In early 2020, the Luckin Coffee scandal drew attention from the insurance, legal and security industries and turned the spotlight on directors' and officers' (D&O) liability insurance policies in China. Luckin Coffee, which is listed in the United States and often called the 'Chinese Starbucks', found itself trapped in a security fraud scandal. Some class actions have also been filed in the United States against the company and its officers.
When it emerged that D&O insurance coverage was discussed in the US litigations, curiosity grew, and the Chinese insurance sector saw an increased interest in D&O insurance.
Historically, D&O insurance has been unpopular in the Chinese market since its emergence approximately two decades ago, and the patronage of this transplanted insurance product has been limited to Chinese companies listed in the overseas security markets or financial institutions under stringent scrutiny from the Chinese regulators.
The reason for such low performance is clear and connected to the loophole in Chinese legislature regarding the liability of corporate directors and officers.
First, even though some simple and general provisions exist in the Company Law to address directors' and officers' responsibility to be loyal and diligent, the lack of concrete guidelines and detailed penalties means that, in practice, few claims have been filed towards directors or officers. The concept of derivative actions has existed in China for years, but the practicality of such an action is so premature that potential plaintiffs are hesitant to file a real action against directors and officers.
Second, the governance structure of some companies is abused by a majority shareholder or actual controller, who ignores the interests of the minority shareholders or beneficiaries and creditors' rights. When a majority shareholder or actual controller pulls strings behind a corporate mask, directors and officers are manipulated, and this multifaceted process stops victims from claiming damages from directors or officers.
Third, the precondition for security fraud litigation, which results in the regulatory penalty being imposed on the fraudulent party before the civil actions, has hindered Chinese security investors from filing litigation in recent years.
To perfect directors' and officers' liability, improve the corporate governance structure and address protection towards investors, the call from directors and officers is loud, but the business volume for D&O underwriters has been low.
Coincidentally, in 2020 the Chinese D&O insurance market faced two events which helped D&O liability insurance take-off – namely, the revision of the Security Law and the Luckin Coffee scandal.
The newly revised Security Law strengthens the liability for directors and officers, and this revision will likely lead to an increase of claims under D&O liability insurance.
Luckin Coffee dominated the Chinese media headlines for almost two weeks after it announced that its chief operating officer (COO) had committed fraud. Articles focused on the fraudulent details, the Chinese security authority's denouncement and D&O insurance coverage. Even with the timing coinciding with the COVID-19 pandemic, the Luckin Coffee scandal has garnered fierce discussion among the insurance, legal and security circles in China.
The Luckin Coffee scandal has brought D&O insurance into the spotlight, but D&O coverage has been litigated in the Chinese courts previously, although most of the litigations were not public due to settlements. The disputed issues in these D&O insurance cases are comprehensive and of interest and are summarised below.
Scope of 'insureds' definition
One of the disputed points regards the scope of the definition of 'insureds'. In some countries outside China, there are three D&O models – namely, 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 a legal prohibition or the company's financial incapability. However, exclusions may apply if a company simply refuses to pay the legal costs of a director or an officer.
- Side B provides coverage for the company when it indemnifies the directors and officers (corporate reimbursement).
- Side C provides coverage to the company itself for security-related claims brought against it.
All three types of coverage can be found in the Chinese market. With respect to Side B policies, 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 the US stock market, but were involved in security fraud, and resulted in class actions in the United States. For most cases, the final controller for such listed corporations are Chinese citizens or residents, but some chief executive officers (CEOs), chief financial officers (CFOs) and COOs are not Chinese citizens or residents. Thus, when facing investigation or class action, the final controller sometimes chooses to ignore the claims or investigations simply because the controller has no intention to sustain the corporation, but the directors and officers could not afford such ignorance. After paying for legal costs in the action on their own, directors or officers often cannot find or force a corporation to reimburse themselves. When they approach Chinese insurers for insurance compensation, it is unsurprising that they are refused because such individuals are not considered insureds under Side B policies.
Applicants' duty of disclosure
In accordance with Article 16 of the Insurance Law, insurance applicants must fully disclose the risks relevant to the contemplated policy. Unlike other jurisdictions, Chinese law requests applicants to answer only the specific enquiries from the insurer. Without the enquiry, even if the applicant might know the potential exposure to risk, the applicant need not disclose such information. With respect to D&O insurance sold in the Chinese market, the majority of applicants bought policy through brokers and such brokers handled the enquiry procedure and collected the disclosed information. Since Chinese law does not allow the general enquiry from insurers, constructing the valid and specific enquiries is often challenging for insurers and their agents.
Disputes often arise over the contents of disclosure, particularly with regard to the good-faith doctrine in the Insurance Law. Frequently asked questions by insurers include:
- 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 judge violations of the Sarbanes-Oxley Act.
Since these D&O insurance policies are governed by Chinese law, but their wording is full of US legal jargon, the interpretation of policies is often hotly debated in the courts.
With regard to the information already known or that should have been known by the insurer, applicants need not disclose such information to the insurer. Some of the cases discussed US investigations, where the applicant denied that it had known about information during the process of applying for insurance, but, in fact, the investigation information had been public on the US Securities and Exchange Commission's website and other sources before the policy's inception. Should this imputed information be deemed as being already known by the insurer, or should the tribunal impose a duty of due care on Chinese insurers to scrutinise the foreign authority's websites in English?
Conflict and connection for different layers coverage
In the Chinese market, some D&O policies are in the form of excess layer 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 layer policy provides specific coverage above an underlying limit of primary insurance. The dilemma for such multiple layer insurance is that the primary insurer is a foreign party, but the second or more insurers are Chinese parties. Should the second or more layer insurers follow the indemnification decision from the underlying layer insurer or should they make a decision at their own discretion?
Matters are more complicated if the different layer policies use laws from different jurisdictions as governing laws.
During the previous cases, the tribunals held that the different layer insurers could make independent decisions to handle the claims unless otherwise stipulated in the policy.
If one specific officer fails in their disclosure obligation or triggers the exclusion clause (eg, through an intentional act), could this excuse the insurer from liability to the 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 many challenges. It is hard to believe that a CEO's fraudulent behaviour could be separated from other subordinate officers or that a CFO could make fraudulent financial statements without approval or knowledge from the directors or the CEO.
In those scenarios, how to allocate the burden of proof between the insured and the insurer would be vital for the trial result. It is unfair to impose a higher standard of burden of proof to insurers, which are outsiders to corporations. In the meantime, the absence of discovery procedures in Chinese litigation restricts insurers with practical means to discern the real picture of fraud, to clearly figure out the collusion of directors and officers.
Some insurers depend on the police to discover the fraud details, but the Chinese police seldom investigate the suspected crime because the suspected crime happens outside China, and the victims usually are not Chinese citizens.
Today, accompanied by the security law amendments and some fraud occurrences, D&O insurance has stumbled into the spotlight after a long period of silence in China. With the developing pace of the security and insurance markets, the renewed focus on D&O insurance gives Chinese underwriters plenty to contemplate.
