Allens Arthur Robinson Insurance & Reinsurance Forums 2005 February. Directors' and Officers' Insurance

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1 Allens Arthur Robinson Insurance & Reinsurance Forums 2005 February Directors' and Officers' Insurance

2 This paper considers a number of issues arising in relation to D & O Policies and the liability of directors and officers. The paper reviews recent case law developments in respect of D & O Policies, followed by a look at cases dealing with the obligations of directors of trustee companies. The paper also briefly considers the implications of The Sarbanes-Oxley Act for Australian companies and directors and officers and finally looks at the new reporting obligations of auditors under section 311 of the Corporations Act. 1. Recent case law developments in respect of D & O Policies 1.1 Settlement not covered by D & O Policy: Vero Insurance Limited v Baycorp Advantage Limited [2004] NSWCA 390 In considering a Directors and Officers Insurance Policy on 6 December 2004 the Court of Appeal of the Supreme Court of New South Wales held that an insurer was not obliged to indemnify the insured company for a sum paid in settlement of proceedings against itself and its officers, but was liable for common defence costs incurred in those proceedings (despite the fact that a non-insured entity also benefited from those costs). Royal & Sun Alliance Insurance Australia Limited (RSA) refused to indemnify Baycorp Advantage Limited (Baycorp) under a Directors and Officers Insurance Policy (the Policy) for: $10 million paid in settlement (the Settlement Sum) of proceedings to which Baycorp and a number of its officers were defendants (the Proceedings); and Defence Costs (as defined in the Policy) incurred in connection with the Proceedings that had benefited both Baycorp and its officers. Clause 2.1 of the Deed of Settlement (the Deed) provided that: Baycorp on behalf of itself and each of the other defendants in the proceedings will pay [the plaintiffs a total of $10 million in respect of the claims in the Proceedings] in full and final settlement of the Proceedings inclusive of costs 'Loss' was defined in the Policy as: 1. The amount (whether determined by judgment or settlement) which [a Baycorp Officer] is legally liable to pay in respect of a Claim and includes damages, interest and claimant's costs and expenses; 2. Defence Costs. 'Defence Costs' was defined in the Policy as: all reasonable legal and experts' fees, costs, charges and expenses incurred by [RSA] or with its prior written consent in defending, investigating, monitoring or settling any Claim Automatic Extension 1(a) contained in the Policy provided: Where [RSA] has confirmed in writing that a Claim against [a Baycorp officer] is covered under this Policy but elects not to exercise its entitlement to take over or conduct the defence or settlement of that Claim then [RSA] will pay Defence Costs, on behalf of [a Baycorp officer] or [Baycorp] as they are incurred and prior to finalisation of the Claim. ssss S v Page 2

3 Claims Condition 6 contained in the Policy provided: In the event that both [Baycorp's officers] and others (including [Baycorp]) are a party to the Proceedings then [Baycorp] and [RSA] will agree on a fair and proper allocation of damages, interest, claimant's costs and expenses and Defence Costs between Loss covered by this Policy and Loss not covered by this Policy. The questions for the Court were: 1. whether, by reason of the execution of the Deed, and on the proper construction of Clause 2.1, the Settlement Sum was an amount which Baycorp's officers were legally liable to pay in respect of the claims in the Proceedings; 2. whether RSA would therefore be liable under the Policy to indemnify Baycorp for the amount of the Settlement Sum; 3. whether, it would be unconscionable for Baycorp to rely on the construction of Clause 2.1 of the Deed as establishing a 'Loss' for the amount of the Settlement Sum; 4. whether RSA had to pay Defence Costs, even though another uninsured person (Baycorp) received a benefit (being defence of the claims) from those Defence Costs being incurred. (the definition of 'Claim' restricts Defence Costs to costs incurred in relation to a claim against Baycorp's officers and not Baycorp itself); and 5. whether Claims Condition 6 was enforceable. Justice Einstein, at first instance, had answered these questions (1) Yes (2) Yes (3) No (4) Yes (5) No, resulting in RSA being liable to indemnify Baycorp for the Settlement Sum and the disputed Defence Costs. Vero Insurance (formerly RSA) appealed. The Court of Appeal adopted Justice Einstein's findings in relation to question 3 and 5, and only considered questions 1, 2 and 4 in detail. Question 1 - Officers' Legal Liability for the Settlement Sum The Court of Appeal held that the officers of Baycorp were not legally liable to pay the Settlement Sum. The Court considered the words 'Baycorp on behalf of itself and each of the defendants will pay' in clause 2.1, indicated that although payment would discharge the liabilities of its officers, the promise to pay was confined to Baycorp. This construction was supported by: the improbability that those Baycorp officers who were not sued in all of the Proceedings settled by the Deed would agree to become liable to pay $10 million to settle proceedings against them which had a much smaller value; the fact that if such liability was intended a clear statement of the officers' liability would be expected to have been provided in the deed (given that the policy required legal liability of the officers before Baycorp would be indemnified); and the fact that the other clauses of the Deed which sought to bind the officers contained express promises by the officers. Question 2 - RSA's Liability to Indemnify Baycorp for Settlement Sum Under the Policy ssss S v Page 3

4 Although unnecessary (given the negative answer to question 1), the Court of Appeal held that even if the Baycorp officers' were legally liable for the Settlement Sum, that did not automatically require RSA to indemnify Baycorp. Although the definition of 'Loss' in the Policy contained the words 'whether determined by judgment or settlement', those words were held to merely clarify that a settlement payment could be a 'Loss', and did not remove the requirement (where a settlement has been reached without the insurer's consent) that in order to be indemnified the insured establish the settlement was for a reasonable amount and was bona fide. Question 4 - Defence Costs The Court of Appeal held that the insurer was required to indemnify Baycorp for common defence costs that benefited both the insured (the officers) and a non-insured party (Baycorp). In the absence of express words such as 'solely and exclusively' in the policy, the Court was not prepared to restrict Defence Costs to only those costs that exclusively benefited the insured officers. This decision illustrates the way a court will construe settlement deeds to determine whether an insurer is liable to indemnify an insured (in circumstances where the insurer is not a party to the settlement), and makes it clear that indemnities for defence costs incurred will not be confined to costs incurred solely and exclusively in defending the insured entities, without express words to that effect in the policy. 1.2 Fraud exclusion leaves directors out in the cold: Silbermann v CGU Insurance Limited; Rich v CGU Insurance Limited; Greaves v CGU Insurance Limited [2003] NSWCA 203 On 18 June 2004 a bench comprising Kirby, Gummow and Cullinan JJ granted special leave to appeal to the High Court from the decision of the New South Wales Court of Appeal in Silbermann v CGU Insurance Limited; Rich v CGU Insurance Limited; Greaves v CGU Insurance Limited [2003] NSWCA 203 which was handed down on 25 July The final outcome of this case will no doubt be of great interest to insurers and insureds alike in the directors' and officers' liability insurance market. We now look at the relevant judgments to date and the arguments which took place before the High Court in course of the special leave application and comment on the issues arising. The relevant provisions of the policy The relevant provisions of the Policy are set out in the judgment of the New South Wales Court of Appeal. Section 1 of the Policy is entitled 'Operative Clause', and it provides as follows: Directors and Officers Liability Insuring Agreement A The insurer will pay on behalf of the Directors and Officers any Loss for which the Directors and Officers may not be legally indemnified by the Corporation arising out of any Claim, by reason of any Wrongful Act committed by them in their capacity as a Director or Officer, first made against them jointly or severally during the period of Insurance and notified to the Insurer during the indemnity Period. ssss S v Page 4

5 Corporate Reimbursement Insuring Agreement B The Insurer will pay on behalf of the Corporation any loss payment which it is legally permitted to make arising out of any Claim, by reason of any Wrongful Act, committed by any Director or Officer in their capacity as a Director or Officer, first made against the Director or Officer during the Period of Insurance and notified to the Insurer during the Indemnity Period. The total amount payable in respect of all Claims under Insuring Agreement A and/or Insuring Agreement B of this Policy shall not in the aggregate exceed the limit of aggregate liability as stated in Item 5 of the Schedule. Section 2 is titled 'Extensions', and it commences with the following paragraph: Unless specified otherwise to the contrary the cover granted by these extensions is subject to all the terms and conditions of this Policy. Under the heading 'Automatic Extensions' there are a number of relevant clauses: 2.1 Advancement of Defence Costs Where the Insurer elects not to take over and conduct the defence or settlement of any Claim in the name of any Director or Officer, the Insurer shall meet the Defence Costs of any Director or officer in defending or settling any Claim made against them as they are incurred and prior to the finalisation of the Claim provided always that indemnity in respect of such Claim has been confirmed in writing by the Insurer. Where the Insurer has not confirmed indemnity and it elects not to take over and conduct the defence or settlement of any Claim, it may, in its discretion, pay Defence Costs as they are incurred and prior to the finalisation of the Claim, provided that It has consented in writing to such Defence Costs prior to their being incurred, such consent not to be unreasonably withheld. The Insurer reserves the right to recover any Defence Costs from the Directors or Officers and/or the Corporation severally according to their respective interests in the event and to the extent that it is subsequently established by judgement or other final adjudication that the Directors and Officers and/or the Corporation were not entitled to the Defence Costs so advanced. 2.6 Attendance at Official Investigations or Inquiries The Insurer will pay Defence Costs incurred with its prior written consent by or on behalf of a Director or Officer in attending any official investigation, examination, inquiry or other proceedings ordered or commissioned by any official body or institution, where a Director or Officer is legally compelled by such body or institution to attend such investigation, examination, inquiry or proceeding and which involves an allegation of a Wrongful Act against a Director or Officer which is the subject of indemnity under this Policy. Section 3 of the Policy is titled 'Exclusions', and it commences as follows: This Policy does not provide an indemnity against any Claim made against any Director or Officer: There are a number of clauses in Section 3, the most relevant of which is Clause.3.1, which provides as follows: 3.1 Dishonesty & Fraud ssss S v Page 5

6 brought about by, contributed to by or which involves: (1) the dishonest, fraudulent or malicious act or omission or other act or omission committed with criminal intent of such Director or Officer, (2) such Director or Officer having improperly benefited in fact from securities transactions as a result of information that was not available to other sellers and/or purchasers of such securities; or (3) such Director or officer having gained in fact any personal advantage to which he/she was not legally entitled. However, this exclusion shall only apply to the extent that the subject conduct has been established by a judgement or other final adjudication adverse to the Director of Officer. Section 4 of the Policy is entitled 'General Conditions': 4.4 Claims Co-operation The Directors and Officers shall use due diligence and do and concur in doing all things reasonably practicable to avoid or diminish any Loss hereunder, and shall immediately give all such information and assistance to the Insurer as it may reasonably require to enable it to investigate and to defend the Claim and/or to enable the Insurer to determine its liability under this Policy. The Insurer may, on request from the Directors and Officers for indemnity under this Policy, take whatever action that it considers appropriate to protect the Directors' and Officers' position in respect of the Claim and such action by the Insurer shall not be regarded as in anyway prejudicing its position under this Policy and no admission of the Directors' and Officers' entitlement to indemnity under this Policy shall be implied. 4.5 Allocation In the event of a Claim which is made against Directors and Officers or the Corporation and which is covered only partly by this Policy, the Insurer will use its best efforts to ensure a fair and proper allocation of the claim for insured and uninsured portions. The Insurer will also advance Defence Costs on a similar basis, which will apply to all Defence Costs unless otherwise agreed by all parties Q.C. Clause Neither the Directors and Officers nor the Insurer shall be required to contest any legal proceedings unless a Queen's Counsel or Senior Counsel (mutually agreed upon by the Directors and Officers and the insurer or in default of such agreement, selected by the Chairman or President of the local Bar Council) shall advise that such proceedings should be contested. In formulating his or her advice, Counsel shall take into consideration the economics of the matter, having regard to the damages and costs which are likely to be recovered by the plaintiff, the likely Defence Costs and the prospects of the Directors and Officers successfully defending the action. The costs of such Counsel's opinion shall, for the purpose of this Policy, be regarded as part of the Defence Costs. In the event that Counsel advises that, having regard to all the circumstances, the matter should not be contested but should be settled, providing settlement can be achieved within certain limits which, in Counsel's opinion, are reasonable, then the Directors and Officers shall not object to any such settlement and shall co-operate with the Insurer to effect such settlement in accordance with this Policy Settlement Procedure ssss S v Page 6

7 Subject otherwise to the provisions of the Insurance Contracts Act 1984 the Directors and Officers shall, as a condition precedent to the right to be indemnified under this Policy, not admit liability for or settle any Claim or incur any costs or expenses in connection therewith or enter into settlement without the written consent of the insurer who shall be entitled to at any time to take over and conduct in the name of the Director or Officer the defence or settlement of any Claim. However, if the Director or Officer shall refuse to consent to any settlement recommended by the Insurer and shall elect to contest or continue any legal proceedings in connection therewith, the Insurer's liability for the Claim shall not exceed the amount for which the Claim could have been so settled plus the Defence Costs incurred up to the date of such refusal. Section 5 of the Policy is titled 'Definitions' and contains the following relevant definitions: 5.1 Claim "Claim" shall mean: (1) any writ, summons, application or other originating legal (criminal, civil or otherwise) or arbitral proceedings, cross claim or counter-claim issued against or served upon any Director or Officer alleging any Wrongful Act; or (2) any written demand alleging any Wrongful Act communicated to any, Director or Officer under any circumstances and by whatever means. 5.3 Defence Costs "Defence Costs" shall mean: all reasonable costs, charges and expenses (other than regular or overtime wages, salaries or fees of any Director or Officer) incurred with the prior written consent of the Insurer in defending, investigating, attending or monitoring any Claim or proceedings, including but not limited to official investigations, examinations, inquiries and the like, or appeals therefrom, together with all reasonable costs of bringing any appeal, 5.8 Loss "Loss" shall mean: the amount payable in respect of a Claim made against the Directors and officers for a wrongful Act and shall include damages, judgements, settlements, interest, costs and Defence Costs. In respect of Section 2.5 (Insured vs insured Cover) and 2.20 (Entity Cover for Employment Practices Liability) this Policy will include back-pay where reinstatement by a court is ordered but excludes any amount which the insured is or was required to pay pursuant to a specific obligation imposed under a contract of employment, employment agreement, statute, award or otherwise. "Loss" excludes a Claim arising from or by reason of or directly or indirectly caused by or arising from fines and penalties imposed by law, punitive, exemplary or aggravated or multiple damages, income tax, customs duties, excise duty, stamp duty, sales tax or any other State or Federal tax or duty Wrongful Act "Wrongful Act" shall mean: any actual or alleged breach of duty, breach of trust, neglect, error, misstatement, misleading statement, omission, breach of warranty of authority or other act done or attempted by or any other matter claimed against any Director or Officer or any of them ssss S v Page 7

8 wherever or whenever while acting in their individual or collective capacities as Directors or Officers. Background to proceedings Silbermann, Rich and Greaves are former directors of One.Tel Limited (One.Tel). In respect of their conduct in the course of the management of One.Tel, the Australian Securities and Investments Commission (ASIC) commenced proceedings against Silbermann, Rich and Greaves. Silbermann, Rich and Greaves were issued a directors' and officers' liability insurance policy (the Policy) by CGU Insurance Limited (CGU). CGU did not confirm indemnity under the Policy and refused to advance defence costs. Silbermann, Rich and Greaves sought a declaration obliging CGU to indemnify each of them and to pay in advance the defence costs of investigations brought by ASIC. In the Supreme Court of New South Wales (Silbermann, Greaves, Rich v CGU Insurance Limited [2002] NSWSC 1195), the matter was heard by McClellan J. McClellan J had previously considered an application by Silbermann, Rich and Greaves on 18 September 2002, in which they sought to strike out certain paragraphs of CGU's defence filed in response to Silbermann, Rich and Greaves seeking a declaration obliging CGU to indemnify each of them and to pay in advance the defence costs of investigations brought by ASIC. The offending paragraphs of the defence were paragraphs 35, 36 and 37: 35. Further and in the alternative, the defendant says that it was an express term and condition that the said policy does not provide any indemnity against any claim made against any director or officer brought about by, contributed to by, or which involves, the dishonesty or fraudulent act or omission of such director or acts or omissions brought about by, contributed to by, or which involve, criminal intent of such director. 36. The defendant says that the claim made against the plaintiff in proceedings number 5934 of 2001, the claim in relation to proceedings number 3028 of 2001, the claim in relation to the examination in proceedings number N3016 of 2001 and the ASIC investigations pursuant to Part 3 ASIC Law if otherwise within the terms of the cover under the said Policy, which is not admitted, are excluded from any obligation to indemnify the plaintiff by reason of being brought about by contributed to by or involving the dishonest and/or fraudulent acts and omissions by the plaintiff and/or by reason of acts or omissions being brought about by contributed to by or involving the plaintiff committed with criminal intent of the plaintiff. Particulars (a) the financial information that was withheld from the Board of Directors: (i) the management accounts were withheld from the Board of Directors; (ii) the management records revealing growth in overdue trade creditors was withheld from the Board of Directors; (iii) the records revealing the true cause and extent of difficulties in the collectability of debtors was withheld from the Board of Directors; ssss S v Page 8

9 (iv) the true Group losses were withheld from the Board of Directors and understated; (v) the true expected cash collections from debtors were withheld from the Board of Directors and overstated; (vi) the true earnings information in the management records was not provided to the Board of Directors; (vii) the management records to permit the Board of Directors to monitor management, properly assess the financial position and performance of the Group and to detect material adverse developments were withheld from the Board of Directors; (viii) the true cash balance at the end of each month was withheld from the Board of Directors; (ix) the extent of unpresented cheques and other cash unavailable for payment of creditors was withheld from the Board of Directors; (x) the reconciliation between the Flash Reports and Management Accounts was withheld from the Board of Directors. (b) the said financial information was necessary for the Board of Directors to fulfil its responsibility in respect of the Board procedure whereby the Board as a whole was to monitor compliance with statutory responsibilities and accounting and financial control procedures to ensure the accounts and other records are accurate and reliable; (c) the plaintiff knew that the said financial information was withheld from the Board of Directors and thereby intended to prevent the Board as a whole monitoring compliance with statutory responsibilities and accounting and financial control procedures to ensure the accounts and other records are accurate and reliable; (d) in the premises the withholding of the said information was dishonest and/or fraudulent acts by the plaintiff; (e) the plaintiff knew of or was recklessly indifferent to the withholding of financial information from the Board of Directors; (f) the plaintiff says that the withholding of information was committed recklessly or was intentionally dishonest and that the plaintiff failed to exercise his power and discharge his duties in good faith in the best interests of the corporation or for a proper purpose within the meaning of s 184 of the Corporations Act For the purpose of application of the said exclusion the defendant seeks a judgment or final adjudication adverse to the plaintiff in relation to the said conduct in these proceedings. Silbermann, Rich and Greaves submitted that: Exclusion Clause 3.1 requires that there be a 'judgment or final adjudication' which establishes the relevant conduct before the exclusion will operate, however, a judgment or final adjudication has not been given, therefore the exclusion is not presently available to CGU; ssss S v Page 9

10 the judgment or final adjudication contemplated in the clause is one given in proceedings, other than the present proceedings in which indemnity is claimed and until such a finding is made in the ASIC matter, or some other relevant proceeding, they are entitled to an indemnity under the Policy; Clause 2.1 of the Policy contains an express provision for the advancement of Defence Costs which includes a right in the insurer to recover those costs in certain circumstances; and in paragraph 36 of the defence CGU has not pleaded any fact alleged to constitute the conduct characterised as 'dishonest and/or fraudulent' or committed with 'criminal intent' and the paragraph os not saved by the particular therefore at least paragraph 36 should be struck out. Silberman and Rich also submitted that Exclusion Clause 3.1 is expressed so that the Policy does not provide an indemnity against any claim with the relevant characteristics since the clause only refers to a 'Claim', 'Defence Costs' being separately defined, therefore the exclusion is confined to financial obligations falling within the definition of a 'Claim'. CGU responded by arguing that: the Policy provides indemnity in relation to any 'Loss', which relevantly means the amount payable in respect of a 'Claim', including 'Defence Costs', therefore Exclusion Clause 3.1 will operate to exclude 'Defence Costs' associated with the relevant 'Claim'; Exclusion Clause 3.1 must be construed according to its natural or ordinary meaning, read in the light of the contract as a whole; to the extent that it is suggested that the application of the Exclusion Clause 3.1 must be established by a judgment or other final adjudication in proceedings to which CGU is not a party, that is not the natural and ordinary meaning of the words used, because the words used are clearly capable of catching a judgment or final adjudication raised in proceedings to which CGU is a party or raised in third party proceedings; it creates an absurd construction that CGU, in the application of the exclusion, is at the 'whim and fancy' of a third party in the bringing of proceedings which alleges and establishes the relevant conduct; and the phrase only apply to the extent that create a condition precedent for the operation of the exclusion and do not have a temporal construction that imposes an interim obligation to indemnify. McClellan J refused to strike out paragraph 35. His Honour was not persuaded that CGU's case regarding the construction of the relevant clauses of the Policy was such that it could not reasonably be argued. His Honour noted that the proceedings may ultimately turn only upon the construction of the Policy, therefore those issues should be determined in final hearing. McClellan J went on to strike out paragraphs 36 and 37, however granted leave to CGU to replead the matters raised by those paragraphs in the appropriate form. ssss S v Page 10

11 Silbermann, Rich and Greaves then brought a motion seeking separate determination of three questions, whether, on the true construction of the Policy: (a) (b) (c) absent an existing judgment, order or other final adjudication adverse to a director or officer, the defendant can rely on exclusion 3.1 in answer to a claim for indemnity under the policy; the defendant itself is entitled to seek a judgment, order or other final adjudication adverse to a director or officer and, thereby, exclude liability for a claim under clause 3.1 of the Policy in the same proceedings in which an insured makes a claim for indemnity against the defendant; exclusion clause 3.1 of the Policy operates to exclude liability on the part of the defendant to pay claims by an insured for the indemnity under clauses 2.1 and 2.6 of the Policy. McClellan J noted that the defences raised by CGU raise two major questions in the proceedings: whether CGU is entitled to avoid the policy by reason of any non-disclosure or misrepresentation; and whether CGU can rely on Exclusion Clause 3.1 of the Policy in answer to a claim for indemnity in circumstances where there has been no relevant judgment or finding by any court or other body. McClellan J considered that the determination of the separate questions as proposed by Silbermann, Rich and Greaves, on the assumption that the matters pleaded against each plaintiff are true, does provide the real possibility of avoiding the necessity of litigating substantial factual allegations which have been made, with consequential savings in time and costs and granted the motion. The matter proceeded to hearing on 3 December The first instance decision The three questions that came before McClellan J for determination in their final form are as follows: 1. whether, on the true construction of the Policy issued by CGU absent an existing judgment, order or other final adjudication adverse to Silbermann, Rich and Greaves, CGU can rely on Exclusion Clause 3.1 in answer to the claim for indemnity by Silbermann, Rich and Greaves under the Policy; 2. whether, on the true construction of the Policy issued by CGU, CGU itself is entitled to seek a judgment, order or other final adjudication adverse to Silbermann, Rich and Greaves and, thereby, exclude liability for a claim under clause 3.1 of the Policy in the same proceedings in which Silbermann, Rich and Greaves makes a claim for indemnity against CGU; and 3. whether, on the true construction of the Policy issued by CGU, exclusion clause 3.1 of the Policy operates to exclude liability on the part of CGU to pay claims by Silbermann, Rich and Greaves for indemnity for Defence Costs under: (i) (ii) (iii) (A) Clause 2.1 of the Policy; Clause 2.6 of the Policy; Insuring Agreement A of the Policy; and Insuring Agreement B of the Policy. ssss S v Page 11

12 The above questions were determined upon the assumption that the allegations pleaded by CGU against the plaintiffs in its defence are true. The first question Silbermann, Rich and Greaves submitted that the last paragraph of Exclusion Clause 3.1 limited its operation to the circumstance where a relevant judgment or final adjudication has been made. Silbermann, Rich and Greaves submitted that until that occurred they are entitled to indemnity. They submitted that the use of the past tense in the phrase 'has been established' is critical. Silbermann, Rich and Greaves also submitted that an exclusion, such as Exclusion Clause 3.1, is to be read subject to the well established general rule of construction, that it is to be construed 'according to its natural and ordinary meaning, read in light of the contract as a whole, thereby giving due weight to the context in which the clause appears, including the nature and object of the contract, and where appropriate, construing the clause contra proferentem in the case of ambiguity'. CGU in response submitted that: Exclusion Clause 3.1 contains no reference to a judgment or other final adjudication in prior proceedings or other proceedings; Exclusion Clause 3.1 assumes that the policy is in operation and provides an exclusion to the insurers obligation where certain conduct is established; although the exclusion only takes effect when a relevant finding is made, the insurer is entitled to decline indemnity and argue that such a finding should be made; it is commonsense that a third party seeking recovery against an insured will not plead fraud or dishonesty (if that is possible) for it is likely to trigger exclusion clauses and may deny the third party access to the insurance fund and therefore the parties to the insurance policy could not have intended that indemnity would depend upon the conduct of a stranger to the policy; the words 'has been established' do not import a concept of 'prior or other' proceedings, and the ongoing nature of a dispute as to indemnity, which is the context of Exclusion Clause 3.1, requires the clause to be given a contemporary meaning; and the construction advanced by the Silbermann, Rich and Greaves is contrary to the 'fundamental principle of all insurance law that the insured is debarred by an implied term from recovering on the policy if he intentionally caused the loss or event upon which the insurance moneys were expressed to be payable'. The second question Silbermann, Rich and Greaves submitted that if the court answered the first question in the negative, it must also answer the second question in the negative. However, Silbermann, Rich and Greaves submitted that if the court's answer to the first question is 'yes', then the issue becomes whether CGU may seek relevant findings in the indemnity proceedings. In this respect, Silbermann, Rich and Greaves submitted that CGU was prevented from doing so by s 13 of the Insurance Contracts Act 1984 (Cth) (the ICA), ssss S v Page 12

13 which implies a term into the Policy obliging CGU to act in good faith in respect of any matter arising under the policy. Silbermann, Rich and Greaves accepted that it is commonplace for insurers to plead reliance upon exclusion clauses and to attempt to make good that position in indemnity proceedings but noted that there is no breach of any duty of good faith in so doing in the ordinary case because the parties are free, once in dispute, to act reasonably in the pursuit of their own interests. However, in the present case, CGU is seeking to breach its duty because it is seeking to establish as against its insured a fact necessary for the attraction of the exclusion clause, namely, a judgment, which would not exist but for the conduct of the insurer. Silbermann, Rich and Greaves argued that on reading the contract of insurance as a whole, seeking to give a practical measure of protection to an insured and bearing in mind CGU s obligations to act in good faith, the 'judgment or other final adjudication' must mean one obtained by a person other than the defendant. It cannot therefore, be a judgment obtained in these proceedings, therefore the answer should be no. CGU responded by submitting that: there is no proper basis to construe Exclusion Clause 3.1 as being confined to circumstances where the exception can only be established by other parties and in other proceedings; the context of Exclusion Clause 3.1 is the relationship between the insurer and the insured, and if the question was answered 'no', CGU is possibly precluded from ever being able to prove that conduct of the character falling within the exclusion has occurred as there may be no proceedings which would be concerned with or depend upon matters in respect of which a relevant finding would trigger the exclusion; and there is nothing in Exclusion Clause 3.1 which justifies or requires the construction advanced by Silbermann, Rich and Greaves. The third question Silbermann, Rich and Greaves submitted that the Policy provides indemnity against two discrete types of liability: 1. 'Claims' namely for demands by third parties alleging a Wrongful Act (clause 5.1); and 2. 'Defence Costs' namely a liability to the insured s own solicitor (clause 5.3). Silbermann, Rich and Greaves submitted that because they are only seeking indemnity for 'Defence Costs', as opposed to a 'Claim', Exclusion Clause 3.1 which refers in its opening words to 'any Claim', does not apply. 'Claim' is a defined expression they argued, it is the claim made against a director or officer by a third party. Accordingly, the quality of the insured s conduct, and any finding in relation to it, is irrelevant to the operation of Exclusion Clause 3.1. Silbermann, Rich and Greaves submitted that the language of Exclusion Clause 3.1 should be contrasted with the obligation of the defendant in 'Insuring Agreement A'. They ssss S v Page 13

14 suggested that the exclusions in Section 3 are differently expressed and narrower in scope than the indemnity. CGU responded by submitting that: CGU s obligation to indemnify derives from the two 'Operative Clauses' in Section 1 of the Policy: the 'Directors and Officers Liability Insuring Agreement A'; and the 'Corporate Reimbursement Insuring Agreement B'. the general scheme of those two clauses being that if the corporation is 'legally permitted' to make payment for a 'Claim, by reason of any Wrongful Act' in respect of a director and officer, CGU will make that payment on behalf of the corporation, and where the director or officer is not entitled to 'be legally indemnified by the Corporation' for any 'Loss' 'arising out of any Claim, by reason of any Wrongful Act', CGU will make that payment on behalf of the director or officer; since for the purpose of this hearing, the conduct required to trigger Exclusion Clause 3.1(1) is accepted to be true, the corporation is not legally permitted to indemnify the plaintiffs; accordingly, the indemnity pursuant to the policy is the obligation to pay pursuant to 'Insurance Agreement A', that is to pay any 'Loss' which includes 'Defence Costs'; however, the obligation to pay pursuant to 'Insuring Agreement A' is subject to Exclusion Clause 3.1 and Exclusion Clause 3.1 of the policy does not contain, nor does any other clause in Section 3 contain, any provision precluding the operation of Exclusion Clause 3.1 in respect of 'Defence Costs' generally or, if operative, payments made pursuant to Section 2 of the Policy. The decision of McClellan J McClellan J has answered all questions 'yes' and gave the following reasons: although exclusion clauses in insurance policies should be construed against the insurer, that rule has no application in the circumstances; the exclusion provided by Exclusion Clause 3.1 operates to confine CGU s obligation under the policy, without which, the obligation would be to indemnify the Director or Officer with respect to any relevant 'Loss' including any 'Defence Costs'; Exclusion Clause 3.1 affects any determination which gives rise to an obligation to make a payment pursuant to a 'Claim' and any 'Defence Costs' associated with the 'Claim'; the primary obligations of CGU are provided in Section 1 of the Policy, while Section 2 provides the Extensions which are 'subject to all the terms and conditions of this Policy', including Exclusion Clause 3.1; the final paragraph of Exclusion Clause 3.1 does not exclude CGU from both pleading the exclusion in the present proceedings and doing so without a relevant finding having been made in other proceedings and all that the final paragraph does is make plain that CGU can only sustain its denial of indemnity if the relevant final determination is ssss S v Page 14

15 made and there there is nothing in the clause to suggest that the exclusion should be confined to a finding in proceedings other than the indemnity proceedings; the rights of the parties to a policy of insurance often have to be determined by a court and in that process either party is able to advance its position and assert that the objective facts entitle the insured to indemnity or otherwise this does not involve any lack of 'good faith' by either party; and it would be extraordinary if a policy of insurance provided indemnity in circumstances where the conduct which gave rise to the claim was dishonest or fraudulent, therefore, without clear words, such a construction of the policy should not be accepted. Silbermann, Rich and Greaves appealed from the decision of McClellan J to the New South Wales Court of Appeal. The decision of the New South Wales Court of Appeal By a majority of 2-1, with Hodgson dissenting in respect of the answer to question 1, the New South Wales Court of Appeal upheld the first instance decision of McClellan J. The first question The majority, consisting of Tobias JA and Beazley JA agreed with the decision of the primary judge an answered 'yes' to the first question. Hodgson JA, dissenting on this question, observed that the final paragraph of Exclusion Clause 3.1 was intended to confer a benefit on the insured, a benefit consistent with the general purpose of the Policy, to assist in defence against allegations, at least until such time as allegations involving dishonesty were proved. His Honour accepted the interpretation put forward by Silbermann, Rich and Greaves in respect of the phrase 'has been established' and stated the Exclusion Clause 3.1 cannot prevent the insurer denying indemnity until the requisite judgment or adjudication has been obtained. In his Honour's opinion this view is supported by Clauses 4.4, 4.5, 4.15 and 4.16 of the Policy. Hodgson JA noted that in cases such as the present an insured can say that, if it does not have the funding for its defence, there will not be a fair decision as to whether there was dishonesty; and the insurer can say that, if it is compelled to fund the defence, the money will be unrecoverable and it will lose the benefit of the dishonesty exclusion. His Honour thought that the correct emphasis was on the insured s interest in a fair hearing, and found for Silbermann, Rich and Greaves on this question. In respect of Clause 2.1 Hodgson JA held that the clause merely gives CGU a discretion in relation to the timing of payment of 'Defence Costs', and it permits CGU in its discretion to withhold payment until 'Defence Costs' have actually been incurred and paid. The majority held that an insurer could wait for the outcome of a claim involving fraud before indemnifying for Defence Costs. This was because in the majority's view, Clause 2.1 was clear and unambiguous in its terms and therefore its has to be given full effect because its discretionary operation is not excluded in circumstances where Section 1 indemnity is refused by CGU solely in reliance upon Exclusion Clause 3.1. However, the court noted that an insurers refusal to indemnify for Defence Costs must be based on reasonable grounds. ssss S v Page 15

16 Further, in respect of the interpretation of the phrase 'has been established' the majority rejected the interpretation put forward by Silbermann, Rich and Greaves noting that the Policy was not intended to provide a form of 'up front' indemnity which would in fact be the effect if the phrase was given the interpretation argued by Silbermann, Rich and Greaves. This is because if indemnity under Section 1 of the Policy with respect to 'Defence Costs' cannot be refused unless and until a judgment or other final adjudication establishes dishonest conduct in accordance with the concluding paragraph of Exclusion Clause 3.1, then it would also follow that unless and until that occurs the insurer would be required to not only indemnify the insured against 'Defence Costs' but also against any other amounts payable in respect of a 'Claim' where the liability to pay such amounts is determined in proceedings between the insured and the third party claimant before the insurer obtains a judgment against the insured establishing conduct which satisfies Exclusion Clause 3.1. The majority viewed this as an unsatisfactory outcome. The second question Hodgson JA, with whom Tobias JA and Beazley JA agreed, answered 'yes' to this question. The court noted that if this question was not answered in the affirmative, an Insurer may not be able to take advantage of the exclusion if it could not raise the fraud defence. Hodgson JA noted however that the obligation of good faith means that the insurer can rely on any defence only if it has reasonable grounds to do so; and generally this would require legal advice given on the basis of full instructions as to facts and evidence known to the insurer. The third question Hodgson JA, with whom Tobias JA and Beazley JA, agreed answered 'yes' to this question. The court rejected the interpretation submitted by Silbermann, Rich and Greaves and found that the Policy as a whole did not support an interpretation which would draw a sharp distinction between indemnity against a 'Claim' and indemnity against 'Defence Costs'. The court held that although Exclusion Clause 3.1 referred to an indemnity against any 'Claim' and 'Claim' was defined in terms of documents, what clearly was meant was an indemnity for the consequences of the 'Claim', which includes the 'Defence Costs'. The hearing of the Applications for special leave to appeal On 21 August 2003 Silbermann and Rich filed Applications for Special Leave to Appeal (the Applications) in the High Court of Australia. The Applications were made, amongst other things, on the grounds that: the Court of Appeal erred in answering in the affirmative the three questions as to the construction of the exclusion clause in the policy; and the Court of Appeal erred in constructing the policy and the relevant exclusion clause: in a manner inconsistent with the commercial purpose and object of the policy; ssss S v Page 16

17 in a manner consistent with the insurer's obligation of utmost good faith; otherwise than in accordance with the natural meaning of the words used in the exclusion clause; without applying the rule of construction that exclusion clauses in insurance policies are to be construed strictly against the interests of the insurer; and in a manner which permitted the insurer to obtain the benefit of the exclusion clause notwithstanding that the proviso thereto had not been satisfied in that the relevant conduct had not been established by a judgment or other final adjudication. On 18 June 2004 a bench comprising Kirby, Gummow and Cullinan JJ granted special leave to appeal to the High Court from the decision of the New South Wales Court of Appeal. Although the exchange between the bench and counsel representing Silbermann, Rich and CGU can not reveal how the High Court may decide the appeal, some of the comments made in the course of the hearing may indicate the position of the three judges hearing the special leave application. Callinan J expressed concerns about the fact that in the circumstances the insured would end up 'in a very difficult position because it ends up with the insurer having much the same interest as the plaintiff or claimant against the insured'. Callinan J thought that this was a factor to be considered when considering the construction of an insurance policy where that policy contains ambiguity of any kind. Callinan J also noted that fraud includes wilful disregard or recklessness and that this should not be overlooked in the circumstances. Kirby J has first focused on the interpretation of the phrase 'has been established' and noted that the wording of a policy was in the hands of the insurer and that it was open to the insurer to frame a particular clause to specifically exclude liability if they wished to do so: [The insurer] could have said where fraud is specifically alleged against a person, knowing that there are rules of law and practice that would prevent you making that allegation without due cause, so that they could have worded it in such a way that there was an easier application but they used the past participle: "has been established". His Honour later noted that the phrase 'has been established' infers that it 'has been established by a court of law' and such an interpretation could have been overcome by the use of another phrase (eg. 'has been specifically alleged'). Mr Bathurst QC, appearing for CGU, brought to the attention of His Honours that the application before them has proceeded on the basis of the hypothesis that the facts raised in the defence are correct and in those circumstances even if Silbermann and Rich were successful on the Applications, their position would not be advanced at all. It was noted that even if the present appeal was successful, CGU alleges that it is entitled to avoid the policy for fraudulent non-disclosure and misrepresentation and its decision to decline to indemnify the insured was not exclusively based on the exclusion clause. Nevertheless, Callinan J considered that various issues may be hived off in these proceedings as they ssss S v Page 17

18 have been done previously and therefore this did not represent an issue which would prevent the High Court form deciding on the appeal. It appears from the transcript of the proceedings that Callinan J was primarily concerned about the position of an insured in the circumstances of Silbermann and Rich and the effect of the interpretation of the exclusion clause by the Court of Appeal in respect of the commercial purpose and object of such a policy. Kirby J appears to have focused on the issue that the insurer had the ability to draft an exclusion clause on terms which were clear and unambiguous, if it wished the exclusion clause to have the effect it was now asserting. Although the special leave application hearing cannot provide a precise guidance as to how the High Court may decide this case, the comments made by at least two of the judges of the court indicate that it is not beyond the realm of possibility that the decision of the NSW Court of Appeal may be overturned. 1.3 Daniel Wilkie v Gordian RunOff Ltd & Anor [2003] NSWSC 1059 This decision affirmed the position in Silbermann v CGU Insurance Ltd & Anor [2003] NSWCA 203 and is to the effect that insurers may avoid liability under an insurance policy on the basis of fraudulent or dishonest conduct, even in the absence of a judgment or final adjudication. Although the policy wording considered in this cost was not dissimilar to that used in many D&O policies, the outcome in each case will largely depend on the precise wording of individual policies. Mr Wilkie was an executive officer or employee of FAI Insurance Ltd, and as such, was covered by FAI's insurance policy provided for by Gordian RunOff Ltd (formerly GIO Insurance Ltd) (the Policy). It was alleged by ASIC that Mr Wilkie breached certain provisions of the Corporations Act 2001 (Cth) (the CA), including sections 1309 (1) and 1311 (1) of the CA by knowingly permitting misleading information to be provided to auditors and acting dishonestly in the discharge of the duties of his office (s 1401 of the CA). Mr Wilkie never admitted to these allegations, and they were never proven against him in any tribunal or Court. The Policy provided for the avoidance of liability in Exclusion 7 in the following terms: This policy does not insure Loss arising out of any Claim: based upon, attributable to, or in consequence of: (i) (ii) any dishonest, fraudulent, criminal or malicious act or omission; or any deliberate breach of any statute, regulation or contract; where such act, omission or breach has in fact occurred;' The words 'in fact' were of importance, and were defined in the following terms: the words "in fact" shall mean that the conduct referred to in those Exclusions is admitted by the Insured or is subsequently established to have occurred following the adjudication of any Court, tribunal or arbitrator.' Automatic Extension 9 of the Policy provided for the advance payment of defence costs if ssss S v Page 18