Arbitration proceedings in D&O insurance
The pros and cons of arbitration as compared to court proceedings are currently the subject of increasing discussion in connection with disputes involving the personal liability of company directors and officers and D&O insurance. The terms and conditions of D&O insurance offered by insurance companies or insurance brokers meanwhile often contain special provisions relating to the conduct of arbitration. While until recently arbitration proceedings have been an infrequent occurrence in D&O insurance, at least for disputes regarding coverage, arbitration in other insurance fields, and above all reinsurance, has been common for a long time. Almost every reinsurance contract contains an agreement on arbitration. In the primary insurance sector, arbitration clauses can be found at least for individual products and risks. One topical example is W&I insurance, for example, in which an arbitration clause is often agreed, like in the underlying sale and purchase agreement.
The current discussion on whether arbitration should be used more frequently in D&O insurance as well has various causes. The main factor is the policyholders’ wish to speed up the settlement of claims in D&O insurance. This has led to thought increasingly being given to what are known as “integrated” arbitration proceedings, where the aim is to settle liability and coverage matters during the same proceedings.
Pros and cons of arbitration proceedings
In principle, arbitration can bring a range of benefits. In international legal transactions in particular, a prominent factor is that the international enforcement of arbitral awards under the rules of the New York Convention on the Recognition and Enforcement of Foreign Arbitral Awards of 10.06.1958 is often easier than enforcing court judgments. However, this aspect tends to be secondary in D&O insurance. Aspects that could speak in favour of settling directors’ and officers’ liability and coverage disputes in arbitration proceedings are their non-public nature and the typical confidentiality of arbitration proceedings. This point is also relevant against the background of the ARAG/Garmenbeck case law of the Federal Court of Justice because in certain circumstances the public nature of state court proceedings can speak against asserting claims against a company’s managers. Other advantages of arbitration may be that the parties are able to select arbitrators who possess special know-how. Apart from this, the parties enjoy autonomy in the proceedings, meaning that they are largely free to determine the course of the proceedings (including for instance the taking of evidence), one key point being the possibility of document production.
However, this potential advantage also has a downside, since arbitration frequently turns out to be extremely complex in practice. Thus at the same time the supposed time and costs benefits of arbitration proceedings frequently mentioned have to be seen in relative terms. Quite often, arbitration entails similar or even higher costs than court proceedings at first or second instance court. This is because the parties have to pay the arbitrators’ remuneration and the fees of the arbitration institution, if applicable. Similarly, it is not possible to come to a general conclusion that arbitration proceedings are completed more quickly than state court proceedings in practice. This is certainly the case when compared to first-instance proceedings before the state courts. Another aspect also applies in relation to directors’ and officers’ liability: disputes regarding the personal liability of company directors and officers often end with a settlement. One advantage of arbitration often referred to is that it can be particularly helpful in promoting an amicable solution, although even this is open to question. Besides this, where stock corporations (Aktiengesellschaften or “AGs”) are involved, the provision in section 93 subsection 4 sentence 2 German Stock Corporation Act has to be taken into account. This states that the company can only settle the claim for damages with the consent of the shareholders’ meeting three years after it has arisen. Thus, in individual cases at least, it may be in the interest of all parties to avoid an (arbitral) decision being reached too quickly.
Regarding the above advantage of being able to select people with special know-how as the arbitrators in arbitration proceedings, there is another factor to consider when weighing up the pros and cons – that the risk of conflicts of interest at the level of the arbitrators is higher than for state courts. It should also be noted that, in Germany at least, our experience shows that the chambers of commerce and court panels responsible for disputes regarding directors’ and officers’ liability are certainly well suited to resolving complex disputes as well. This often applies equally to coverage disputes. Notably, in disputes involving fundamental legal principles only the state justice system is able to contribute to development of the law by publishing its decisions.
Another main advantage of state court proceedings is that it is considerably easier to involve third parties in state court proceedings than in arbitration proceedings. An D&O insurer may be interested in involving an intervening in a D&O dispute, for instance. There might also be several claimants or several defendants (as is often the case on the side of the members of the governing bodies). Finally, the participation of co-insurers or excess insurers has to be borne in mind. The participation of such third parties in arbitration proceedings leads to high requirements on the drafting and coordination of arbitration agreements, which in some circumstances may vary. Another point under insurance law is that agreeing on arbitration between the company and members of its governing bodies (at least retrospectively) can be relevant for the legal aspect of coverage. Thus it may be necessary to consult on this with the D&O insurers.
This list of pros and cons illustrates that opting for arbitration is not a universal remedy. Instead, each case has to be viewed separately. It is also necessary to differentiate between whether arbitration proceedings are to be agreed on for D&O disputes, coverage disputes or possibly even for combined treatment of liability and coverage topics in the same proceedings.
D&O liability disputes
In D&O cases, arbitration proceedings above all come into play in practice in disputes concerning the personal liability of members of management. These are generally based on an arbitration agreement previously reached by the director/officer and the company. The primary instrument for arranging arbitration agreements between managing directors or management board members with the company concerned is the employment contract. In this context it is important to make sure, among other things – especially where several members of management may possibly participate in the same arbitration – that the arbitration agreements are consistently drafted and allow various proceedings to be combined. Entering into arbitration agreements with supervisory board members is somewhat more difficult. In limited liability companies (Gesellschaften mit beschränkter Haftung or “GmbHs”) the general meeting is responsible; in stock corporations the shareholders’ meeting is responsible as the body appointing the person involved if the position is unclear. Whether or not a universal arbitration agreement is allowed by providing for this in the articles of association is disputed. Arguments against such an agreement being admissible are the lack of authority of the management members to alter the articles and the lack of compliance with the basic requirement that arbitration agreements have to be in written form and signed. In practice this often leads to companies potentially having to initiate several arbitrations or parallel arbitration and court proceedings if D&O liability claims are brought against several management board members, rather than one court proceeding. The potential benefits of arbitration proceedings are then more than ever called into question.
Apart from this, the parties can agree an arbitration clause for disputes regarding coverage in the insurance terms and conditions. D&O insurance entails special considerations in that it is concluded between the company and insurer as insurance for a third party. This leads to any disputes between the parties initially being subject to the arbitration clause. This may be relevant in the context of company reimbursement, for example. In practice, however, the focus is on claims against members of governing bodies, and therefore any coverage disputes between these managers and the D&O insurers. The prevailing opinion in Germany is that the members of governing bodies should also be bound by the arbitration clause agreed between the company and the D&O insurer. However, up to now this matter has not been resolved by the courts. In individual cases at least, depending on how the arbitration clause is drafted its effectiveness may be called into question if the members of the governing bodies were unreasonably disadvantaged by the arbitration clause agreed.
Integrated arbitration proceedings
Recently, the possibility of integrated arbitration proceedings in which liability and coverage issues are to be dealt with during the same proceedings has been discussed. A few new sets of terms and conditions already contain provisions catering for this. The intention of integrated arbitration proceedings is that the loss event and all the liability and coverage aspects should be resolved exclusively by the company and the D&O insurer. The plan is to achieve this by typically assigning the insured person’s indemnification entitlement to the company. In the direct action between the company and the D&O insurer, the matter of liability will be dealt with as an ancillary matter that is a requirement for the indemnification entitlement.
Such integrated arbitration proceedings throw up a range of questions. These start with the still-open question of whether the indemnification claim in the D&O insurance is actually assignable under section 108 subsection 2 of the German Insurance Contract Act. Even if this were generally the case, this could be called into question at least for situations where the jurisdiction of the state courts or another kind of arbitration has been expressly agreed for the D&O liability claim. Regardless of these questions regarding admissibility, integrated arbitration proceedings throw up a range of practical problems which in our opinion call into doubt their advisability. On the one hand, there is the desired benefit of settling the claim as quickly as possible. On the other, it has to be taken into account that both liability and coverage issues will then have to be decided on by the same arbitrators. The responsibilities for D&O liability and insurance disputes are separated at the state courts, this for good reason, because they often require special expertise. Whether it can be guaranteed that arbitrators will possess know-how on both these subjects is questionable. This applies all the more since the relevant group of individuals is very limited. From the point of view of the insurer at least, it should be taken into account that their prospects of being able to successfully raise objections under the law on coverage once the liability issue has been settled (for instance by excluding deliberate breach of duty) may be lower if the same arbitrators who initially confirmed the damage subsequently have to rule on exclusions under insurance law.
Other questions also arise: the D&O insurer relies on the cooperation of the company and the members of the governing bodies to be able to examine and if necessary defend against claims for damages. The duties set out in the insurance policy are helpful in this respect. Besides this, there are good reasons for direct proceedings because the reversal burden of proof regarding the breach of duty and fault under section 93 subsection 2 sentence 2 Stock Corporation Act does not fall to the D&O insurer. However, the fact that duties on the part of the policyholder and the person insured to provide information are limited in current insurance terms and conditions and that there are attempts to set down the reversal of the burden of proof under section 93 subsection 2 sentence 2 Stock Corporation Act at the expense of the insurer, precisely in connection with integrated arbitration proceedings, is to be viewed critically.
Thus integrated arbitration proceedings can certainly turn out to be suitable in individual cases. Such proceedings can still be agreed on with all parties after an event of loss has occurred. However, in our opinion, already agreeing on integrated arbitration proceedings as a general solution in the insurance policy or even making them obligatory is to be viewed critically. They are definitely not an all-purpose weapon for simplifying the settlement of insurance claims.
Type of arbitration proceedings
Provided that the parties in principle accept the solution of disputes by way of arbitration, then a wide range of options exist. Arbitration can be conducted on an ad hoc basis, for example. In this case, the statutory rules for arbitration proceedings merely apply. Where the place of arbitration is Germany, this would be the provisions of the 10th Book of the Code of Civil Procedure. These largely allow the parties to determine the details of the arbitration proceedings individually.
As this can entail considerable effort, the parties – above all outside the insurance sector – often opt for so-called “institutional” arbitration proceedings. Such proceedings are based on the arbitration rules of a recognised arbitration institution. In Germany, these include for example the German Institution of Arbitration or, on an international level, the International Chamber of Commerce (ICC) in Paris. Special institutions also exist for (re-)insurance disputes. There are differences between the arbitration rules of the various institutions and as well as their costs. Although in our opinion the choice of institutional arbitration proceedings is generally advisable, importance should be attached to selecting the suitable arbitration institutions.
In most cases it at the same time makes sense to use the model clauses developed by the arbitration institutions for the arbitration agreement, at least as a basis. Apart from this, the parties should typically set out the place of arbitration (not to be confused with the place where the proceedings of the arbitral tribunal take place), which at the same time determines the applicable law of arbitration. Other points to be agreed on are the language of the arbitration, the law applicable to the arbitration agreement and, finally, the number of arbitrators, typically one or two arbitrators who have to decide on a dispute. Something that is frequently observed – often in reinsurance contracts, for example – is that the parties try to stipulate special qualifications on the part of the arbitrators. It is important to tread carefully when agreeing on such provisions. Firstly, where there are three arbitrators, one arbitrator is appointed by the claimant and one by the defendant, meaning that they already have an influence on the composition of the arbitral tribunal. Secondly, specifications regarding the qualifications of the arbitrators might not only severely restrict the group of people available, but also make the appointment of the arbitrators legally contestable or make it difficult to conduct the arbitration on a practical level. Whatever the case, it is advisable to make sure that the chairperson of the arbitral tribunal is a lawyer with experience of conducting arbitration proceedings.
The importance of arbitration will certainly grow in the coming years, including in D&O insurance. This is especially true for disputes involving directors’ and officers’ liability. Apart from this, arbitration can offer benefits when solving coverage disputes. However, arbitration proceedings are certainly not to be understood as a universal remedy. Integrated arbitration proceedings, in particular, are to be viewed critically, especially where they are used by one party to undermine the “equal playing field” between the claimant and the D&O insurer. In our experience, disputes both at the D&O liability and coverage levels are often better placed at the state courts, particularly in Germany. State justice offers particularly strong safeguards ensuring that decisions will be made neutrally and without any conflicts of interest.
We often represent the parties to arbitration proceedings or arbitrators as part of our practice, including in the fields of insurance and reinsurance. We would be happy to discuss and expand on our practical experience both in preventative drafting of arbitration agreements and in performing arbitration proceedings. Please feel free to contact us should you have any questions regarding this article.
Any questions? Please contact: Dr. Oliver Sieg oder Dr. Henning Schaloske
Practice Group: Insurance & Reinsurance