IN THE NEWS: Financial Institutions
Banks have been in the news for all the wrong reasons lately.
Some of us are old enough to remember the financial crisis of 2009 (and even the collapse of Barings bank in 1995!) I’m not going to analyse why banks are struggling – there is a glut of material out there on that. What are some of the policy issues likely to arise when a bank collapses or is taken over unexpectedly? Here’s a handy summary on the main products below.
D&O
Everyone leaps for their policy. For US traded banks US securities class actions will be commenced as soon as the share price plummets on the release of unexpectedly worrying news. This is before developments play out and we know whether the bank will trade through, be taken over or goes insolvent. It’s important at this point to notify the policy promptly of any claims or circumstances likely to give rise to a claim.
If the bank trades through …
There are no immediate policy consequences, but the next scheduled renewal could be a challenge.
Avoid insolvency exclusions where possible as if the bank subsequently goes insolvent there will be no company indemnification and the policy becomes the directors’ only hope. Insurers could face an accusation of “illusory cover”. Underwrite (or decline) the risk and price accordingly.
The prior notified matters exclusion on the renewed policy ought to ensure that anything related to the issues that caused the problem notified stays in the expiring year. If there has to be a specific matters exclusion make sure it takes out the matter specifically.
If the bank is taken over (Credit Suisse being a re cent example) …
The policy will go into run-off for the remainder of the policy period and serious thought will need to be given to purchasing a run-off policy (in practice an extension of the current policy, as amended) for at least six years from the transaction to pick up claims that relate to the problematic pre-transaction period.
Clarify who pays for it and to whom matters are notified on it – if the bank is absorbed and effectively ceases to exist someone in the acquiring entity will need to be authorised to notify and manage the claims on behalf of the former directors.
Any claims after the takeover that relate to matters after the takeover will be for the acquiring entity’s D&O insurers. On that subject, a large acquisition would need to be advised to the acquiring entity’s D&O insurers beforehand because under the terms of its D&O policy it’s unlikely the coverage would be extended automatically. Also, it’s the right thing to do to ensure everyone is on side.
So, if there’s a chance to clarify what happens on an imminent renewal this could be a good idea. And if an
insolvency or takeover seems likely the termination provisions ought to be checked – do not assume they are the
same as in a D&O policy!
Professional Liability
Professional liability is a very broad church, and the policies vary wildly depending on the professional sector insured. What follows is solely from an FI perspective.
If the insolvency / takeover is linked to a large PI loss(es) this will complicate matters. This has happened – remember the collapse of Arthur Andersen after the Enron, Worldcom and Waste Management accounting scandals?
Similar considerations to the D&O will apply to the notification of claims. However, in the case of PI it’s important to check whether there is a mandatory notice of circumstances provision. This is likely to be less onerous in terms of the quality and amount of information required to be notified but a failure to notify promptly could have more serious consequences.
Insolvency and takeovers may or may not be treated the same, like in the D&O. They may put the policy into run-off, so the same considerations apply (see above). From experience though the PI is less likely to say explicitly what happens than the D&O even though it would make sense for it to do so. If silent:
Arguably the policy continues as normal until policy expiry, and this may be the best option for the Insured in the case of insolvency.
In the case of a takeover, if a run-off policy is going to be needed following policy expiry it would be better to engage on the subject at the point of the transaction and not run the risk of an issue on policy expiry.
In a takeover the acquiring entity’s PI policy may not contain any automatic acquisition coverage and so if the bank is to continue to be covered for ongoing matters post acquisition this will need to be addressed with the acquiror’s existing PI insurers and a run-off policy bought for claims arising out of the bank’s pre-transaction matters.
There is a further consideration on the PI where the bank goes insolvent: the insolvency exclusion.
There is quite likely to be an insolvency exclusion in the policy. This ought to just capture claims caused by the insolvency of the bank, in other words errors and omissions subsequent to the collapse. An insolvency event is very likely to cause huge disruption to the daily business of the bank and so more mistakes will be made, and trading commitments left unhonoured. People may be leaving in droves in an unstructured way mid-transaction or
assignment.
This could lead to an avalanche of claims that would otherwise not have been brought and insurers take the understandable position this is a material change in the risk and should be excluded.
What should not be excluded is claims subsequent to the insolvency that arise from matters pre-dating the insolvency, even if they helped cause the demise of the bank. This is where the choice of exclusionary language becomes important so that the distinction is clear. This may be worth checking for any imminent renewal to ensure it does what is intended.
Of course, nothing in the above or in the policy language necessarily prevents the parties from achieving more innovative or nuanced solutions in these situations. Out of risk also comes opportunity. I can think of many occasions when markets have done this, so an open mind should be kept.
ESG: STOP PRESS
If you’re involved in D&O, look out for the new TCFD* statements in public company Annual Reports now!
The Financial Reporting Council (soon to become “ARGA”) have commented: ‘The first year of mandatory TCFD disclosures has been challenging for many preparers due to the complexities of data collection, the need to establish robust new processes, sometimes involving information provided by third parties in the company’s value chain, and the lack of established good reporting practice.’
* Task Force on Climate-Related Financial Disclosures
HEADS UP: CLIP POLICIES
What is a CLIP? CLIP stands for Contractual Liability Insurance Policy
What does it cover? It covers the liability of the Insured that it assumes under a contract in certain situations, such as a guarantee.
Why is it needed? Most standard liability policies exclude liability assumed under contract.
Is it topical? Yes, it is having a resurgence in the InsurTech eld. Typically, it will be used to back up a guarantee or warranty that goes with a service or product being provided by the Insured. In InsurTech this might be a specialised technical service or innovative product.
How does it work? The insurer covers all or a proportion of the loss under service/product guarantee/warranty if triggered by a customer of the Insured who has a valid claim under the guarantee/warranty.
What does it not cover? Any liability outside of the guarantee/warranty, consequential loss, invalid claims under the guarantee/warranty, anything known to be likely to cause claims, anything covered under a regular liability or product recall policy.
FOCUS ON CLAUSES: The FINC
Global programmes are the norm these days.
In fact, it’s exceptional to come across a policy that is not called upon to give international coverage given the globalisation of business in the last three decades. That doesn’t mean providing this cover is easy! You will all be aware of licensing and tax issues that arise and there are pitfalls for the unwary. The Financial Interest Clause (“FINC”) in the wording is one device used to overcome some of these challenges.
I could write a very long piece about this but instead take a look at the general pointers below and watch out for my session on LinkedIn with the D&O Training Hub in the Summer in relation to D&O global programmes.
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You have established there are multiple Risk Locations ( Lloyd’s Crystal has detailed information about risk location and is a great resource).
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You have also established that in some of those Risk Locations non-admitted insurance is permitted and in some it is not permitted ( AXCO is a great resource for this if you do not have expertise in-house). It’s this latter category (“non-admitted non-permitted”) that presents the challenge.
The insurer may have explicitly stated in the main programme that whilst cover is provided on a “global” basis it will only actually be provided where it is permitted to provide cover.
How do you provide coverage in non-admitted non-permitted Risk Locations?
Local policies tied in with the main programme – the most reliable option but adds to the cost and may be disproportionate with the risk in some places. May not be able to provide enough limit for some risk locations.
Establish a separate non-interlocked programme in each place – this can provide significant cover where needed but will be very expensive.
Use a FINC clause - insure the parent company / policyholder’s financial interest in those risk locations using a FINC clause on the main programme. It is not widely tested, and the insurance pay-out does not go to the risk location that suffered the event giving rise to a loss.
What are the considerations for the FINC clause?
The parent company/policyholder needs to have a financial interest in the risk location – this is usually via a corporate ownership structure but may be something else depending on applicable law. This can be a challenge where the Insured in such risk location is a natural person (eg in Side A D&O).
The parent/policyholder needs to be in a territory where the insurer is licensed or is permitted to provide non-admitted insurance.
The FINC should make clear:
Cover is for the policyholder/parent with the financial interest and explain what the financial interest is.
It applies to the non-admitted non-permitted locations (ideally saying exactly where but this may not be practical) and explain there is otherwise no cover in those locations.
Claims in the affected locations will be adjusted via the policyholder/parent and not directly with the affected risk location.
The covered loss will be paid to the policyholder/parent as Insured.
The FINC may be part of a more general “International Exposures” clause in the main programme which wraps around any local policies on a DIC/DIL basis. DIC/DIL cover in the affected risk locations that have local policies should also be only on a FINC basis.
Finally, you must align the tax allocation – the FINC is insurance of the policyholder/parent and so IPT should be allocated to the parent/policyholder’s risk location and NOT to the affected risk locations.
Hopefully this is helpful. If in any doubt speak to your in-house global programme/regulatory people. Good luck!
HOT TOPIC: Professional Fines
Who should be paying civil fines? It’s a commercial not a moral question.
The UK’s Financial Reporting Council (“FRC”) ned auditors and individual partners/managers £46 million+ from 23 investigations in the last 24 months. The FRC regulates auditors, accountants, and actuaries, and sets the UK’s Corporate Governance and Stewardship Codes. Its jurisdiction includes those directors & officers who are also chartered accountants (eg the CFO) and so this can very much be a D&O as well as an accountants’ PI issue.
Recent Fines
The frequency and severity of the fines has already been increasing. Whilst the Big 4 paid the most in fines, medium sized rms (who might not have captives picking up an uninsured primary layer) did not escape. Recent audit failings range from deliberate / reckless misconduct (eg KPMG in respect of Carillion and Regenersis audits) to substandard work / insufficient challenge (eg PWC in respect of Galliford Try audits). Of the fourteen fines handed out in 2022, only two were for "misconduct", the rest were for "substandard" work. This hardening approach appears to be borne out by an article in the FT on August 3, 2022, in which the then Chief Executive of the FRC, Sir Jon Thompson, said that accountants should stop complaining about extra scrutiny and fines for audit failures and improve the quality of their work. ‘’It’s no good complaining about the fines” he told the FT: “The solution is entirely in [the audit rms’] hands. Do a good audit and you don’t get in trouble with us. ”
Imminent Changes
The FRC is due to be replaced by the Audit, Reporting and Governance Authority (“ARGA”), which intends to be an even more powerful and rigorous regulator.
The FRC published it’s draft three-year plan in December 2022. The plan assumes that by the end of this year the long-awaited legislation will be in place to establish ARGA. The FRC will be subsumed into ARGA and ARGA will have the powers it needs to enforce rigorous corporate governance in the UK.The draft plan sets out strategic goals which include:
Setting high standards in corporate governance and stewardship, corporate reporting, and auditing, enforcing them where it is in the public interest. Immediate evidence of this is (1) the proposed Minimum Standard for Audit Committees of Premium Listed Companies, a draft of which has been in circulation since November 2022; and (2) a revised Corporate Governance Code, a draft of which will be published mid-summer this year.
Creating a more resilient audit market through greater competition and choice.- Transforming the organisation into a new robust, independent, and high performing regulator, acting in the public interest.
Better resourcing – increasing the FRC/ARGA’s total staff numbers over the next four years to around 600 with a budget for 2023/24 of £67.9m.
So, it sounds like ARGA will mean business, which will include more fines and heavier fines for audit (and for nance directors, financial reporting) failures.
Insurance of Civil Fines
No one argues that deliberate/reckless misconduct should be insured. Civil fines for merely substandard work are in principle insurable under English law even though they are punitive. But is this the best use of the PI (or D&O) cover, and shouldn't rms be incentivised to try harder to avoid substandard work as Sir Jon Thompson suggested? In many cases there are significant civil claims following on which the cover will be needed for. The increasing frequency and severity means insuring these fines may not be commercially sustainable.
Most policies cover civil fines "where insurable by law" so if insurers don't want to cover them a change in the policy language would be needed. This is preferable to objecting to covering a fine because it’s “not insurable" after claims have arrived: this is too late and due to the fact sensitivity in every case is likely to be highly contentious.
D&O: THE "S" IN ESG
In terms of practical business guidance there has been less said about the ‘S’ part.
The acronym ‘ESG’ (Environment, Social, Governance) has been around a few years to describe a benchmark standard of behaviour for companies. Reflecting wider societal attitudes, it now matters in the eyes of regulators, investors, and companies. The fact the FCA has appointed Sacha Sedan as “Director of ESG” is a clue. He has been named a ‘City Influencer’ by Financial News as one of the biggest 25 names who have been instrumental in shaping the UK's financial services industry.
The Good Business Charter (GBC) is another sign of the increasing importance of the ‘S’. It’s an initiative of the Good Business Foundation, a charity formed by, amongst others, Julian Richer of Richer Sounds who transferred his company into an employee trust. The CBI and the TUC both have trustee representation on the board of the GBC to ensure that the voices of business and employees are heard.
The GBC is a simple accreditation which organisations in the UK can sign up to in recognition of responsible business practices. It measures corporate behaviour over ten components: (1) real living wage, (2) fairer hours and contracts, (3) employee well-being, (4) employee representation, (5) diversity and inclusion, (6) environmental responsibility, (7) paying fair tax, (8) commitment to customers, (9) ethical sourcing, and (10) prompt payment.
Examples include:
All employers should pay directly employed staff and regularly contracted staff the real living wage as set out by the Living Wage Foundation and for those with over 50 employees, commit to becoming an accredited Living Wage Employer within a mutually agreed time frame.
There be a fair approach to zero hours contracts, including fair shift scheduling and cancellation policy, and proper consideration given to contracts with guaranteed hours.
Businesses should evidence how they monitor the diversity of their workforce and their commitment to close the gender, disability and ethnicity pay gaps.
Businesses should sign up to the government’s Prompt Payment Code.
For more detail on the ten components and how they are helpfully defined search online for the Good Business Charter website https://www.goodbusinesscharter.com/.
Not all companies will want to subscribe to the Charter, but studying the specifics set out in the GBC website will help companies to design, benchmark and measure the ‘S’ in ESG and there’s no doubt that employees, the regulator (FCA), and investors will be paying serious attention. Boards should do the same.
Implications for D&O?
It’s good news there is now guidance on how to implement the “S” in ESG. But beware, governance standards can be used by courts in assessing whether directors have “promoted the success of the company” or “acted with reasonable skill, care and diligence”. Now bodies such as the GBC have set out measures for companies, directors will not be able to say it was reasonable not to take them into account.
The key question is: will the changes lead to more, or fewer claims? Undoubtedly more, as we are starting to see in the US. Derivative claims in particular, perhaps against former boards. Many such claims will not get very far because of the high bar to bringing them. But the reputational impact will be greater. Brokers and carriers will need to focus on it more in the placement process – where again the GBC guidelines might come in handy.
Also, there is a suspicion, expressed by some in the media and also in a recent meeting of the House of Lords All Party Parliamentary Corporate Governance Group, that with increasing inflationary and interest rate pressures companies may be talking a better game than they are actually playing, and investment in the “S” in ESG is stalling, with budgets being cut. Where there is a disconnect between what companies are saying publicly and actually doing this runs the risk of securities claims.
The good news is that if there are "S" related D&O claims, as an “all-risks” product a D&O policy should, subject to its terms, provide cover. This doesn’t mean the D&O product can’t be more ESG “friendly”. If you’re a broker or carrier looking to make ESG enhancements for clients taking it seriously, drop us a line.