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Director liability for fines against companies?

21.07.2015
This article deals with the significance of fines in director liability law and D&O insurance. The term “fine” has several meanings under German law. A fine can be a so-called Geldbuße under administrative offences law (Ordnungswidrigkeitengesetz, OWiG) for less serious offences not qualified as crimes under the German Criminal Code (Strafgesetzbuch). Fines can also be imposed under criminal law (Geldstrafe) as a result of proceedings before a court. For the purposes of this article fines will mean administrative fines (Geldbußen) only. The term “director” as used in this article comprises managing directors in German stock corporations and limited liability companies (Vorstände und Geschäftsführer) as well as supervisory board members (Aufsichtsratsmitglieder) in those entities.

Fines require a specific legal basis. Among other acts, the Administrative Offences Act (OWiG) and several more specific acts, such as the Insurance Regulatory Act (VAG), the Securities Trading Act (WpHG) and the Act Against Restrictions of Competition (GWB) provide a legal basis for fines against companies. Fines can be imposed on both, the companies and the persons acting on behalf of the companies. The amount of a fine is usually determined by the economic benefits that the company derived from the actions in question.

Fines usually consist of two elements, a penalty element (Ahndungsteil) and a disgorgement element (Abschöpfungsteil) aiming to deprive the company of the economic benefits obtained through illegal acts.

Fines against companies have recently increased dramatically and would continue to do so with the introduction of the planned corporate criminal code. Further, from July 2016, the new market abuse regulation will provide an overhauled penalty system for most of the administrative offences presently governed by the WpHG. The new regime will mirror the one currently in place for antitrust breaches and will determine fines based on a company’s turnover, thus making much higher fines probable. The same applies to the draft corporate criminal code. The often feared “American standards”, known from the German discussion on civil class action litigation, could arrive in Germany via the detour of the discussion on fines (at least with regard to the amounts).

In the light of constantly increasing fines, companies are faced with the crucial question of whether they can recover fines paid to the authorities from their directors responsible for the actions that led to the fine. Not surprisingly, companies look not so much to the private assets of the directors but rather to claims under the D&O insurance policies. This question is particularly important for supervisory board members whose duties include representing the company against management board members. Can the supervisory board even be obliged to demand reimbursement of the fine from a management board member?

Comfortable position for companies

Holding a director position in a Germany company is increasingly subject to liability risks. Director liability has been intensified and damage claims have increased significantly since the arrival of the D&O insurance on the German market in the mid-1990s. This is not a new insight. Even the 70th Deutscher Juristentag 2014 chose director liability as its topic (see Insurance Newsletter October 2014).

Asserting a claim against a director is usually quite easy for a company. This is due to the favourable distribution of the burden of proof in director liability cases. The company must only assert a specific action or omission possibly resulting in a breach of duty of the director and assert and prove that specific damage was caused thereby. Committing an administrative offence and thus causing a fine against the company violates the so-called duty of legality of the directors and is not privileged under the Business Judgment Rule. The directors then have to prove that the action or omission did not breach their duty as directors to the company or that even a compliant action or omission would have caused the damage. However, directors can exempt themselves from liability in situations when the law was unclear. The requirements of this exemption are, however, not yet clearly defined.

State Labour Court Düsseldorf, judgment of 20 January 2015 – Internal recourse generally excluded

January 2015 marked the first time that a German appellate court – the State Labour Court Düsseldorf – had to decide on the recourse claim of a company against a director (a management board member of a subsidiary) for a fine. The reverse situation had already been decided by the Federal Court of Justice in mid-2014. A company may, in principle, pay a fine imposed on one of its directors. However, in a German stock corporation, this requires the approval of the general meeting if the director at the same time breached a duty to the company.

Notwithstanding a precise dogmatic reasoning, the State Labour Court Düsseldorf decided that the company may generally not demand reimbursement of fines imposed on the company from a director. A similar judgment of the UK Court of Appeal is known from 2010.

The Düsseldorf court held that the recourse would defeat the very purpose of the fine. The fine is intended to affect the owners of the company, i. e. the shareholders and to deter them from further breaches. This is because it was the owners of the company who ultimately appointed the director who acted illegally. The possibility of recourse from the director would frustrate the general purpose of the fine to prevent future violations.

The court found it irrelevant that the company would be allowed to pay a fine imposed on one of its directors in the reverse case. Whether someone is allowed to pay a fine imposed on a third party and whether someone must pay a fine imposed on a third party are two different questions, according to the court. The court further reasoned that fines not only aim to penalise offences but also to disgorge profits. The disgorgement of profits, however, would have no effect if the company could reclaim the fine from its director.

In addition, according to the State Labour Court Düsseldorf, German antitrust law clearly expresses a distinction between fines against natural persons and fines against companies. The Federal Cartel Office (Bundeskartellamt) can fine natural persons up to
EUR 1 million. This, according to the State Labour Court, excludes a higher penalty against directors by way of internal recourse.

Ultimately, the State Labour Court Düsseldorf did not find its decision to contradict the so-called “tax advisor cases”. The German Federal Court of Justice (Bundesgerichtshof) had decided that a client could claim damages from a tax advisor if false advice had led to a fine against the client. The State Labour Court distinguished the “tax advisor cases” from other cases involving fines. The court mainly held that, unlike tax advisors, directors are not contractually obliged vis-à-vis the company to protect the company from fines. Lastly, the State Labour Court denied recourse among two perpetrators of an administrative offence, holding that both, the director and the company were perpetrators of the offence in question.

The decision of the State Labour Court Düsseldorf does not finally settle the question, however. The judgment is not yet binding because the Federal Labour Court (Bundesarbeitsgericht) still has to rule on the matter. Further, the Federal Court of Justice will also have to decide on cases of recourse against directors. The State Labour Court Düsseldorf was only competent because the defendant was not a “genuine” director but merely a so-called Bereichsvorstand, i.e. a regional executive with no position on the statutory management board. The liability of “genuine” directors falls within the jurisdiction of the Federal Court of Justice.

Are fines recoverable damages?

Even before the judgment of the State Labour Court Düsseldorf, it was unclear whether a company can recover a fine as a damage from its director under Sections 249 et seq. of the German Civil Code.

Mostly affirmed for fines

In the discussion on director liability so far and in the practice of D&O insurance, the primary question with regard to fines imposed on companies was whether and if so in what amount the payment of a fine results in a recoverable damage of the company. Ultimately, the underlying circumstances of the fine, i.e. a cartel agreement, the payment of bribes or other compliance breaches, serve the promotion of the company’s business interests and therefore the achievement of profits. The disgorgement element of the fine is correspondingly high. It is therefore discussed whether the profit achieved by the company should be taken into account when calculating the damage under Sections 249 et seq. of the German Civil Code or can be deducted from the damages by way of the so-called adjustment of damages (Vorteilsausgleichung).

German legal literature has regarded and continues to regard fines as recoverable damages of the company and thus allows the company to recover damages from its directors. The judgment of the State Labour Court Düsseldorf followed the minority opinion in this regard. The prevailing view holds that the objective of the fine has already been achieved with the imposition of the fine with all negative consequences for the company’s reputation. In addition, any disgorgement of profits would not be made good by recourse against a director because the recourse against directors would usually be insufficient even including payments under a D&O insurance policy. The main argument, however, evolves around the decisions of the Federal Court of Justice in the “tax advisor cases”. Directors are, the argument goes, like tax advisors, obliged to protect their company – i. e. their client – from fines. The duty of legality, contrary to the view of the State Labour Court Düsseldorf, constitutes an adequate duty of care of the director to the company.

Reimbursement of legal costs can always be claimed

Companies can, however, always claim the legal costs for example of external advisors investigating the facts without restriction. Spectacular cases such as Siemens have shown that the legal costs alone can reach hundreds of millions and more. At least in extremely complex matters, such as antitrust and financial manipulation cases, the costs for investigation can render a discussion about reclaiming the fine superfluous through the back door.

Limitation of director liability?

Because German legal literature mostly permits the company to recover fines as damages from its directors, many authors argue that director liability must be limited. It is recognized that the fines greatly exceed the financial means of the directors. The discussion on limitation of liability has two elements. The first question is whether one should in general limit director liability, for example through provisions in the articles of association or through new provisions in general contract law? Or should specific limits apply for specific areas such as fines? We can only mention the first discussion without going into the details. We expect no legislative action in the current term.

The Labour Court Essen, as the first instance before the State Labour Court Düsseldorf, had shown sympathy for a limitation to a maximum amount for individual fines. Some authors in German legal literature follow this approach.

The prevailing view is, however, that the company’s recourse should be limited to the penalising element of the fine. This is because the company should not be able to demand compensation for damages and on the other hand demand to be placed in the position as if the damaging event had actually taken place. In the Siemens case, the penalising elements amounted only to EUR 1 million and EUR 250,000.00. The disgorgement elements were EUR 200 million and approximately EUR 395 million. In antitrust law, on the contrary, the limitation to the penalising element would not apply. The Federal Cartel Office and the EU Commission impose considerable fines that only consist of a penalising element without showing a disgorgement element. This is due to the severe difficulties in calculating the company’s profits to be disgorged. If one assumes that recourse for antitrust fines is possible, then a limitation of director liability for antitrust fines cannot be based on the distinction between the penalising and disgorgement elements of the fine.

Is the supervisory board obliged to pursue recourse claims?

In its ARAG/Garmenbeck decision of 1997 the Federal Court of Justice held that the supervisory board must in principle pursue claims of the company against management board members and may refrain from doing so only in the company’s interest. Otherwise, the supervisory board itself breaches its duties to the company. This threat of liability of the supervisory board is a considerable driver for claims against management board members. After fines have been imposed against a company, the supervisory board must therefore consider two aspects: Does the company have a promising claim against management board members for recovery of the fine? And: Does an exception to the enforcement apply based on the company’ best interests?

Whether or not the company has a promising claim against its directors depends on two factors outlined above with regard to fines: Are fines recoverable damages of the company and if so up to what amount? And is the recourse generally prohibited after the decision of the State Labour Court Düsseldorf? Neither of these questions has been answered by Federal Courts and opposing positions can be convincingly argued. If the legal position is unclear, the supervisory board would be well advised to obtain an external opinion. With regard to the legal costs of pursuing such claims, no specific limits apply. In case of doubt claims will be pursued for legal costs alone.

Factors to be weighed in the company’s interest under ARAG/Garmenbeck primarily include the effect on the company’s reputation if litigation were to continue, the actual prospects of collecting compensation for the damages suffered and the effects of the litigation on the day-to-day workings of the management board. In particular, the supervisory board will have to consider whether a D&O insurance cover exists.

Exclusions in D&O insurance policies

D&O insurance policies usually contain two exclusions relevant to recourse claims case against directors because of fines.

Usually an exclusion of cover for liability claims applies “due to”, “because of” or “in connection with” contractual penalties, bail, administrative or criminal fines and other forms of compensation with a penalising nature. Whether or not an exclusion applies, needs to be determined on a a case-by-case basis.

Another obstacle for insurance claims of the insured persons (and indirectly of the companies themselves) is the exclusion of cover for knowing or intentional breaches of duty. The findings regarding the degree of fault (intent or negligence) by e.g. the Federal Cartel Office or the EU Commission in antitrust cases have a certain significance but usually lack any binding effect with regard to liability or insurance aspects. They are however indications which the supervisory board must absolutely take into account in its decision about pursuing recourse claims.

Conclusion

More than ever, the implementation and maintenance of an appropriate compliance system, i. e. observance of legal provisions, is crucial for directors. In an environment of increasingly dense regulatory activity, the legislator imposes considerable fines for many breaches in order to render regulation more effective. Authorities increasingly test the limits of already existing possibilities to impose fines on companies. This increase in penalties against companies directly affects D&O insurers. D&O insurers have to expect more and higher claims for damages by companies against their directors because acting as a director is subject to a growing number of legal risks.

Whether companies can claim damages from their directors for fines imposed against the company is at least provisionally unclear after the decision of the State Labour Court Düsseldorf in January 2015. It remains to be seen what solution the Federal Labour Court finds and how the Federal Court of Justice will ultimately decide in relation to “genuine” directors. There will be no shortage of such cases in the future. We will keep you informed.

In addition to the editorial in this regard, the newsletter includes an overview of new judgements, legislation and notices as well as our insurance calender.

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