D&O cover crucial during tough economic times

Simon Colman

The liability risks associated with cyberattack might dominate South Africa’s news headlines; but directors and officers at the country’s small and medium enterprises (SMEs) are just as concerned about the potential for liability claims arising from business rescue; insolvency or various events that result in reputational damage. Simon Colman, Business Head: Digital and Financial Lines at SHA Risk Specialists, says that directors face many tough decisions in navigating their firms through the post-pandemic economic turmoil, not least of which ensuring that adequate liability cover remains in place. He was commenting during an SHA webinar to address some of the critical issues facing directors and officers circa 2021.

Business rescue basics

SHA’s 2020 Specialist Risk Review identified business rescue as an area of special concern due to directors’ poor understanding of the process. “Something that we found particularly worrying, is the perception that many business leaders had around the use of business rescue as an intervention when the business is in distress,” writes SHA. Only half of the business leaders surveyed said that they would apply for business rescue as soon as it became evident a company could not pay all of its debts, which SHA says is the prudent time to do so. This compares to 8% of directors who said they would only apply for business rescue in the event a creditor put in an insolvency application and 18% who said they would do so when shareholders to put in an application. The remaining 23% admitted to having “little to no understanding of the process”. 

SHA invited Karl Gribnitz, an experienced business rescue practitioner, to share some of his insights around the business rescue process, which is set out in Chapter 6 of the Companies Act. He told the audience, made up largely of non-life insurance brokers and corporate risk managers, that business rescue should be seen as a tool to assist in salvaging businesses rather than as a last resort to stave off insolvency or stall liquidation proceedings. When carried out correctly, the business rescue process allows businesses to realign their strategies within the economic and competitive environments, with a view to staying liquid and eventually returning to profitability. 

The timing of the decision to enter business rescue is critical and it makes sense for a firm’s management to implement the process as soon as they become aware that the company is financially distressed. Section 128(1)(f) of the Companies Act reasons that a company is in financial distress if: “It appears to be reasonably unlikely that the company will be able to pay all of its debts as and when they become due and payable within the immediately ensuing 6 months [commercial insolvency] or if its liabilities will exceed its assets within the ensuing six months [factual or balance sheet insolvency]”. 

Getting the timing right

SHA noted that “embarking on the business rescue journey too late can severely impede any hope of a sound turnaround”. The risk specialist is concerned that “an astonishing number of directors are unaware of how to correctly utilise tools and processes available to them to salvage their companies”. Firms are therefore encouraged to seek out expert practitioners to navigate the complex legal environment surrounding the process. Gribnitz supported their call, saying that legislation was not properly aligned to the process and warning that businesses often faced a maze of legal challenges. 

A surge in business rescue applications could increase firms’ D&O liability risks. One possibility is that unhappy third parties could bring claims against directors for failing to enter and implement a business rescue process timeously. The 2020 Specialist Risk Review predicted an increase in the number of “allegations of wrongdoings brought against directors and officers” as the long-term impact of the pandemic reveals itself. “Given the fiduciary responsibilities that directors carry, they are expected to respond to all risks in a reasonable manner as expected of a business leader,” writes SHA. “And directors have a responsibility to maintain and enhance value for their company and its shareholders, or at the very least, protect it from eroding”. 

Legal defence for directors’ negligence

The risk that attaches to failures by directors and officers can be transferred by having adequate D&O cover in place and mitigated through improved director education and internal risk policies. It is therefore more important than ever for brokers that specialise in the liability risk class to have a clear understanding of what D&O cover is designed for and when and how it performs. “Reputational damage is another notable issue [in the D&O space] … there are a growing number of well-publicised cases lodged against directors and officers following ‘bad news’ events,” writes SHA. The crux of the matter, in the listed company space, anything that causes a big dip in listed company share price can result in a D&O claim. 

SHA explained as follows: D&O coverage is taken out by the company on behalf of the directors and officers of the business to cover the legal defence costs, damages and awards when such an allegation is made by a third party. The need for the cover arises because third parties can, per the Companies Act, “seek recourse from the directors of a company in their personal capacity where the members of management or the board may have failed or been negligent in carrying out their fiduciary duties”. D&O policies can be triggered following a range of operational and risk-related leadership failings. One recent example is a claim brought against a US-based director for failing to take out cyber risk cover for his firm. 

The long-tail awaits ill-thought cancellations

There are some concerning trends that brokers need to be on the lookout for. One of these is that businesses, whether under own management or subject to a business rescue process, might seek to cancel a portion of their insurance cover. “Imagine a business rescue practitioner who decides to close the D&O policy to save on insurance costs,” said Colman. This is a dangerous move, especially in the liability class. “Cancelling or not renewing a claims-made liability policy also removes all of the historic cover that comes with unbroken insurance periods,” writes SHA. “This could be a catastrophic mistake given the long-tailed nature of liability claims”. 

Another aspect brokers should pay close attention to is whether their SME clients’ cyber risks are adequately covered upon renewal. “We are concerned about cyber exclusions [being included] in other specialist policies like D&O; we are keeping an eye on this trend with big renewals happening on 1 July,” said Colman. “Underwriters will have to look carefully at the cyber offerings available in the market at present”. They must also pay close attention to economic conditions and the evolving risk environment. 

“There is certain information that is valuable in structuring the right insurance programme,” concludes Colman. “Brokers, clients and insurers must enter the risk transfer relationship with their eyes open and [ensure that they] operate in an environment of increased transparency”. The brokers’ role is to clearly communicate what information is required to place a client’s business on risk. 

Writer’s thoughts:
It is easy for brokers and their clients to be lulled into a false sense of security insofar niche or specialist liability cover. A fatal mistake is to simply drop such covers on the basis that a claim is unlikely, infrequently or of little consequence. On what basis would you consider removing sections of your SME clients’ liability cover? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za