right to inspect its terms. But the disclosure and inspection requirements will apparently not apply to arrangements for companies to pay up front a director's defence costs.

Indemnities given by other group companies

Section 310 will be amended to make clear that it does prohibit a company indemnifying the directors of another company in the same group. At present there is some doubt about the scope of the section. It remains to be seen whether the reforms will leave room for such indemnities to be given by unconsolidated entities.

Auditors – no reform, but not the end of the story?

In relation to auditors, for the time being at least the Government will not introduce a statutory cap on auditors' liability or allow auditors to impose a cap through negotiations with their audit client. This result was widely expected after the OFT concluded last month that such a reform would not improve competition in the audit market.

Whilst not promising any reform, the Government has said that it "remains committed to improving the operation of the audit market and will continue to consider any proposals, including the possibility of limiting liability on a proportionate basis by contract, which can be demonstrated significantly to enhance competition, and to improve quality, in the audit market." It has called upon auditors, business, and investors to work together to examine whether proposals for a system of proportionate liability via contract are practical and/or desirable. Although such a system has an attractive logic, various reviews of company law have previously concluded that legal difficulties would make it unworkable.

Nevertheless, the ICAEW has already committed to form a task force which will produce a report to industry and Government "underpinning the case for proportionality by contract and setting out how this might be achieved".