Liabilities of non-executive directors - an Equitable outcome?
On Friday 17th October the Honourable Mr Justice Langley dealt a blow to nine former non-executive directors of Equitable Life being sued by the mutual by rejecting their application under Part 24.2 CPR to strike out the negligence and breach of duty claims against them, on the grounds that they had no real prospect of success at trial. The claims against the high profile City players will now proceed to full trial, estimated to take six months and scheduled for April 2005, which could cost more than £30 million.
Earlier this year in related proceedings, Mr Justice Langley allowed much of Equitable Life's claim against its auditors, Ernst and Young, to be struck out, a decision that was subsequently overturned by the Court of Appeal. No doubt this decision was at the forefront of his mind when reaching this judgment.
Background to the Claims
The claims arise out of policies issued by Equitable until 1988 that provided for guaranteed annuity rates ("GARs"). The GARs contained an option that permitted the policyholder to choose an annuity at the guaranteed rate rather than the current annuity rate ("CAR") on retirement.
In the mid nineties, GARs exceeded CARS for the first time and the board of Equitable were alive to the potential problem it could cause. On 22 December 1993 the board addressed the problem by adopting a differential terminal bonus policy ("the DTBP") which adjusted bonuses payable to GAR policyholders to the same as those payable under non-GAR policies. In effect the guarantee was meaningless. The DTBP was applied to the annual bonuses in each year from 1993 to 2000.
The directors believed that they were entitled to adopt the strategy because of the discretion provided for by Equitable's Articles of Association and the extent of their powers and their exercise was the subject of a test case that came before the House of Lords in July 2000 (Equitable Life Assurance Society -v- Hyman [2002] 1 AC 408). The House of Lords found against Equitable and held that the DTBP was in breach of its constitution and, as a result, the mutual had to meet its GAR commitments and as such was exposed to additional liabilities of £1.5 billion. Equitable stopped writing new business in December 2000.
The Claims
Equitable brought actions against its auditors and against certain former executive directors and non-executive directors; the latter claims being the subject matter of this application.
The allegations of negligence against the directors are that:
- In 1996, 1997 and 1998, they failed to take legal advice as to the validity of the DTBP before awarding bonuses in the February in each of those years; and
- In 1999 and 2000, after the problem was known and legal advice had been sought, they failed to reduce bonuses and to ensure that policyholders were aware of the potential costs to Equitable, in the event that the Hyman litigation was lost.
The case on causation was that, had the board obtained legal advice earlier, they should have taken precautions against losing the Hyman litigation by, in 1996, using derivatives to hedge against the potential cost of the GARS if they had to be honoured in full and in each year, by reducing bonuses so as to build up reserves.
In fact, Equitable was in discussions with Goldman Sachs, much later in 1999, but the board rejected the plan to guard against liabilities as "prohibitively expensive". Eventually, the decision cost Equitable £1.5 billion and almost caused it to collapse.
In addition to the negligence claim, Equitable claimed that, in adopting the DTBP, the directors were in breach of fiduciary duty by exercising their discretion for an improper purpose.
The Defences
The non-executive directors argued that they acted properly at all times and they did what any reasonable non-executive would do in the circumstances. They said that they were entitled to rely on the Articles and on the Appointed Actuaries, whose duty it was to advise on matters such as guarantees and bonuses and whose duty it was to bring the matter to their attention.
It was maintained that the actuaries had dismissed the directors' concerns and assured them that there were no contractual issues and no issue regarding the policyholders' reasonable expectations in adopting the DTBP.
It was also argued that it was unreasonable to have expected the non-executives to find and appreciate the details of the policy by focusing on a single paragraph in complex and lengthy papers produced at a board meeting in February 1996 that some of the non-executives were not routinely expected to attend (according to the letter enclosing the papers and agenda). Three of the non-executives did not join the board of Equitable until after the policy had been introduced, although it was alleged that the breaches in duty occurred each year after the introduction of the policy.
Duties of Non-Executive Directors
In his judgment, Langley J reviewed the case-law relating to the duty of skill and care owed in law by a non-executive director to a company. Langley J stated the well known common law test from Re D'Jan of London [1993] BCLC 646 taken from s214 (4) Insolvency Act 1986.
"It is the conduct of a reasonably diligent person having both:-
(a) The general knowledge, skill and experience that may reasonably be expected of a person carrying out the same functions as are carried out by that director in relation to the company; and
(b) The general knowledge, skill and experience that that director has"
However, Langley J said that the combined objective and subjective test provide no answer to the question of what were the functions of the Equitable non-executive directors. He placed reliance on the case law put forward by Counsel for Equitable (Re Barings Plc (No.5 ) [2000] 1 BCLC 523) that directors have a duty to acquire and maintain sufficient knowledge of the company to allow them to discharge their duties. Although directors can delegate certain functions, this does not absolve a director from his duty to supervise, although this duty must depend on the facts of each case.
Langley J discounted the case relied on by Counsel for the directors (Re City Equitable Fire Insurance Company [1925] 1 Ch 407) that states that all duties can properly be left to another official and that the director is justified in trusting that official (in the absence of grounds for suspicion), as unrepresentative of modern law if it means unquestioning reliance upon others to do their job.
It was concluded that the extent to which a non-executive director may reasonably rely on the executives and other professionals is a developing area and is fact sensitive. Arguably, given their backgrounds and experience, the degree to which the non-executive directors were qualified to question a consulting actuary may need to be looked at more fully at trial.
In respect of the directors' application that they be excused from liability to Equitable under s727 Companies Act 1985 (by having acted honestly and reasonably and that, having regard to all the circumstances of the case, they ought fairly to be excused), Langley said that:
"it would require an exceptional case for a court to conclude on an application of the present kind that it was appropriate to grant relief"
because the court would have to be satisfied that it was aware of all the circumstances. As such it was highly improbable that such knowledge could be obtained from a summary judgment application.
The Application for Summary Judgment
Under CPR 24.2, the court may give summary judgment against a claimant if it considers that they have no real prospect of succeeding on the claim and there is no other compelling reason why the case or issue should be disposed of at trial.
Langley J referred to the Court of Appeal judgment (overriding his own decision) in the auditors proceedings and stated that:
"the overriding concern is the interests of justice…the simpler the case, the easier it is for a court to be able to take a view that the basis of a claim is fanciful or contradicted by all the documentary material on which it is founded. There is a danger of injustice in seeking to try such cases summarily on the documents and thus without oral evidence tested by cross-examination. It should not be done unless the court can be confident that all the relevant facts had already been satisfactorily investigated."
Although it was accepted that doing justice included bringing a conclusion to expensive, drawn out cases with no real prospect of succeeding (given the potential futility of pursuing individuals for such large sums) Langley J held that the court had not heard evidence as to the means of the directors and "each undertook for reward the duties which the law imposes".
Langley J stressed that the conclusion did not mean that he thought that Equitable's case against the non-executive directors was right "or even probably right" although it could not be said that Equitable had no prospect of succeeding.
Implications
Most of the non-executives will, as a result of the decision, face ruin or near ruin from the costs of defending themselves in the main trial.
Equitable's Chairman, Vanni Treves, said "In the interests of policyholders we have a duty to proceed". However, given that Equitable's Directors and Officers liability insurance is believed to be limited to £5 million (which, in the words of one of the former directors is "almost burnt") and that, during the trial, Langley J was told that Equitable had "not the slightest hope" of recovering the £3.3 billion claimed, it is not surprising that the decision to pursue the claim has already been branded a waste of policyholders' money. Whether this proves to be the case may depend on the findings of the private investigators who have been retained to track the assets of the directors.
In the wider business context, this case will cast something of a chill in the air in many a boardroom. It may have a significant impact on the ability of companies to retain high calibre independent non-executives, a central issue of the recent Higgs report. Although actions against non-executives are rare, with the possibility of ruinous litigation, and for relatively little financial reward, just who will be prepared to do this job in the future?
Similarly, the ruling may well have an impact on D&O premiums for all companies if it is perceived that the risks to insurers have increased.
The law needs to be clear on what is expected of non-executive directors. It is hoped that the trial judge will take the opportunity to clarify this area in the main trial in April 2005.
For further information, please contact Maxine Cupitt at maxine.cupitt@cms-cmck.com or on +44 (0)20 7367 2865 or Gabrielle Folliard at gabrielle.folliard@cms-cmck.com or on +44 (0)20 7367 2662.
