Important commercial purpose of D&O liability insurance upheld in "insolvency exclusion" case

The Federal Court's recent judgment in Kaboko Mining Limited v Van Heerden (No 3) [2018] FCA 2055 has cemented Australian judicial authority that directors' and officers' (D&O) liability insurance must be construed in such a way as to honour its important commercial purpose. In this case, the Federal Court construed an insolvency exclusion clause in favour of the policyholders, holding that to do otherwise would be to render the policy practically illusory (Clayton Utz acted for the successful applicant, Kaboko Mining Ltd (Subject to a Deed of Company Arrangement)).

D&O insurance serves an important commercial purpose, allowing individuals who take on directorships to perform their role without becoming excessively risk-averse, and by ensuring that directors can meet monetary judgments against them for the benefit of the company, shareholders, regulators, liquidators, creditors and employees.

In recent years, the market for D&O insurance has been hardening: premiums have risen, and insurers press for wider exclusions and limitations. In Kaboko, an insurer declined indemnity to four former company officers against whom a civil action for damages was brought for alleged breaches of the Corporations Act 2001 (Cth). The insurer unsuccessfully argued that because the former directors and officers' alleged breaches of the Corporations Act 2001 (Cth) also led to the eventual insolvency of the company, an "insolvency exclusion" clause in the policy was enlivened.

The substantive Kaboko proceeding

Kaboko Mining Limited (Subject to a Deed of Company Arrangement) (Kaboko) was a manganese exploration, development and mining company based in Perth with projects in Zambia. In 2012, the company entered into pre-paid financing and offtake agreements with a financier in order to develop certain of its manganese interests in Zambia.

The projects did not run to plan: in July 2014, the financier issued a default notice to the Kaboko board alleging numerous breaches of the pre-paid financing agreement. Ultimately, receivers and managers were appointed and the company entered into a deed of company arrangement with its creditors.

Kaboko commenced an action for damages against its former directors and officers in September 2016, following investigations by its administrators which revealed potential breaches of directors' and officers' duties under the Corporations Act and general law, including the duty to act with care and diligence, and in good faith for a proper purpose.

The D&O policy

The D&O policy held by the former directors and officers was the only realistic source available to satisfy a substantial judgment against them. However, their insurer denied liability to indemnify the directors and officers for both their legal fees in defending the proceeding and any ultimate judgment sum, on the basis of an "insolvency exclusion" in the policy.

Kaboko and the insurer agreed to refer to question of liability under the insolvency exclusion to a hearing as a preliminary issue.

Why the "insolvency exclusion" was not enlivened

Justice McKerracher favoured Kaboko's argument that Kaboko's pleaded loss in the substantive proceeding did not "'arise out of' nor originate in, or spring from, or have its foundation in" Kaboko's insolvency. That was because the relevant loss, as pleaded and as demonstrated by the underlying facts (if proven at trial), was the loss to Kaboko of an opportunity to exploit a valuable commercial opportunity. Namely, to develop the manganese mining projects.

In coming to this conclusion, His Honour opined that the relevant claim had to "be based in whole or in part" upon the insolvency of the company. His Honour also considered:

• the commercial purpose of the D&O policy;
• the risks it was designed to insure against (finding that the pleaded claims were the "exact class of risk" the policy was intended to insure against); and
• the mischief sought to be excluded by the insolvency exclusion.

Justice McKerracher cautioned that to construe the insolvency exclusion in the manner contended for by the insurer would result in the insolvency exclusion operating to exclude from cover under the policy claims "against directors of any nature whatsoever if the relevant conduct of the directors giving rise to the claim also played some part in the eventual or alleged insolvency of the company". His Honour emphasised that such a construction would be contrary to the commercial purpose of D&O liability insurance policies and the objectives of parties entering into them, and would render the policy "practically illusory".

External controller's costs

Justice McKerracher found that Kaboko was correct to concede that the receivers' and administrators' costs and disbursements did "arise out of", were "based on" and "attributable to" the company's insolvency, and as such properly fell within the insolvency exclusion.

What the decision means for directors, companies and others

For now, the judgment brings comfort to directors who hold D&O insurance policies, or those seeking to bring proceedings against directors of an insolvent company, provided the claim is not based in whole or in part on the company's insolvency.

However, watch this space. The insurer has recently filed an appeal against the decision, which will be heard by a Full Court of the Federal Court later this year.