Directors of insolvent company evade “insolvency exclusion” for claims made under D&O policy

The Federal Court of Australia in Kaboko Mining Limited v Van Heerden (No 3) [2018] FCA 2055 handed down a significant decision which clarified the operation of "insolvency exclusion" clauses in a D&O liability insurance policy. The issue arose after Administrators commenced proceedings against four former directors of the company, and the insurer relied on an insolvency exclusion to decline to indemnify the former directors in respect of the claims made in the proceedings.

 

The facts

In July 2012, Kaboko Mining Limited (Kaboko) entered into an offtake agreement with Noble Resources Limited (Noble) pursuant to which Kaboko agreed to sell, and Noble agreed to buy, manganese ore from various deposits in Zambia. On the same day, Kaboko entered into a prepayment facility agreement with Noble by which Noble agreed to advance USD$10 million to Kaboko in two tranches.

Noble advanced USD$5.95 million to Kaboko in accordance with the prepayment facility agreement. However, Kaboko did not comply with the terms of the agreement and its directors were served with a default notice by Noble. Soon after, Kaboko failed to comply with a notice of demand for repayment of the initial advance, and the company ultimately entered administration.

Kaboko commenced proceedings against four former directors in respect of losses caused by them (amongst other things) allegedly allowing the advanced funds to be used for purposes other than those permitted under the agreements, and allowing Kaboko to sell products to third parties in contravention of the agreements.

Kaboko’s primary claims against the former directors were for breaches of sections 180 and 181 of the Corporations Act 2001 (Cth) (the Act), being the obligations to discharge their duties with care, diligence and in good faith, as well as for failure to uphold the general law duty to act in good faith, in the best interests of Kaboko, and for a proper purpose.

The former directors made claims for indemnity under a D&O liability insurance policy which provided that the insurer "shall pay the Loss of each Manager arising from Management Liability". Relying on an insolvency exclusion appearing elsewhere in the policy, the insurer declined to indemnify the four directors. As a result, the Federal Court agreed to determine as a preliminary question whether the insurer was correct in doing so.

Interpretation of the "Insolvency Exclusion" clause

The "Insolvency Exclusion" clause in the D&O policy read as follows:

"The Insurer shall not be liable under any Cover or Extension for any Loss in connection with any Claim arising out of, based upon or attributable to the actual or alleged insolvency of the Company or any actual or alleged inability of the Company to pay any or all of its debts as and when they fall due"

The insurer argued that the insolvency exclusion operated because the alleged breaches by the former directors caused Noble to demand repayment of the $5.95 million advance, and ultimately Kaboko’s insolvency. It was further argued that the claims under the policy would never have been made had Kaboko been able to meet that demand for repayment of the advance. Therefore, the insurer contended, the loss which is the subject of the proceedings "arises out of" Kaboko’s inability to repay its debts and its subsequent insolvency.

The Court (McKerracher J) disagreed with these arguments of the insurer. His Honour noted that "it is not sufficient to look to the specific causes of action alleged. It is necessary to look at the underlying facts".

Although McKerracher J accepted that the alleged breaches by the defendants led to Kaboko’s insolvency, his Honour also determined that the relevant loss "does not ‘arise out of’ nor originate in, or spring from, or have its foundation in Kaboko’s insolvency". Rather, his Honour reasoned that the relevant loss that the claims arose out of was "the loss of Kaboko’s opportunity to exploit a valuable commercial opportunity".

McKerracher J placed great weight on the commercial purpose of D&O liability insurance policies. That is, those policies play an important role in protecting directors and officers as they face great potential personal liability by occupying those company positions, and in the absence of D&O policies, individuals would be unwilling to act as directors, or would become excessively risk-adverse in their role.

Finally, McKerracher J held that claims under sections 180 and 181 of the Corporations Act "are the exact class of risk the Policy is intended to insure against", and to construe the Insolvency Exclusion in the manner the insurer proposed would render the policy "practically illusory".

What does this decision mean for directors, and external administrators?

  1. Insolvency exclusion clauses will not necessarily operate to exclude cover for directors and officers under D&O liability insurance policies if the policyholder (i.e. the company) goes into administration or liquidation. Generally speaking, there will need to be a sufficient connection or nexus between the claim(s) made against the directors and officers, and the insolvency of the company, for an insolvency exclusion to be engaged.
  2. Directors and officers should regularly review the company’s D&O liability insurance and be alive to the options of (a) making a claim under the policy if they are pursued for alleged failure to discharge their duties, and (b) challenging any decision of the insurer to decline cover.
  3. Exclusions in D&O policies should be construed in the context of the policy as a whole and with particular regard to the commercial purpose of the policy, and the risks it is designed to insure against.
  4. Administrators and liquidators should be alive to the possibility of any directors and officers, who are the subject of claims by the company, in turn making claims under a D&O policy held by the company. This will be particularly relevant if there is a risk that the directors and officers may not have sufficient net assets to meet any judgment obtained against them.
McCabe Curwood’s Litigation and Dispute Resolution Group has significant experience in advising on the proper construction of insurance policies, including but not limited to D&O policies, and on making claims under such policies.

Contributors

Nathan Jones Senior Associate
Gidon Kangisser Lawyer