2 Sep 2019
The Mainzeal decision is a potential game changer when it comes to directors and officers (D&O’s) insurance, but there are also many lessons that can be taken from the outcome. We note the decision is being appealed and we will follow its progress with interest. There are four key lessons company D&O’s can take away from the Mainzeal case.
In brief:
Litigation Funders
Historically New Zealand has not a seen significant level of legal action activity supported by litigation funders. This lack of activity is likely for four reasons:
This development should be of concern to directors. To see how ugly things can get you need only travel to Australia where there are at least 25 active litigation funders operating. Litigation funders and plaintiff law firms looking for a cut of the awards helped lead Australia to a record 50 class actions in 2018, 24 of which were shareholder class actions (i.e. D&O claims).
Having witnessed the development of D&O litigation in various countries our view is that once litigation funders establish success then it’s reasonable to expect an increase in litigation activity. If this judgement isn’t overturned, then funders have proved their model in New Zealand and they have the precedent judgement. Such a precedent may lead to increased pressure on D&O’s and their insurers to settle litigation knowing there’s a very real threat of losing in court.
The outcome for D&O’s is there will likely be more scrutiny of their actions and disclosures. This will be most common when there’s a company collapse, a significant loss of value, contentious merger and acquisition activity or issues regarding disclosures to shareholders.
Judgement Risk
There’s judgement risk in any trial. Both of losing what you may think is a strong case and that the judgement may set new precedent in respect to a particular aspect. In the Mainzeal case there are several unique features which are potentially dangerous for D&O’s. These are:
There is a history of calculating damages in reckless trading cases in New Zealand albeit there are a limited number of cases. Mason v Lewis is referred to as the standard approach. This calculation approach bares similarities to non-disclosure shareholder class actions in other countries.
The theory is simple. There’s a date of the D&O’s error and a date of discovery of the error. Losses incurred in the intervening period act as strong guide to what the damages might be.
In the Mainzeal case the date of the error of D&O’s is when directors should have placed the company into receivership or remedied the situation. The error was discovered when the company was put into receivership. Barring any other considerations, the period in between should be the starting point for computation of loss.
Both the plaintiffs and defendants provided experts on this approach. Although the judge used a different methodology, he did comment on it for comparative purposes: “The ultimate conclusion is that creditors were better off than they would have been had there been an earlier liquidation. There would accordingly have been no loss arising from the breach on this approach.”
Simply put if standard approach was taken with no adjustments there would have been no damages awarded against directors.
The Judge's Alternative Approach
So, on one extreme we have the potential for a guilty verdict but no damages. What played out was the implementation of an alternative approach focusing on the actions of directors and what they could have done. The following quotes from the judgement sum up the position:
“Liquidation was the very thing reasonable directors would want to avoid”
“The breach of director’ duties in this case did not arise because the directors failed to cease trade and put Mainzeal in liquidation or receivership in January 2011. The breach of directors’ duties arose because they caused, agree or allowed Mainzeal to engage in trade in a vulnerable state – being balance sheet insolvent, with a poor financial trading position, and depending on assurances of support in a way I have found to be unreasonable.”
“If directors breach their s 135 duty by continuing to trade a company that should be liquidated, the directors will only be liable for the additional loss to creditors that they cause by failing to cease trading. But if the s 135 breach arises by creating a substantial risk of failure for a company that should have otherwise not fail, then the loss caused by the breach is the loss created by that failure.”
The judgement implies if Mainzeal was run appropriately from the breach date Mainzeal wouldn’t have collapsed. Here’s a summary of some of the commentary mentioned:
To put it another way, if the directors hit the proposed breach date (the 2009-2010 restructure) and put the company into receivership would they be facing this claim in the first place?
If this judgement isn’t overturned or amended on appeal, then future D&O claims may be subject to significant awards of damages. This in turn presents a real challenge in determining appropriate D&O insurance limits.
Lessons for Directors
One of the saddest parts to the Mainzeal case is there were times where the directors identified an issue and took some action. Ultimately though the identification of potential issues and various actions didn’t conclude with concrete outcomes that remedied the situation. The first lesson is the requirement of directors to own decision making and be the captain of the ship. As issues arise, give them the attention they deserve and put them on the record. If the issues are complex or outside of a director’s expertise then advice should be sought. Finally have a plan and in event that you can't execute it for issues as critical as solvency then take the next appropriate step.
Warren Buffet has a saying that a teaspoon of prevention is worth a pound of cure. This couldn’t be more appropriate for the second lesson which is how directors best position themselves to prevent trading whilst insolvent. Understandably a lot of the focus to prevent trading whilst insolvent is a point in time analysis, often with advice, when a company is deeply distressed and on the verge of collapse. Advice at that point in time seems like common sense however this situation misses one key point: it will sometimes be alleged that long before that point in time the company was trading whilst insolvent.
The best advice to avoid trading whilst insolvent comes from the Australian Securities & Investment
Commission following the successful $200M D&O claim against Centro. The advice was:
In the Mainzeal case it was clear that Richard Yan had a very different position to the other directors. This was due to his ownership of the parent company and in turn other group companies. It’s commonplace that a director will be the choice of a large shareholder or group of shareholders. Provided the director acts in accordance with the law and the companies constitution there’s no immediate issue with this.
This can cause competing agendas though. In the Mainzeal case the competing agenda arose for the most critical of issues, the issue of financial support. It was in the interests of Mainzeal to have a written agreement for unlimited financial support (which was callable and enforceable) from their parent company. Naturally it was not in the interest of the parent company to have an unlimited financial guarantee in place. For many reasons it seems logical that the parent company didn’t want Mainzeal to collapse however it wasn’t in their interest to have unlimited support in place either. In the end Mainzeal collapsed with no formal enforceable agreement of support in place. This is at the heart of the case against the directors
Adequacy of Director and Officer Insurance Limits
Mainzeal is a potential game changer, Directors should consider the adequacy of their D&O insurance limit and look for solutions to ensure they have access to a limit for themselves as a policy of last resort.
In the context of recent developments, it signals to a potential increase in both in claims frequency and severity.
When we consider the Mainzeal ruling alongside other changes there’s a solid basis for increasing D&O insurance limits. These other changes include:
Imagine for a minute this all unfolding in front of a backdrop of a modest D&O insurance limit. As with almost all insolvency’s Mainzeal was unable to financially indemnify the D&O’s so the directors personal assets become exposed if the insurance limit was insufficient. This surely must really turn the dial on the already heightened stress levels.
As we know all companies have finite financial resources. If a decision needs to be made in terms of deciding where to allocate insurance spend, we would suggest D&O comes first to ensure comprehensive cover and conservatively high limits are in place.
What D&O’s Should Consider When Setting D&O Limits
Let’s start by looking at how D&O claims have developed:
What else should I consider?
In many D&O cases there are ‘Black Hats’ and ‘White Hats’ or alleged criminal D&O’s and innocent D&O’s (often non-executive directors). This distinction is important because Black Hats often use the greatest amount of the limit of a D&O policy. They can have multiple cases to defend (criminal and civil) and because of their position spend the greatest amount on defence costs. Mainzeal didn’t have a Black Hat/White Hat dynamic however Mr Yan was in a different position to the directors, this showed in the damages awarded against him and the fact he had separate defence counsel.
D&O policies are typically a shared limit for all directors and are also shared with the company. It’s shared with the company when they indemnify D&O’s (and can do so) and also shared with the company for securities claims. We suggest D&O’s should always make sure they’re protected as an individual. There are solutions available that provide additional protection for D&O’s which we suggest most D&O’s seek. This includes dedicated ring fenced limits for each director (via extension), cover sitting in excess of other D&O policies for directors only (not the company) called Side A cover, excess cover for directors only with ‘difference in condition’ language sometimes meaning exclusions on the underlying D&O policy will not apply. Lastly it’s possible to to apply these coverages to the board only, named positions only, or named individuals only.
In summary, a business as usual insurance approach isn’t appropriate when looking at D&O insurance, consider the adequacy of your D&O placement and always look after your own interests. When it comes to the development of D&O claims just remember saying “it’s always a first until the next first.” New Zealand is not alone in witnessing an environment evolve from few claims with small losses to large claims happening more frequently.
In brief:
- Litigation funders.
- They exist in New Zealand and have appetite for claims against directors.
- Judgement risk.
- The way damages have been calculated against directors has not been seen before.
- For directors there’s always risk in going to trial (assuming settling is an option), this case is considered contentious by some qualified observers.
- There are other unique aspects of this case which should be of concern to directors.
- Lessons for Directors.
- Be the captain of the ship. Speak up, seek advice where appropriate, act, and document.
- The directors knew many of the issues and took some steps however a clear plan was lacking, and appropriate action was never taken.
- Simply raising issues doesn’t constitute a director fulfilling their duty.
- The directors spent too little time on important and strategic items and focused too much on day to day operational activities.
- Prevent trading whilst insolvent.
- The issue is not companies failing, it’s that action is often taken long after a company has already traded whilst insolvent.
- Prevention starts on day one of appointment, not avoidance on the final day of operation of a company.
- Be sceptical, have financial accounting knowledge, understand the business and ensure risk management and controls are in place, and set an appropriate culture.
- Don’t assume you’re all rowing in the same direction.
- Mainzeal was a case with three directors in a different position to the fourth, Richard Yan.
- Regardless of how a director is appointed to the board it doesn’t change their duty. There can be situations where a major shareholders agenda competes with a director’s duties.
- Be the captain of the ship. Speak up, seek advice where appropriate, act, and document.
- Adequacy of D&O insurance limits.
- The Mainzeal loss is a potential game changer and was well in excess of the policy limits.
- When considered alongside other developments D&O’s should consider if they have adequate cover in place.
- D&O policies are group policies shared between the company and D&O’s. The company and other D&O’s can erode the policy so D&O’s should ensure they have cover in place specifically for their needs.
Litigation Funders
Historically New Zealand has not a seen significant level of legal action activity supported by litigation funders. This lack of activity is likely for four reasons:
- The lack of clarity regarding the legality of litigation funding outside of representative actions;
- A lack of a class action regime;
- The non-litigious environment and the low level of awards for damages; and
- A shortage of attractive ‘slam dunk’ large cases for litigation funders to pursue.
This development should be of concern to directors. To see how ugly things can get you need only travel to Australia where there are at least 25 active litigation funders operating. Litigation funders and plaintiff law firms looking for a cut of the awards helped lead Australia to a record 50 class actions in 2018, 24 of which were shareholder class actions (i.e. D&O claims).
Having witnessed the development of D&O litigation in various countries our view is that once litigation funders establish success then it’s reasonable to expect an increase in litigation activity. If this judgement isn’t overturned, then funders have proved their model in New Zealand and they have the precedent judgement. Such a precedent may lead to increased pressure on D&O’s and their insurers to settle litigation knowing there’s a very real threat of losing in court.
The outcome for D&O’s is there will likely be more scrutiny of their actions and disclosures. This will be most common when there’s a company collapse, a significant loss of value, contentious merger and acquisition activity or issues regarding disclosures to shareholders.
Judgement Risk
There’s judgement risk in any trial. Both of losing what you may think is a strong case and that the judgement may set new precedent in respect to a particular aspect. In the Mainzeal case there are several unique features which are potentially dangerous for D&O’s. These are:
- The judgement was based upon a case not submitted. The plaintiffs had the option to amend their case and didn’t;
- The computation of damages methodology is based on a new ‘alternative’ approach; and
- The methodology for this approach involves a lot of subjectivity and arguably crystal ball gazing.
There is a history of calculating damages in reckless trading cases in New Zealand albeit there are a limited number of cases. Mason v Lewis is referred to as the standard approach. This calculation approach bares similarities to non-disclosure shareholder class actions in other countries.
The theory is simple. There’s a date of the D&O’s error and a date of discovery of the error. Losses incurred in the intervening period act as strong guide to what the damages might be.
In the Mainzeal case the date of the error of D&O’s is when directors should have placed the company into receivership or remedied the situation. The error was discovered when the company was put into receivership. Barring any other considerations, the period in between should be the starting point for computation of loss.
Both the plaintiffs and defendants provided experts on this approach. Although the judge used a different methodology, he did comment on it for comparative purposes: “The ultimate conclusion is that creditors were better off than they would have been had there been an earlier liquidation. There would accordingly have been no loss arising from the breach on this approach.”
Simply put if standard approach was taken with no adjustments there would have been no damages awarded against directors.
The Judge's Alternative Approach
So, on one extreme we have the potential for a guilty verdict but no damages. What played out was the implementation of an alternative approach focusing on the actions of directors and what they could have done. The following quotes from the judgement sum up the position:
“Liquidation was the very thing reasonable directors would want to avoid”
“The breach of director’ duties in this case did not arise because the directors failed to cease trade and put Mainzeal in liquidation or receivership in January 2011. The breach of directors’ duties arose because they caused, agree or allowed Mainzeal to engage in trade in a vulnerable state – being balance sheet insolvent, with a poor financial trading position, and depending on assurances of support in a way I have found to be unreasonable.”
“If directors breach their s 135 duty by continuing to trade a company that should be liquidated, the directors will only be liable for the additional loss to creditors that they cause by failing to cease trading. But if the s 135 breach arises by creating a substantial risk of failure for a company that should have otherwise not fail, then the loss caused by the breach is the loss created by that failure.”
The judgement implies if Mainzeal was run appropriately from the breach date Mainzeal wouldn’t have collapsed. Here’s a summary of some of the commentary mentioned:
- Directors could have forced the group to abandon the reckless trading approach.
- Directors could have taken legal advice prior to 2012, in such event they would likely have received the same advice stating to get the financial support needed to be legally binding.
- If the group didn’t agree to this, the directors they could threaten to resign.
- Threatening to resign would have likely resulted in receiving the formal support required from the parent company.
- Had directors insisted the company needed to be made solvent they could have:
- Recapitalised Mainzeal so it can operate independently
- Sought legally binding support from the parent company
- Sought more limited support sufficient to restore solvency
- The starting point is the entire $110M owed to creditors
- Discounted for directors acting in good faith (other than Richard Yan)
- Richard Yan is conflicted, but he acted honestly so his damages should be higher than the others
- Causation and responsibility for the loss is considered (reference is made to Contributory Negligence Act 1947 for comparison) but no further discount or calculation is referenced
- Then the judgement concluded at 1/3 or rounded to $36M of damages
To put it another way, if the directors hit the proposed breach date (the 2009-2010 restructure) and put the company into receivership would they be facing this claim in the first place?
If this judgement isn’t overturned or amended on appeal, then future D&O claims may be subject to significant awards of damages. This in turn presents a real challenge in determining appropriate D&O insurance limits.
Lessons for Directors
One of the saddest parts to the Mainzeal case is there were times where the directors identified an issue and took some action. Ultimately though the identification of potential issues and various actions didn’t conclude with concrete outcomes that remedied the situation. The first lesson is the requirement of directors to own decision making and be the captain of the ship. As issues arise, give them the attention they deserve and put them on the record. If the issues are complex or outside of a director’s expertise then advice should be sought. Finally have a plan and in event that you can't execute it for issues as critical as solvency then take the next appropriate step.
Warren Buffet has a saying that a teaspoon of prevention is worth a pound of cure. This couldn’t be more appropriate for the second lesson which is how directors best position themselves to prevent trading whilst insolvent. Understandably a lot of the focus to prevent trading whilst insolvent is a point in time analysis, often with advice, when a company is deeply distressed and on the verge of collapse. Advice at that point in time seems like common sense however this situation misses one key point: it will sometimes be alleged that long before that point in time the company was trading whilst insolvent.
The best advice to avoid trading whilst insolvent comes from the Australian Securities & Investment
Commission following the successful $200M D&O claim against Centro. The advice was:
- Be sceptical. When relying on information from third parties issues should be identified by asking the appropriate questions. Wilful ignorance is not a defence.
- Financial accounting knowledge. Directors must be able to read financial statements and be fully informed about the financial position of a company
- Understand the business. Directors need to understand the business and ensure that the executive team has the right risk management and control systems in place which are enforced appropriately.
- Culture. The tone from the top is key and they should ensure they’re driving the right culture of oversight and compliance.
In the Mainzeal case it was clear that Richard Yan had a very different position to the other directors. This was due to his ownership of the parent company and in turn other group companies. It’s commonplace that a director will be the choice of a large shareholder or group of shareholders. Provided the director acts in accordance with the law and the companies constitution there’s no immediate issue with this.
This can cause competing agendas though. In the Mainzeal case the competing agenda arose for the most critical of issues, the issue of financial support. It was in the interests of Mainzeal to have a written agreement for unlimited financial support (which was callable and enforceable) from their parent company. Naturally it was not in the interest of the parent company to have an unlimited financial guarantee in place. For many reasons it seems logical that the parent company didn’t want Mainzeal to collapse however it wasn’t in their interest to have unlimited support in place either. In the end Mainzeal collapsed with no formal enforceable agreement of support in place. This is at the heart of the case against the directors
Adequacy of Director and Officer Insurance Limits
Mainzeal is a potential game changer, Directors should consider the adequacy of their D&O insurance limit and look for solutions to ensure they have access to a limit for themselves as a policy of last resort.
In the context of recent developments, it signals to a potential increase in both in claims frequency and severity.
When we consider the Mainzeal ruling alongside other changes there’s a solid basis for increasing D&O insurance limits. These other changes include:
- Appetite of litigation funders to back claims against directors;
- The potential for a class action regime to be passed into law in New Zealand;
- A push for greater responsibility and enforcement under companies and securities laws following the collapse of many finance companies and more recently international criticism following the involvement of a New Zealand company in a large arms trafficking deal; and
- New board room challenges such data security which has led to claims activity overseas.
Imagine for a minute this all unfolding in front of a backdrop of a modest D&O insurance limit. As with almost all insolvency’s Mainzeal was unable to financially indemnify the D&O’s so the directors personal assets become exposed if the insurance limit was insufficient. This surely must really turn the dial on the already heightened stress levels.
As we know all companies have finite financial resources. If a decision needs to be made in terms of deciding where to allocate insurance spend, we would suggest D&O comes first to ensure comprehensive cover and conservatively high limits are in place.
What D&O’s Should Consider When Setting D&O Limits
Let’s start by looking at how D&O claims have developed:
- Prior to 2006 we estimate there were 12 claims greater than $1M with none breaching $10M
- Since 2006 our estimate is 25 claims of greater than $1M with 8 of these claims being greater than $10M
- The upper end of that limit is currently Mainzeal followed by the finance company cases and settlements and the likes of the ongoing Felex Carpets case. If we applied estimated legal costs to the Mainzeal ruling this would come in around $41M.
- Damages: what will an award of damages cost?
- Note the judges starting point for Mainzeal damages award was to consider directors liable for the entire $110M
- For larger companies note there’s still not been a truly large D&O claim in NZ, some of the larger collapses (South Canterbury Finance and AMI) were bailed out by the government which reduces losses to some effected parties
- Defence costs: what will it cost to defend a claim?
- Defending claims is a costly business, the cost of appeals also needs to be considered
- In complex claims such as Mainzeal the defence costs would have been well into the millions.
- D&O’s sometimes require separate legal representation, this increases costs
- Even frivolous claims can cost significant amounts to investigate, prepare, and dismiss
- The average cost to dismiss a securities class action overseas is close to $2M.
- Defending claims is a costly business, the cost of appeals also needs to be considered
- The potential for multiple claims to erode the limit of liability.
- There may be a criminal case against alleged wrong doers and separately a civil case with shareholders claiming compensation
- Coverage considerations
- For example, does the policy cover ‘Side C’ (securities claims) cover? If yes then directors are sharing cover with the company.
What else should I consider?
In many D&O cases there are ‘Black Hats’ and ‘White Hats’ or alleged criminal D&O’s and innocent D&O’s (often non-executive directors). This distinction is important because Black Hats often use the greatest amount of the limit of a D&O policy. They can have multiple cases to defend (criminal and civil) and because of their position spend the greatest amount on defence costs. Mainzeal didn’t have a Black Hat/White Hat dynamic however Mr Yan was in a different position to the directors, this showed in the damages awarded against him and the fact he had separate defence counsel.
D&O policies are typically a shared limit for all directors and are also shared with the company. It’s shared with the company when they indemnify D&O’s (and can do so) and also shared with the company for securities claims. We suggest D&O’s should always make sure they’re protected as an individual. There are solutions available that provide additional protection for D&O’s which we suggest most D&O’s seek. This includes dedicated ring fenced limits for each director (via extension), cover sitting in excess of other D&O policies for directors only (not the company) called Side A cover, excess cover for directors only with ‘difference in condition’ language sometimes meaning exclusions on the underlying D&O policy will not apply. Lastly it’s possible to to apply these coverages to the board only, named positions only, or named individuals only.
In summary, a business as usual insurance approach isn’t appropriate when looking at D&O insurance, consider the adequacy of your D&O placement and always look after your own interests. When it comes to the development of D&O claims just remember saying “it’s always a first until the next first.” New Zealand is not alone in witnessing an environment evolve from few claims with small losses to large claims happening more frequently.