November 14th, 2011

Continental European Legislative and Judicial Trends: Directors and Officers (D&O) Liability Insurance: The Emerging Market in Poland

Posted at 1:00 AM ET

David Lewin, Managing Director

Introduction

Directors and officers (D&O) insurance has grown steadily in popularity since it was introduced in Poland 15 years ago. Accompanied by a rise in risk-aware corporate leadership, D&O insurance has evolved from an unknown product in the mid-1990s to a near necessity during periods of economic instability.

Liability for damages caused by the decisions of professionals has become apparent. Although the market for D&O insurance is still developing, insurance premiums for 2010 were between PLN30 million and PLN50 million (approximately USD10.2 million and USD17.1 million). Current predictions indicate the market size will double in the coming years.

Managers increasingly consider D&O insurance an important instrument for their futures, with damages against directors and officers easily exceeding individual wealth. Liability includes actual loss (damnum emergens) and lost profits (lucrum cessans). Beyond personal risk, however, companies benefit from D&O liability insurance because it allows management to operate with less risk aversion. Management tends to be willing to make more difficult decisions when it has sufficient protection, resulting in the possibility of larger profits and increased shareholder wealth. D&O insurance also increases a company’s likelihood to regain its losses when riskier decisions fail.

Insurance products are continually being modified, in part because of increased competition among insurers. Some changes, though, are clearly the result of legal disputes arising from contracts already in force.

Managerial Liability

The legal basis for the liability of corporate officers can be found in the Polish Code of Commercial Companies (CCC) of September 15, 2000. Under Art. 483 (for joint-stock companies) and Art. 293 (for limited liability companies) members of a management board are liable to the company for any damage inflicted upon the company through negligence or action contrary to the provisions of law or the company’s articles, unless no fault can be attributed to this person. A suit against an officer can be filed with a prior approval by the shareholders’ meeting (Art. 228 No. 2, Art. 393 No. 2 CCC). This type of lawsuit constitutes up to 95 percent of all claims brought against managers.

Additionally, if the action of several managers causes damage to a company, specific factual circumstances can establish joint liability (Art. 294 CCC). This type of liability falls under the articles of the Civil Code (Art. 366 CC) that govern joint liability because there are no specific provisions in the CCC. Scholarship on the issue recognizes that other managers who do not prevent the damage from occurring are concurrently liable with the manager who causes damage. But, this is possible only when there is no specified division of tasks within the management board. The underlying principle of such liability is that the members of the board of managers have a duty of care to the company. Negligence in controlling the actions of another manager, while not expressly noted in the CCC articles, can become a basis of liability to the company.

Should the issue reach judicial proceedings with the supervisory board, a special attorney appointed at the shareholders’ meeting represents the company against the manager (Art. 379 sec. 1 CCC). During judicial proceedings, the plaintiff must establish three elements: (1) the extent of the damages brought on the company, (2) the contributing behavior of the manager that violated the provisions of law or the company’s articles and (3) a causal link between the damage and the manager’s actions.

During the proceedings, the member of the management board must prove a lack of guilt, whereas the company must prove the existence of damages. The court evaluates the manager’s action using due diligence standards that should be applied to a professional manager (1).

If the company fails to bring an action redressing damages within one year following disclosure of injury, a single shareholder or person otherwise entitled to participate in the profit can bring a derivative suit on behalf of the company (actio pro socio). An example of this type of person is a bondholder with rights to participate in company profits. This action is authorized under the provisions of Art. 486 CCC. In such a suit, the plaintiff must prove an abuse by the manager, damage inflicted upon the company and the casual link between the damage and the manager’s actions (2).

However, derivative actions are not an efficient remedy, for several reasons:

  • Free-rider effect and shareholders’ passivity preclude shareholders from bringing a suit in the hope that someone else will bear the costs of the action, especially when the payoff is likely to be negative.
  • There is no favorable cost regime. In fact, the court may order bail to be provided as security for damage caused by the derivative action. This regulation (Art. 486 sec. 2 CCC) aims to prevent an abuse of the derivative action.
  • The information asymmetry makes it difficult for the shareholders to bear the burden of proof. Additionally, in case the action proves to be groundless, and the court establishes that the plaintiff acted in ill faith or was flagrantly negligent, the plaintiff is likely to cover the damages brought by the action upon the manager.

When the manager is insured, depending on the provisions of the contract, the company can sue the manager’s insurer directly, or have a claim against the insurer after a final judgment has been made against the former employee. In such a case, the insurer can also act in the proceedings against the manager as an intervener. Polish civil procedure allows a party to notify and call to attend the proceedings a third party against whom it would have a claim in case of a negative court judgment (Art. 84 C ode of Civil Procedure). A sued manager may notify the insurance company that it can step into the proceedings and argue in the manager’s favor in order to reduce its own liability. The insurer may do this because the insurer would be obligated to pay the company if a court issues a judgment against the manager.

Fact Pattern

In one recent D&O insurance case, a company faced a difficult situation when the insurer refused to pay compensation. The company (Plaintiff) and the insurance company (Respondent) entered into a D&O liability insurance contract. The Respondent agreed to insure all four members of the board of managers against third-party claims or the Plaintiff. It also agreed to pay indemnification in connection with claims occurring during the duration of the contract, or the additional, contractually specified period of time. The contract covered all claims that would result from real or alleged wrongful actions taking place during and in connection with the performance of managerial functions.

One of the managers negotiated and closed a frame agreement concerning delivery of the Plaintiff’s goods and failed to secure the company’s interests. When the recipient failed to meet obligations on the payment for delivered goods, the Plaintiff entered bankruptcy. The Criminal Court sentenced the manager in two instances to imprisonment and issued a fine for inflicting damages upon a legal entity when performing an executive function within it (Art. 296 sec. 3 and 4 of the Polish Penal Code). According to one of the provisions of the general terms of the insurance contract, the Respondent was not liable for the damages caused by actions that constituted a criminal act according to the Penal Code. No investigation against the other managers took place.

Legal Issues of the Case

The main legal problem in the case described above was in determining whether the rest of the management board members could be held liable for failing to prevent the criminal act. These members were not accused in criminal proceedings. Consequently, their case would not fall under the general terms of an insurance contract shielding the Respondent. The Respondent emphasized that there was an internal division of tasks within the board, and that the managers (other than the one convicted) were not supposed to interfere with one another’s tasks. As a result, they claimed they were not liable for damages. The Plaintiff responded that the internal division of tasks did not prevent other managers from controlling the actions of the rest of the management board. This position was supported by the judgment of the Court of Appeal in Katowice (3).

A second issue addressed whether the company could sue the insurer directly or only after a final judgment against the managers was released.

In the first issue described above, the court ruled in favor of the Respondent, stating that the division of tasks was clearly stated in the articles of the management board and that each manager was  responsible for the specific company entities subscribed to them. The action causing damage was not in the scope of the insurance contract, and consequently, the Plaintiff was not entitled to it. In the evaluation of the court, the Plaintiff also failed to prove the liability of other managers. According to the court, the principle of individual liability of a member of the board of managers did not allow a suit against the insurer for the breach of other managers’ obligations towards the company. The Plaintiff appealed.

The Plaintiff argued that the rest of the managers did not fulfill their duties because they knew about the financial condition of the contractor, and moreover, they participated in the creation of the agreement by taking part in negotiations and cosigning the documents. According to the Plaintiff, the internal division of tasks among the members of the management board was not sufficient, especially when Art 371 sec. 1 CCC requires all of the managers to deal with matters of the company. Additionally, Art. 483 sec. 2 CCC puts a duty of care on every manager that is a result of the professional character of their actions. The Plaintiff pointed out that there are at least two spheres of activity of the managers: the internal one within the company and an external one. The external sphere might include entering into interactions with a third party on behalf of the company. Despite the internal division of tasks, the company’s statute required a co-action from the managers, and a joint action of the managers cannot be defined simply as the technical act of co-signing documents. As a result, all of the managers were involved in the creation of the delivery contract that led to the bankruptcy. The duty of every manager is to take care of interests by applying the professional duty of care when taking any actions.

Additionally, the argument that a final judgment against the managers was a prerequisite for suing the insurer was not correct, because the wording of the contract did not provide such terms. The interpretation of the Respondent and the court of first instance missed the nature of the insurance agreement because the scope of the agreement included all actions resulting from fallacious actions. Also, the nature of the insurance contract enables a suit against the insurer directly. The Respondent tried to argue that it was possible for the parties to change this within the contractual freedom of the parties. According to the Plaintiff, however, the terms of agreements cannot be shaped against the nature of the obligation (Art. 3531 CC).

Conclusion

The parties to the dispute, urged by the court, decided to enter into negotiations and finally reached a settlement. Despite an unfavorable judgment of the first instance, the Plaintiff’s position was very strong, and the arguments could likely have been shared by the court of second instance. The fact that the insurer changed the general contract provisions after the settlement indicates a rule about the liability of all managers for the actions or inactions of another member of the board of managers. This rule can be established on the basis of the CCC provisions in cases with similar fact patterns. This finding should motivate other insurers to redesign their contract provisions accordingly in order to limit their liability.

Notes:

1 Judgment of the Supreme Court of January 26, 2000, I PKN 482/99.
2 Judgment of the Supreme Court of February 9, 2006, V CK 128/05.
3 Judgment of the Court of Appeals in Katowice of November 5, 1998. I ACa 322/98.

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