In a December 23, 2013 ruling that will be surprising and unwelcome to D&O insurers and their insureds in New Zealand (and perhaps elsewhere) , the New Zealand Supreme Court has reversed the holding of an intermediate appellate court and ruled that, by operation of a statutory “charge” on insurance in favor of third party claimants, the former directors of the defunct Bridgecorp companies cannot have their defense costs paid under their company’s D&O insurance policies.
A copy of the New Zealand Supreme Court’s opinion can be found here. Special thanks to Francis Kean of Willis for sending me a link to his January 8, 2014 Willis Wire blog post about the New Zealand court’s ruling.
The New Zealand Supreme Court’s opinion actually relates to consolidated appeals involving two defunct companies, Bridgecorp and Feltex Carpets Ltd. In both cases, directors of the failed companies seek access to their company’s D&O insurance in order to defend themselves from claims following in the wake of their company’s failures. Though the appeal involved two companies, most of the discussion in the Court’s opinion relates to Bridgecorp, and so my discussion below is focused on Bridgecorp.
The Bridgecorp group operated as a real estate development and investment firm. (For more information about the Bridgecorp group and its demise, refer here.) When it collapsed in July 2007, the group owed investors nearly NZ$500 million. The group’s former directors faced numerous criminal and civil claims arising out of the collapse. Several directors of Bridgecorp have been convicted of offenses under the New Zealand Securities Act of 1978. Bridgecorp’s receivers have sued the directors for damages in excess of NZ$340 based on allegations that the directors breached duties they owed the Bridgecorp companies and caused the companies loss.
At the time of its collapse, the Bridgecorp group carried NZ$20 million in D&O Insurance. The group also carried $2 million of statutory liability defense cost protection (the “SL policy”), but the limits of the SL policy were exhausted in payment of the directors’ attorneys’ fees. The directors then sought to have their fees paid under the D&O insurance policy. The D&O policy combines both indemnity and defense cost protection for the company’s directors and officers in a single policy subject to single aggregate limit of liability. Under the policy’s terms, defense costs are inside the limit – that is, the insurer’s payment of defense costs erodes the limit of liability.
The Bridgecorp receivers advised the D&O insurer that they assert a “charge” under Section 9 of the Law Reform Act of 1936, which they contend creates a priority entitlement in claimants’ favor over monies that may be payable under any insurance policy held by the person against whom the claim is made. The Bridgecorp group directors in turn initiated an action seeking a judicial declaration that Section 9 does not prevent the insurer from meeting its contractual obligation under the D&O policy to reimburse them for their defense costs.
As discussed here, on September 15, 2011, New Zealand High Court (Auckland Registry) Justice Graham Lang ruled in favor of the Bridgecorp’s receivers, holding that the receivers’ “charge” on the D&O insurance policy’s limits of liability under Section 9 “prevents the directors from having access to the D&O policy to meet their defence costs.”
Justice Lang stated that the provision provides a “procedural mechanism” to ensure that a claimant can “gain direct access to insurance monies that would have been available to the insured.” Justice Lang acknowledged that this result is “harsh” and even “unsatisfactory,” he reasoned that Section 9 was designed to “keep the insurance fund intact” for the benefit of claimants and that this legislative purpose should not be defeated merely because coverage for both defense costs and indemnity were combined in a single policy. The directors appealed Justice Lang’s ruling.
As discussed here, in a December 20, 2012 opinion, a unanimous three-Justice panel of the Court of Appeal of New Zealand quashed Justice Lang’s lower court ruling.In ruling that the Section 9 does not apply to the D&O policy’s defense cost coverage. The Court of Appeal noted that the policy provides coverage for “two distinct kinds of losses” that operate “independently.” The court reasoned that if the two coverages had been set up in separate policies, Section 9 could not have applied to the defense cost policy, and that the combination of the two coverages into a single policy should not affect the analysis. The court also reasoned that “it is irrelevant” that the policy proceeds would be depleted by payment of defense costs, as that is that is “the necessary consequence of the policy’s structure.”
The Court of Appeal also noted that the practical effect of Justice Lang’e ruling was to deny the directors of their contractual rights to defense cost reimbursement. The Court noted that a “charge” under Section 9 is “subject to the terms of the contract of insurance as they stand at the time the charge descends” and it “cannot operate to interfere with or suspend the performance of mutual contractual rights and obligations relating to another liability.” Bridgecorp’s receivers appealed the intermediate appellate court ruling.
The Supreme Court’s Ruling
The New Zealand Supreme Court overturned the intermediate appellate court’s ruling in a 3-2 decision that included three different opinions. In the lead two-Judge opinion by Chief Judge Sian Elias and Judge Susan Glacebrook (in which Judge Noel Anderson separately concurred), the Court held that “the scheme, the text, the caselaw and the legislative history of Section 9 make it clear that the statutory charge attaches at the time of the occurrence of the event giving rise to the claim for compensation for damages in respect of the liability to third parties which is covered by the policy. Reimbursement to the directors of their defense costs is not within the statutory charge.”
The insurer’s contractual obligation to pay defense costs as they arise is “immaterial” and the effect of the charge is such that the contractual obligation to pay the directors’ defense costs “can be met only at the peril of the insurer when there is sufficient insurance cover under the limit of the policy to meet both insurance obligations.”
In response to concerns that the Court’s holding would leave the directors without the means of defense, the lead opinion responded that “An insured would only be deprived of the ability of the ability to mount a defence if he or she had not other funds available for a defence and where no lawyer would act on a contingency basis. Further, an insurer may well have an incentive to fund a good defence out of its own funds as that would reduce the insurer’s exposure under the policy.”
In justifying the harsh result the Court’s ruling imposes, the lead opinion attempted to pin the blame for the result on the way the policy is structured. After first asserting (supported only with an obscure footnote reference) that “a combined limit is not necessarily the norm,” lead opinion then asserts that this combined limits structure is the cause of the problem:
These unusual cases arise because the policies in issue have made the defence costs the subject of cover in a policy that also covers third-party liability that gives rise to the defence costs. As a result, the statutory charge protects the third party claimant and prevents the performance of the defense cost obligation without risk to the insurer. This means that the insurer and the insured have struck a poor bargain because the policy has not been properly drawn, overlooking the effect of the statutory charge.
Judges John McGrath and Thomas Gault dissented from the lead opinion, essentially on the ground that Section 9 does not require an unproven claim to be given priority over an immediate policy obligation.
As some level, the Supreme Court’s ruling is just the unfortunate outcome of a divided Court’s attempt to interpret a peculiar local statutory provision.
At another level, the Court’s ruling demonstrates the difficulties the D&O insurance industry faces as it attempts to deploy policies that will respond in jurisdictions where there is little developed case law interpreting the policies. The tortured procedural history of this case alone shows how unpredictable the contract’s performance can be when there is little local case law.
The tortured procedural history and the divided result in the Supreme Court also underscore how off target the lead opinion is in suggesting that the parties to the insurance contract struck a “poor bargain” by failing to take the operation of Section 9 into account. As if the parties should have known when they entered the contract how Section 9 would ultimately be applied, even though the various judges and courts that have looked at the question of how Section 9 should operate have been all over the map. (In that regard, Francis Kean notes in his blog post that of the nine New Zealand judges that reviewed these issues in the various New Zealand courts, five of them ruled that the Section 9 charge did not prohibit the insurer from paying the directors’ defense costs, and only four found that the charge prohibited the defense cost payment.)
To the extent the lead opinion’s analysis depends on its loose assertion that it is not the “norm” for D&O insurance policies to have defense expense and indemnity protection both provided in a single form, the Judges writing the opinion would have done well to consult someone –anyone—that actually knows anything about D&O insurance. It is in fact very much the norm for D&O insurance policies to combine the two coverages in a single form.
The lead opinion’s response to the suggestion that the Court’s holding will deprive the directors of the ability to defend themselves ignores the reality of directors’ position. The lead opinion’s suggestion that there are no problems because the directors can just defend themselves using their own assets or get a lawyer to represent them on a contingency (say what?) ignores that fact one of the principal reasons that the insurance is even in place was so that the insurance would pay these very costs. To say, as the lead opinion does, that a director will only be deprived of an ability to defend themself “if he or she had no other funds available” simply ignores the very reason this kind of insurance exists. This insurance is catastrophe insurance. The insurance frequently operates as the insured persons’ last line of defense. The lead opinion’s “let them eat cake” dismissiveness of the position their ruling puts the directors in is, well, disappointing to say the least.
Perhaps it is owing to its antipodal provenance, but the lead opinion’s interpretation of Section 9 stands the very idea of liability insurance on its head. Liability insurance does not exist to protect claimants, it exists to protect the insureds. Insurance buyers procure the insurance to protect themselves from third party lawsuits. The very idea that a mere assertion of an unproven claim is enough to strip the insured under a liability policy of the protection they procured for themselves is questionable in its very approach to the insurance equation.
I hope that the New Zealand Parliament will give due consideration to the nature and purposes of liability insurance and make appropriate adjustments to Section 9 to ensure liability insurance can operate to protect the persons whom it was intended to protect – that is, the insured persons.
While awaiting a parliamentary revision (that may or may not ever come), the insurance industry will have to respond. I suspect the D&O insurance professionals in New Zealand are even now struggling to figure out how to try to structure D&O insurance policies going forward so that no other directors are put in the absolutely rotten position that these directors have been put in. One possibility is to set up the policy with defense outside the limits, so that the defense costs do not erode the limit. (Defense outside the limits is actually required in Quebec.) Another possibility is to structure the defense cost protection separately from the indemnity insurance.
As Francis Kean points out in his blog post, these possibilities may address the problem on future policies, but that doesn’t help on the policies that are already in place. Insureds with policies in force will understandably be concerned whether their policies will fund their defense. While companies could attempt to supplement their existing coverage to add defense cost protection, that is not going to help the companies that have pending claims.
I noted at the outset of my commentary that at one level this may all be just a reflection of a local problem under a New Zealand statute. But the impact of the New Zealand Supreme Court’s ruling may be felt in Australia as well. The New Zealand Supreme Court’s opinion expressly references a parallel proceeding pending in the courts of New South Wales that involves a nearly identical statute in that jurisdiction. Kean notes in his blog post that the High Court of Australia (the country’s highest court) is “due shortly to pronounce on an appeal under the equivalent legislation in New South Wales, and it is entirely possible that it will go down the same path as New Zealand.”