October 5th, 2009

Continental European Legal Update: Mandatory Deductible in German D&O Insurance

Posted at 1:00 AM ET

recentlegislationDavid Lewin, Managing Director
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Formerly, D&O insurance seldom included deductibles borne personally by the members of a company’s Management Board (Vorstand). The Act on the Adequacy of Management Board Compensation (Gesetz zur Angemessenheit der Vorstandsvergütung — “VorstAG”), adopted on June 18, 2009 by the German Parliament, now makes this mandatory.1

The Legal Situation

VorstAG modifies the legal regime governing the compensation of members of the Management Board of German stock corporations and introduces a mandatory deductible for D&O insurance policies.

The new rules are intended to establish an “adequacy” standard and bring clarity to previously “customary” (angemessen) practices. Under the new law, the compensation of members of the Management Board will be structured in terms of long-term incentives designed to encourage the sustainable growth of the company. Simultaneously, new disclosure rules regarding executive remuneration specify that the Supervisory Board (Aufsichtsrat) must reduce the compensation of Management Board members in the event of any deterioration in the company’s financial position and should undertake to prevent breaches of duty by Management Board members.

Of particular importance for the casualty insurance industry is the mandatory deductible which must be included in all D&O policies as of the day the Act enters into force (Inkrafttreten). As a result, D&O protection will no longer be granted in full for members of the Management Board who commit breaches of duty or employment-related wrongful acts.

Impacts on D&O Insurance

Pursuant to Sec. 93 para. 2 cl. 3 of the new version of the German Stock Companies Act (Aktiengesetz - AktG), if a company provides insurance cover to the members of the Management Board for risks resulting from their occupational activities, a mandatory deductible personally borne by the Management Board member must be included. The amount of the deductible ranges from a minimum of 10 percent of the damage up to a minimum amount of 1.5 times the annual base salary (feste jährliche Vergütung).

This provision, however, is not applicable to Supervisory Board members or executives of other types of German corporations (e.g., limited liability companies [GmbH]) which are not stock-capitalized. As the new provision is incorporated into Sec. 93 AktG, one could argue that the mandatory deductible is solely applicable for claims which are raised within the framework of Sec. 93 AktG. Hence, the mandatory deductible would not apply to the costs incurred to defend or appeal a claim made against a member of the Management Board.

For current insurance contracts (Altverträge), there will be a one-year transitional period (until June 30, 2010) to allow for the implementation of this regulation. Thus, insurance agreements that do not provide for a mandatory deductible will have to be amended. It would not be sufficient to implement the mandatory deductible in an employment agreement with the Management Board member.

Many questions remain, however, based on the wording of Sec. 93 para. 2 cl. 3 AktG. It remains unclear if (or to what extent) the provision applies to subsidiary stock companies which are not policyholders on their own behalf (e.g., co-insured subsidiary companies). This is even more complicated for subsidiaries that are part of a group structure (Konzernstruktur) in which the insurance cover is taken by the controlling company. Even though the legislature did not address this point specifically, the underlying rationale of the VorstAG leads to the assumption that there should be no exemptions from the mandatory deductible requirement even for Management Board members of subsidiary stock companies.

Another question emerges from the fact that a variety of German stock companies are subsidiaries of foreign parent companies. The controlling foreign company usually provides D&O insurance cover for the whole group under its particular foreign law regime. In this context, it can be concluded that the deductible requirement is not mandatory for Management Board members of German (subsidiary) stock companies. Further, it remains doubtful if the aim of the VorstAG — i.e., to provide incentives for the sustainable growth of companies — will be achieved by obligating a regime of mandatory deductibles. The deductible may lead to an overly cautious business approach, as Management Board members presumably will become more risk-averse if they could be held liable for a minimum amount of 10 percent of the damage up to a minimum amount of 1.5 times the annual fixed salary.

It can certainly be assumed that Management Board members will attempt to minimize their personal liability. Even before the enactment of the VorstAG, several insurance companies provided insurance cover for the remaining costs resulting from an agreed deductible. There is broad consensus that under the VorstAG the members of the Management Board are not barred from taking insurance cover on their own behalf. But it should be pointed out that the legislature - in response to the current financial crisis - intended to create a new liability regime that emphasizes responsibility and requires members of the Management Board to participate in the losses resulting from breaches of their duties. Although this intention might be undermined by allowing for insurance cover for deductibles, it follows from the freedom of contract that such provisions are in accordance with the law. From a legal point of view, there are no convincing arguments that would prevent the purchase of such supplementary insurance contracts on a private basis.

Summary

Despite criticism expressed from different sides during the legislative process, the German Parliament ultimately adopted a provision that might cause more problems than it solves. This is due to the fact that the German Grand Coalition of Conservatives and Social Democrats, with an eye towards the forthcoming elections in September 2009, felt compelled to convince the public of their resolve in handling the financial crisis.

It remains to be seen whether a mandatory deductible for members of the Management Board will alter decision-making processes (as intended) and lead to the sustainable growth of stock companies, or whether future executive remuneration will contain an additional element that provides insurance cover for deductibles. Those who profit most from the VorstAG may be those insurance companies that develop a new line of business selling German deductible insurance.

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Footnote

  1. Previously, even though the non-binding German Corporate Governance Code had recommended an appropriate deductible in D&O insurance contracts, most corporations and insurers did not comply.
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