Company directors and executives – and their insurers and brokers – can have more confidence that directors’ and officers’ (D&O) policies will fund legal costs as intended, following the NSW Court of Appeal’s decision in the Great Southern case.

The five judges say the NSW law on which it was asked to rule “should be repealed altogether or completely redrafted in an intelligible form”.

Great Southern became the first Australian test of entitlement to D&O proceeds following the 2011 Bridgecorp decision, when the New Zealand High Court found a receiver had first claim on the funds when the claim might exceed the amount of cover.

NSW, the ACT and the NT have similar legislation to the New Zealand law on which Bridgecorp was based, so shareholders in two class actions against directors and executives of plantation company Great Southern asserted a charge over D&O policies here, saying their claims had priority over legal expenses being incurred by company officers.

This led to a dispute between the eight executives and the insurers, as well as with the Great Southern claimants. The insurers asked the court to clarify who was entitled to any funds payable.

The executives hold cover in primary and excess policies with Chubb, Liberty Mutual, Allianz, AIG, Axis, QBE and Wesfarmers/Lumley.

The insurers asked the court for declarations on the interpretation of section 6 of the NSW Law Reform (Miscellaneous Provisions) Act that would enable them to pay defence costs.

The primary policy covered D&O liability and professional liability, with a maximum liability of $30 million each, or $60 million combined. The insurance was brokered by Aon’s Perth office.

The insurers successfully argued NSW law should not apply because the shareholder class actions are being run in Victoria and WA, the company was headquartered and mostly did business in WA and all the executives lived and worked there.

The judgement says the company has no special connection with NSW and section 6 should apply only to claims brought in that state, so has no application to the Great Southern proceedings.

But it says even if the NSW law did apply, and there was a charge under the shareholder actions, that charge would not extend to the insurance payable for defence costs before there was any judgement or settlement of the shareholders’ claims.

The judgement describes the provisions of section 6 as “somewhat enigmatic”, but says it was enacted to prevent people being paid from policies “and then the insured either disappears or fritters away the sum or enters into a collusive arrangement with the insurer”.

In these cases, someone who wins a claim against the insured might not recover any money.

But the court says it must consider whether section 6 operates to deprive an insured of the “vital benefit” of having defence costs paid. It finds the insurers would not be acting reasonably if they did not allow the executives to incur costs to defend themselves.

The decision means when the limit of cover includes costs, payment of defence costs will reduce the amount available for any later settlement to third parties.

But the judgement says although all the insurance money could be spent on defence costs, if the insured is found liable they will have to pay the claimant out of their own funds.

A third-party claimant should not be in a more favourable position than an insured when an insurance policy is intended to cover defence costs.

“An insured should not be required to wait until after the question of its liability to a claimant has been determined before it can be indemnified for such costs.”

The court says section 6 has been described as “undoubtedly opaque and ambiguous”, and calls for it to be redrafted to achieve its original purpose.

It could be a month before it is known whether the judgement will be appealed.

The original Bridgecorp decision has since been overturned. The final avenue of appeal, the Supreme Court of New Zealand, will decide the matter in a hearing due to start on October 17.

Allens Partner Andrea Martignoni says the Great Southern judgement gives insurers, brokers and directors confidence that policies will operate as intended, and no third party will have greater rights than the insured under the policy.

It means insurers can provide defence costs without the risk of eroding any third-party right and later having to pay out twice, he told insuranceNEWS.com.au.

AIG Commercial Institutions Manager Jeremy Scott-Mackenzie says the judgement will allay directors’ fears following Bridgecorp, which raised concerns that people would start refusing to serve on boards.

“There are now more than 700 laws in Australia that directors have to traverse, that impose liability on directors,” he told insuranceNEWS.com.au. “And we have better-funded regulators and the emergence of litigation funders running class actions.”