Can directors recover their legal fees from their own company?

079月2018

Given the complexity of today’s corporate governance, the question of whether directors can be indemnified out of the assets of their company remains a complex issue. In a hectic world where decisions are made without the benefit of hindsight, directors can find themselves the subject of long and costly legal battles. As a general rule in Hong Kong a company has a choice in deciding both whether and how it chooses to indemnify its directors. It can do so through the use of the company’s Articles of Association and through Directors and Officers Liability Insurance which generally provides cover for any liability that the company is unable or unwilling to cover. If neither the company’s articles nor insurance are available to a director, a director has to fall back on principles established under the common law.

Indemnification through Articles of Association (Articles)

Under the Companies Ordinance (Cap. 622) s. 468 a company may choose in its articles to indemnify its directors for liability arising due to third party liability.  However the liability must not be in connection with any negligence, default, breach of duty or trust.  If the liability against the director was the result of any of these, any provision to provide an indemnity would be void. The rationale behind this is that directors have a duty of care to the companies they serve and as a consequence cannot be exempt from liability. Subsequently, s.469 (2) goes further and states that the articles must not provide any indemnity against:

  • criminal penalties or penalties imposed by regulatory authorities,
  • the costs of defending criminal proceedings (where the director is convicted),
  • the costs of defending civil proceedings (where judgment is given against the director), and
  • the costs of defending a derivative action (in which judgement is given against the director).

These prohibitions would suggest that indemnification of a director’s defence cost would be allowed if the director is eventually acquitted in criminal proceedings, or where judgment is given in favour of the director’s civil proceeding or derivative action. Furthermore, the law is unclear as to whether costs of defending regulatory action are prohibited as the law only stipulates that regulatory penalties cannot be indemnified. It is also debatable whether a company could pay in advance of any judgment, but it is unlikely that advance payment would be allowed considering the construction of the ordinance. S.468 and s.469 states that any indemnity must not be extended to a director who incurs liability from unsuccessfully defending criminal or civil proceedings. Considering that one cannot predict all outcomes, advance payment would appear to conflict with the relevant law.[1]

How should the Articles be Drafted?

Companies seeking to provide indemnification through their articles should ensure that the relevant provisions in their articles are clearly drafted as to the precise offer and content of indemnification. In addition, setting out the terms of indemnification in a director’s service agreement or contract will aid the director in enforcing the articles (given the directors are not a party to articles).

The Common Law

In situations where a company has failed to provide indemnity provisions in its articles, the common law may provide relief as it continues to govern indemnities that fall outside of the scope of the Company Ordinance. In order for common law principles to be applicable the court must be satisfied that the relevant costs were incurred as a result of a director discharging his duty in the interests of the company during the ordinary course of business.[2] It does not work for a director to claim that the expenses would not have been incurred if he or she had not been a director of the company. In Tomlinson v Liquidators of Scottish Amalgamated Silks Ltd the court stated that a director could only be indemnified if the expenses incurred were a direct result of him discharging his duty as a director or an agent of the company.[3] Furthermore, there appears to be a requirement that the expenditure must be in accordance with the company’s articles. In the case of Pickering v Stephenson the court barred the directors of the company from any further access to the company’s assets for a prosecution brought about by them, as the payments were inconsistent with the objects and the spirit of the company.[4]

Shareholder Approval

It is likely that approval of shareholders to indemnify the cost of the directors is not always required. In Studdert v Grosvenor directors did not receive sanction from the shareholders to pay costs for their prosecution from the company’s assets. The court held that the directors did not act beyond their legal authority for paying the costs of the prosecution, as the prosecution was entirely in the interest of the company.[5] However, as stated previously, the relevant costs must be consistent with the objects and spirit of the company.

Practical Tips and Considerations

Judgment calls made by directors often come under close scrutiny from regulatory agencies or members of the company and it is therefore important that companies and directors ensure that they are protected and that the relevant indemnification offers both clarity and sufficient protection.

In order to ensure that a company has the authority to indemnify its directors it must clearly state the relevant provision in its articles. Whilst the common law may proffer a way out, it is as a last resort.

Ian De Witt

If you would like to discuss any of the matters raised in this article, please contact:

Ian De Witt
Partner | E-mail

Disclaimer: This publication is general in nature and is not intended to constitute legal advice. You should seek professional advice before taking any action in relation to the matters dealt with in this publication.

[1] It is important to bear in mind that according to Model Article for Private Companies Limited by Shares, Division 5 “Director’s Indemnity and Insurance”, it appears that indemnity will only be provided after the final decision in the proceedings have been reached. Refer to paragraph 31(2-3).

[2] Halsbury’s Laws of England, Volume 15A (2016) Paras 576

[3] Tomlinson v Liquidators of Scottish Amalgamated Silks Ltd 1935 S.C. (H.L.) 1 p.5

[4] Pickering v. Stephenson (1872) l. r. 14 eq. 322 p.339

[5] Studdert v Grosvenor (1886) 33 Ch. D. 528