Authors: Zhan Hao、Wan Jia
In the beginning of 2020, Luckin Coffee event brought the attention from the insurance, legal and security industries to the directors and officers liability insurance policy (“D&O”) in China. In this event, Luckin Coffee, which is listed in the US and called Chinese Starbucks, found trapped in the security fraud scandal, and some class actions have been filed in the US against Luckin Coffee and its officers.
When Chinese society found D&O insurance coverage behind those American litigations, Luckin Coffee event inspired curiosity towards to D&O insurance, and insurance sector quickly remembers this transplanted product.
The uneven road for D&O insurance in China
During the previous years, D&O insurance actually has been lukewarm in China market after its first appearance around two decades ago, and the patronage to this transplanted insurance product has been limited to Chinese companies listed in the overseas security market or some financial institutions under the stringent scrutiny from China regulator.
The reason for such embarrassing performance is obvious, which is relevant to the loophole in PRC legislature about the liability of corporate directors and officers.
First, even though some simple and general provisions exist in PRC Company Law to address the loyalty and diligence responsibility for directors and officers, but the lack of the concrete guidelines and detailed penalty usually results in the fact that rare claims have been filed towards directors or officers in reality. The derivative action has been injected into the docket of Chinese tribunal for quite some years, but the practicality of action is so premature that potential plaintiffs are hesitant to file a real action against those directors and officers.
Second, the governance structure of some companies is abused by the majority shareholder or actual controller, who would ignore the interest of minority shareholders or beneficiaries, and let alone the creditor’s right. When the majority shareholder or actual controller pull strings behind corporate mask, directors or officers are manipulated, and this multifaceted tragedy stop victims from claiming damages for directors or officers.
Third and last, the precondition for the security fraud litigation, which requests the regulatory penalty be imposed to swindler before the civil actions, has hider Chinese security investors from filing litigation during the past years.
To perfect the directors and officers liability, improve the corporate governance structure and address the protection towards investors, the hail for claim to directors and officers is loud, but the business volume for D&O underwriter has been miserable.
Coincidentally, in 2020 China D&O insurance market comes across two events, the revision of Chinese Security Law and Luckin Coffee event, which are beneficial for the take-off of D&O insurance.
The newly revised Chinese Security Law strengthens the liability for directors and officers, and this revision possibly leads to the increase of claims under D&O insurance, or at least in theory.
Luckin Coffee event dominated the headline of Chinese media for almost two weeks after it announced that its COO committed fraud, and the news ranges from the fraudulent details, China security authority denouncement and D&O insurance coverage. Even under the background of corona viruse, Luckin Coffee stimulates the fierce discussion among the insurance, legal and security circles in China.
Factually, D&O insurance goes to the spotlight this time, but there are not many people know that D&O coverage has been litigated quite some times in Chinese courts, while most of litigations did not go into public due to settlement. The disputed issues about those D&O insurance cases are comprehensive and of interest worth being noted.
The scope of insureds
One of the disputed points is about the scope of the insureds. In some countries outside China, there are three D&O models, called side A, side B and side C.
Side-A provides coverage to individual directors and officers when their losses are not indemnified by the company as a result of law prohibition or financial incapability of the company. However, exclusions may apply if a company simply refuses to pay the legal costs of a director or officer. Side-B provides coverage for the company (organizations) when it indemnifies the directors and officers (corporate reimbursement). Side-C provides coverage to the company (organizations) itself for security-related claims brought against it.
In China market, all those three coverages could be found. With respect to Side-B policy, the insureds are the companies rather than individuals. The occurrences regarding D&O often are about the scandals of China-domiciled corporations, which have been listed in American stock market, but were involved in security fraud, and aroused class actions in the US. For most cases, the final controller for such listed corporations are Chinese citizens or residents, but some CEO, CFO and COO are not Chinese citizens or residents. Thus when facing investigation or class action, the final controller sometimes chose to ignore the claims or investigations simply since the controller has no intention to sustain the corporation, but those directors and officers could not afford such ignorance. After paying for legal costs in the action against directors or officers on their own, directors or officers could not find or force corporation to reimburse themselves. When they approach Chinese insurers for insurance compensation, it is not a surprise to expect the refusal because those individuals are not insureds under Side-B policy.
The disclosure duty of applicant
In accordance to Article 16 of PRC Insurance Law, the insurance applicant shall fully disclose the risks relevant to the contemplated policy. Different from the other jurisdictions, PRC law only requests applicant to answer the specific inquiries from insurer. Without inquiry, even if applicant might know the potential exposure to risk, it is not obligatory for applicant to disclose such information. With respect to the D&O insurance sold in China market, the majority of applicants bought policy through brokers, and actually brokers handled the inquiry procedure and collected the disclosed information. Since China law does not allow the general inquiry from insurer, how to construct the valid and specific inquiries would be challenging to insurers and its agents.
The rhetoric issue always trigger dispute about the contents of disclosure, and it finally touches the utmost good faith doctrine in PRC Insurance Law. Among the often-asked questions by insurers, how to interpret the previous circumstances before the policy inception, how to define the information known or should have been known by applicants, and how to verdict the violation of Sarbanes-Oxley Act are focuses for the confrontation between insured and insurer. Since those D&O insurance policies are governed by PRC law, but their wording is full of jargons extracted from American law in the meantime, naturally the interpretation of policy also becomes hot debate in court trial.
For the information already known or should have been known by insurer, applicant is not obligatory to disclose such information to insurer. Some interesting episodes were about US investigation, which was denied to be known by applicant during the process of insurance application, but in fact the investigation information had been public in the website of SEC or other sources before policy inception. Should those imputed information be deemed as being known by insurer already, or would tribunal could impose a duty of due care to Chinese insurers to scrutinize the foreign authority websites in English?
The conflict and connection for the different layers coverag
In China market, some D&O policies are in the form of excess insurance, in which the primary insurer is first responsible for defending and indemnifying the insured in the event of a covered or potentially covered occurrence or claim. An excess policy provides specific coverage above an underlying limit of primary insurance. The dilemma for such multiple layers insurance is the primary insurer is foreign one, but the second or above insurers are Chinese ones. The second or above layers insurers shall follow the indemnification decision from the underlying layer insurer, or they could make decision at their own discretion?
Things would be more complicated if the different layers policies use laws from different jurisdictions as governing laws.
During the previous cases, tribunal preferred to take approach in which upheld the different layer insurers to have independent decisions to handle the claim unless otherwise stipulated in the policy.
The separation of liabilities
If one specific officer fails in his/her disclosure obligation or triggers the exclusion clause such as intentional act, could it excuse insurer from liability to other insureds? In most D&O policies, there are clauses to separate the insurance liability among the insured directors or officers, but those standard clauses encounter lots of challenges in trail. It is hard to believe that a CEO’s fraudulent behavior could be segregated from other subordinate officers, or a CFO could make fraudulent financial statements without approval or knowledge from the directors or CEO.
In those scenarios, how to allocate the burden of proof between insured and insurer would be of essence for trial result. It is obviously unfair to impose a higher standard of burden of proof to insurer, who is an outsider to a corporation. In the meantime, the absence of discovery procedure in China litigation disables insurer with practical means to discern the real picture of fraud, to clearly figure out the collusion of directors and officers.
Some desperate insurers want to depend on the police to dig out the fraud details, but Chinese police seldom investigates the suspected crime because the suspected crime happens outside of China, and victims usually are not Chinese citizens.
Today, accompanied by the security law amendments and some fraud occurrences, D&O insurance stumbles to spotlight again after a long period of silence in China. With the developing pace of security market and insurance market, the refreshed D&O insurance gives imagination to Chinese underwriters.