Extension of the Liability of the Management of Publicly Traded Stock Companies and Banks by the Restructuring Act (Restrukturierungsgesetz) and Implications for D&O Insurance

10.05.2011

[] The most recent legislative offshoot of the crisis in the financial markets is what is referred to as the Restructuring Act, which – insofar as can be told – is the keystone in a series of legislative efforts intended to stabilize the financial markets (Financial Market Stabilization Act (Finanzmarktstabilisierungsgesetz – FMStG) of 17 October 2008, Federal Law Gazette (Bundesgesetzblatt – BGBl.) 2008, page 1982, Financial Market Stabilization Amendment Act (Finanzmarktstabilisierungsergänzungsgesetz – FMStErgG) of 7 April 2009, Federal Law Gazette I 2009, page 725, Act for the Strengthening of the Financial Markets and Insurance Supervision (Gesetz zur Stärkung der Finanzmarkt- und der Versicherungsaufsicht – FMVAStärkG) of 29 July 2009, Federal Law Gazette I 2009, page 2305)). The Restructuring Act is an attempt to achieve this goal through the creation of new rules to govern the reorganization and restructuring of banks on the one hand (Bank Restructuring Act (Gesetz zur Reorganisation von Kreditinstituten – KredReorgG) and Restructuring Fund Act (Gesetz zur Errichtung eines Restrukturierungsfonds für Kreditinstitute – RStruktFG)) and through intervention in the regulatory apparatus already in place on the other hand. This presentation addresses a change in the German Stock Corporation Act (Aktiengesetz – AktG) (section 93(6) of the new version) and the Banking Act (Gesetz über das Kreditwesen – KWG) (section 52a) that would at first glance seem innocuous as well as addressing the implications of this change for D&O insurance policies already in place. In this context, it is necessary to keep in mind that the term "bank" or "financial institution" as used in section 1(1) of the Banking Act does not imply any specific type of legal entity. As a result, what follows also applies to companies other than stock corporations if they operate as banks or financial institutions within the meaning of section 1(1) of the Banking Act.

The liability of the management of stock corporations for breaches of duty is based on section 93 of the German Stock Corporation Act, which also applies to members of the supervisory board of such companies due to the reference contained in the first sentence of section 116 of the German Stock Corporation Act. The Restructuring Act left the scope of the diligence duties of officers of stock companies unchanged. Executive officers and members of the supervisory boards of stock companies therefore remain liable for failure to discharge their duties with the care of a prudent and conscientious manager. However, claims arising from the breach of the duty of diligence now become time-barred after ten years instead of after five. According to section 52a(1) of the Banking Act, the same applies accordingly to the liability of managerial personnel, executive officers and supervisory board members towards banks and other financial institutions.

Pursuant to section 24 of the Introductory Act to the Stock Corporation Act (Einführungsgesetz zum Aktiengesetz – EGAktG), the extension of the period of liability also operates retroactively. This applies for all claims for damages arising from breaches of duty that had not become time-barred as of the 15 December 2010, which is when the Restructuring Act went into force and effect. On the other hand, claims that had already become time-barred as of that time were not affected by the extension of the period of liability (which section 52a(2) of the Banking Act makes explicitly clear). According to the case law of the Federal Constitutional Court, no constitutional reservations exist in respect of retroactive application under these conditions.

This pseudo retroactive application does, however, result in a series of problems in connection with the insurance protection against such liability that officers and supervisory board members often enjoy.

Executive officers and directors of larger stock corporations and financial institutions regularly insist that a clause be included in their service contracts that obligates their companies to take out what is referred to as directors & officers (D&O) liability insurance to insure them against personal liability for breach of duty. In most cases, this takes the form of a clause that entitles the officer or supervisory board member to "appropriate" or "usual" D&O insurance with a specific minimum coverage.

Unlike the usual liability insurance offered on the market, which provides coverage for all claims occurring during the term of the policy, most D&O insurance is based on the "claims made" principle. That means insurance coverage is provided only if the claim occurs during the term of the policy and is also reported to the insurance company during the term of that policy. In order to avoid situations in which executive officers or supervisory board members are exposed to liability after their terms of office expire and they no longer have insurance coverage, most D&O insurance policies make provision for what is referred to as an extended reporting period. In this case, claims relating to the term of the policy that are reported to the insurer prior to the expiration of the extended reporting period will also be covered. The extended reporting period and the period during which claims may be brought before they become time-barred pursuant to section 93(6) of the older version of the German Stock Corporation Act usually coincide.

However, extension of the period during which claims may be brought against officers and directors has resulted in the creation of a new situation that originally seemed to have already been resolved by the existence of extended reporting periods. It is now possible for executive officers or directors of stock corporations to commit a breach of duty while in office and then find themselves confronted with claims arising from such breaches when insurance coverage no longer exists because the extended reporting period has expired.

This scenario is likely to be least problematic for executive officers and supervisory board members who are currently still in office and whose service contracts entitle them to D&O insurance. As a general rule, the parties to such contracts will in fact not have agreed to a specific extended reporting period. This detail is usually regulated in contract practice through the use of the terms "appropriate" or "usual" in agreements. Both terms are of course susceptible to and require interpretation. When a service contract otherwise contains no provisions that are more specific, it can be assumed that the construction of what is to be considered "usual" or "appropriate" can change in the course of the term of the contract. When the Restructuring Act went into force and effect, it had already become no longer possible to consider D&O insurance with an extended reporting period of only five years as appropriate. The same is likely to apply in the case of the term "usual" in connection with a shorter reporting period since an extended reporting period of 10 years will very quickly become usual for new D&O policies as soon as the Restructuring Act goes into force. As a result, it is as a general rule possible to assume that the service contracts of such executive officers and supervisory board members entitle them to have the extended reporting periods of their D&O insurance adjusted accordingly.

This does not, however, apply in the case of former executive officers or supervisory board members, who may under certain circumstances find themselves confronted with a situation in which the reporting period for claims arising from breaches of duty is about to end. In such cases, it is likely to be much more difficult for such officers and directors to claim entitlement to a longer extended reporting period under their service contracts. This is not likely to be possible through interpretation of service contracts and the meaning of the terms "appropriate" or "usual" contained therein. Since the service contracts have already been terminated in such cases, the usual criteria for construction provided by the German Civil Code (Bürgerliches Gesetzbuch – BGB) will make it very difficult to base the interpretation of such contracts on factual circumstances that come into being only after the termination of the agreements. The only possibility here would then be the adaptation of the contractual agreement pursuant to section 313 of the German Civil Code on the grounds of interference with the contractual basis.

Section 313 of the German Civil Code is a legal formulation of the notion of good faith and permits adaptation of agreements that even goes beyond mere changes in wording. However, this is possible only if a "contractual basis," i.e., a circumstance tacitly assumed by both parties upon execution of an agreement without separate mention therein, either changes after execution or completely disappears. Without wanting to deal here in excessive depth with the standards required for the application of section 313 of the German Civil Code by case law and legal doctrine, there would definitely seem to be some question as to whether congruity of the period during which claims arising from breaches of duty may be triggered and the extended reporting period agreed with the insurer constitutes a circumstance that falls solely into the sphere of responsibility of the former officer or supervisory board member. It is generally acknowledged that circumstances that fall solely into the sphere of responsibility of one of the parties to an agreement cannot constitute a contractual basis within the meaning of section 313 of the German Civil Code.

A further consideration that is more of practical than legal relevance is that the stock corporation or financial institution affected is not likely to be particularly motivated to seek a potentially costly addition to a contract from its D&O insurer for the benefit of a former officer or supervisory board member.

In the final analysis, the legal situation of former officers or supervisory board members in respect of the prolongation of the extended reporting period law is unclear and it is therefore difficult to foresee what legal position will ultimately prevail in the case law and scholarly commentary.

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