Does an insolvency exclusion in a D & O Policy apply when a mining company’s business fails and it becomes insolvent?

Background

An Australian mining company based in Perth, Kaboko Mining Limited (Kaboko), conducted the exploration, development and mining of manganese in Zambia. Like all mining adventures, it is a speculative business.

The company borrowed money from a financier, which took security for the loan over the anticipated flow of manganese from the mine.

The mine was not as productive as anticipated. Kaboko fell into default under the loan and the financier appointed receivers to run the company. The company eventually entered into a scheme of arrangement with its creditors.

Kaboko then sued its directors for potential breaches of their duties as directors under Australia’s Corporations Act. This included the common allegations of failing to act with care and diligence and failing to act in good faith for a proper company purpose.

Insolvency exclusion

The directors claimed under their D & O Policy with their insurer. Their insurer declined the claim, relying on the insolvency exclusion, which said:

The Insurer shall not be liable under any Cover or Extension for any Loss in connection with any Claim arising out of, based on or attributable to the actual or alleged insolvency of the Company or any actual or alleged inability of the Company to pay any or all of its debts as and when they fall due.

The drafting of the exclusion is wide; it applies to any damages in connection with a claim against the directors arising out of, based on or attributable to Kaboko’s insolvency.

Federal Court of Australia decision

In Kaboko Mining Limited v Van Heerden (No 3) FCA 2055, the Federal Court found the exclusion did not apply.

The court considered the nature of the allegations pleaded against the directors and more importantly, the facts that gave rise to those allegations. The court approved of an earlier New South Wales Supreme Court decision that said:

… the craftiness or the clumsiness of the claimant’s pleading is not determinative of the characterisation of the claim … . … whether a claim falls within an exclusion depends on the facts that give rise to the claim and not its formulation by the claimant …

The court found Kaboko based its allegations on the following failings by the directors:

• Allowing Kakobo to breach the finance agreement,
• Failing to ensure that Kakobo kept proper books and accounts,
• Allowing Kakobo to breach the finance agreement by failing to ensure that its subsidiaries held all relevant mining licences that it had warranted would be held,
• Allowing Kakobo to breach the finance agreement by allowing it to sell manganese product to third parties.

The court noted that while these allegations led to the company’s insolvency, the allegations did not:

… arise out of nor originate in, or spring from, or have its foundation in …

Kakobo’s insolvency. The exclusion required the claim against the directors to be based, at least in part, on the insolvency itself. It was not.

Interestingly, the court partly relied on the business efficacy rule of contract interpretation to come to its decision. The court considered:

• The commercial purpose of a D & O Policy,
• The risks it was designed to insure against (noting that the pleaded allegations were the exact class of risks the policy intended to insure),
• The mischief sought to be excluded by the insolvency exclusion.

The court cautioned that to interpret the insolvency exclusion in the way contended by the insurer would result in the insolvency exclusion operating to exclude all claims against directors of any nature whatsoever if the relevant conduct giving rise to the claim also played a part in the eventual insolvency of the company.

The court said such an interpretation would be contrary to the commercial purpose of the D & O Policy and would render the policy ‘practically illusory’.

Comment

This case is a good example of why it is dangerous to apply an exclusion based on a literal interpretation of the words used. While that is the starting point, it should never be the finishing point.

An insurer must go on to consider the commercial purpose of the policy and the type of risk that the exclusion is objectively addressing. An interpretation that ‘guts’ the cover from the policy should ring alarm bells.

This case is also a good example of how exclusions in liability policies must be interpreted against the backdrop of the underlying facts of the claim made against the insured. The way the claimant pleads the claim against the insured is not necessarily determinative.

We understand the insurer is appealing the decision and we will keep you updated about the outcome of the appeal.

Please feel free to contact us if you require any further information.

Crossley Gates or Frank Rose