DIRECTORS’ LIABILITY AND INSURANCE The Case of Cyprus by Christos Gavriel MSc Insurance and Risk Management (2004-5) September 2005 Dissertation submitted to Cass Business School, City University, London in partial fulfilment of the requirements for the degree of Master of Science in Insurance and Risk Management Supervisor: Professor Christopher Parsons ABSTRACT This project examines the D&O environment in Cyprus. It introduces the main local laws and regulations, a brief outline of Directors’ and Officers’ liability insurance as well as a critical assessment of its usefulness as a method of boardroom risk transfer. Main analysis presents the results of primary qualitative research on the views of a sample of key stakeholders, namely directors, auditors and D&O insurers. It highlights the need for further training to directors, especially non-executives, on their duties and possible liability and leads to a variety of recommendations and stimuli for further research. ACKNOWLEDGMENTS Many thanks to my supervisor, Professor Christopher Parsons, for his guidance and encouragement, as well as to the Committee of the Cyprus Association of Directors and especially the Chairman Mr Dinos Kittis for their noble patronage and kind cooperation. I also owe my gratitude to all the respondents to the survey. Without their contribution this project would not have been possible. My work is dedicated with all my heart to my parents, whose endless support has been guiding me throughout my studies. EXECUTIVE SUMMARY The use of Directors’ and Officers’ Liability insurance (D&O) as a mechanism for boardroom risk transfer has expanded rapidly over the last twenty years. The last decade in particular has seen a number of high profile corporate scandals and spectacular company collapses across the world. Using recent activity on corporate governance and Directors’ liability as a stimulus, this study presents the state of the D&O environment in Cyprus, a recent member of the European Union. Given the small size of the local economy and insurance market, as well as the relative immaturity of its capital market, the aim of the study was to explore the extent of familiarity of directors with the extent of their duties and potential liability, the views of key auditing firms, as well as the extent of development of the local D&O liability insurance market. The initial hypotheses were that Directors in Cyprus are not adequately informed on their duties and potential liability. As a consequence they could be relatively under- compensated and unaware of the risks they assume when joining a company board. We also presumed that in an environment that runs a deficit on effective on boardroom risk management, D&O liability insurance would be considerably underdeveloped, with main pressures for its adoption coming from accounting/auditing firms. Primary research consisted of three separate qualitative questionnaires. The first type was sent to key partners from each of the “Big Four” of the accounting profession, which control the lion’s share of audit work for companies listed on the Cyprus Stock Exchange. It aimed at collecting their views on Cypriot D&O liability and insurance. The second questionnaire was sent to the two local D&O insurers to assess local technical expertise, capacity, as well as their views on the future of D&O on the island. The third questionnaire, which formed the basis of the project was sent to directors from a quota sample of the largest companies listed on the local Stock Exchange, and aimed at analyzing awareness of their duties, possible liability and familiarity with D&O liability insurance. The response rate was sufficient across the surveys and allowed some significant conclusions to be drawn. The initial hypothesis that a number of Cypriot directors place their personal financial solvency at risk by joining a company board without being adequately informed on their duties and possible liability was indeed confirmed. 58% of respondents found difficulty in identifying the spectrum of laws and regulations that govern their duties, with 13% of them admitting ignorance of the extent of their liability and a further 4% claiming that their liability is limited to the company’s share capital. Contrary to our hypothesis there was remarkable awareness of D&O liability insurance and considerable utilization of this type of insurance in companies’ risk management programmes. 87% of respondents expressed familiarity with D&O insurance with 49% actually buying cover. Nevertheless, this figure is expected to be significantly lower among smaller companies not included in the sample. Auditors do not seem as pressing for widespread use of D&O as their counterparts in Anglo-Saxon economies. Commercial reasons arising from the small size of the local market and the readiness of smaller accounting firms to take new accounts without setting strict prerequisites are probable making D&O liability a secondary issue for auditors at the moment. However the local Corporate Governance Code, formulated in 2002 and gradual adjustment to the competitive environment of the European single market are expected by all respondents to bring the issue higher up in the agenda in the near future. As far as insurers are concerned, the two local D&O underwriters seem technically well versed to deal with the demanding nature of this type of insurance, while the most notable finding from such responses was the absence of local D&O broking expertise. The main recommendation refers to the need for training Directors on their general duties and potential liability. At the moment it is likely that especially non-executive directors are underestimating the multitude of risks they are exposed to when joining a listed company’s board, and could hence be considerably under-compensated, especially in the absence of D&O cover. At the moment the lack of a “compensation culture” among local investors prevents litigation to the extent observed in western capital markets. Nonetheless further opening of the local capital market to foreign institutional investors could find Cypriot directors unprepared. This recommendation could be particularly appealing to the Cyprus Association of Directors, a recently founded trade association, aiming to promote the interests of local directors, as they seem the most qualified body suitable to provide this kind of general training. This study concentrated on key players of the Cypriot capital market. Further research could stress-test the findings and proceed to involve a wider sample, such as directors of smaller companies, smaller accounting firms and insurers that are considering to enter this market. It could also explore issues, largely ignored by this study, such as D&O claims experience and the impact of Cyprus’ recent accession to the EU on directorial liability. 1 INTRODUCTION 1.1 BACKGROUND Market economies have long adopted the view that systems of “pure enterprise liability”, where directors are not accountable for their actions to other stakeholders lack both accountability and the ability to prevent various forms of corporate wrongdoing. In effect they place personal liability on directors primarily to deter wrongdoing as well as to maintain the ability to compensate victims of such actions. Globalisation, worldwide deregulation, spectacular corporate scandals and the subsequent growth in litigation in western economies has increased demand for structures to improve transparency and good management (corporate governance) as well as instruments to spread the risk of financial destruction for directors and facilitate compensation to potential victims (Directors’ and officers’ liability insurance). It is indicative that surveys by Wyatt & Co in 1991 and 1994 found a growth in the take-up of Directors’ and Officers’ liability insurance (D&O) in the UK from 46% to 62% of surveyed companies. Given that the Combined Code of Corporate Governance in the UK now requires companies listed on the London Stock Exchange to provide insurance protecting directors in case of legal action against them, if a similar survey was conducted at present, the take-up of D&O would certainly be considerably higher. Having in mind developments in Directors’ liabilities and D&O liability insurance both in the EU as well as in North America, this study will explore a variety of issues with regards to D&O risk management in Cyprus, a recent member of the European Union. 1.2 OBJECTIVES One of the main objectives of this study is to ascertain whether directors in Cyprus are aware of their duties and potential liabilities through surveying a sample of directors of companies listed on the Cyprus Stock Exchange. This will be a starting point to explore possible strategies adopted to transfer or manage the risk of corporate wrongdoing and subsequent claims by affected parties. Particular importance will be placed on D&O insurance, where the views of local underwriters will be sought through a separate questionnaire. The puzzle will be completed by a third questionnaire to auditors of the said companies. In order to analyse the state of the D&O environment in Cyprus the following research questions will be addressed: What is the legal standing in Cyprus with regards to D&O liability? Do Directors fully understand the spectrum of liabilities that derive from their duties? If yes, do they command a risk premium on their remuneration or do they transfer the risk of a lawsuit to an insurer through D&O liability insurance? Do Directors understand the D&O policy terms and conditions and does it affect their behaviour? How do they perceive future developments? As far as auditors’ views are concerned, the following research questions are to be answered: Do they understand the liability of their clients, and how do they perceive its impact on their business? Do they take D&O into account when pricing the services they offer to clients? Would they encourage/support further development of D&O insurance in Cyprus? Questionnaires to underwriters were the most technical, and sought to examine available insurance capacity, policy details, issues on distribution of D&O insurance, market penetration and views on the future of this line of business on the island. 1.3 BACKGROUND TO THE CYPRUS ECONOMY AND THE CYPRUS STOCK EXCHANGE Cyprus is an island in the East Mediterranean with a population of less than one million1. Being an English colony until independence in 1960, it has inherited a Common Law system and has long had a market economy. On 1 May 2004 it joined the EU in the union’s last enlargement wave. Its economy is dependent on services with tourism accounting for more than 20% of GNP. Gross insurance premium in 2003 was CYP350 million (IAC, 2003) therefore the island seems, to the outsider, 1 37 % of the island has been under Turkish occupation since 1974. Therefore any reference to Cyprus hereon refers to the Greek-Cypriot administered Republic of Cyprus. more attractive for a nice holiday rather than large-scale insurance and reinsurance operations. The local insurance market consists of 25 insurers with only two being composites. The Cyprus Stock Exchange (CSE) was established in 1996 and grew to list 144 companies. As in many similar situations, the immaturity of the market climaxed with a bubble in 1999-2000. Its spectacular burst led the Stock Price Index from around 800 to the mid 70s in late 2004, the Cypriot society in turmoil and small investors in despair, while causing a shake-up in the foundations of the Cyprus capital market. The following years witnessed considerable steps in introducing legislation and regulations to govern the CSE, the introduction of the Corporate Governance Code in 2002 and the division of the market into sub-categories depending on the level of adoption of corporate governance regulations as well as capitalisation. Five years after the burst of the bubble most of the wounds of the past are beginning to heal. The intention to adopt the Euro by 2008 led the Cyprus Pound into ERMII earlier this year and signalled a subsequent rally of interest rate cuts. In accordance with considerable restructuring within key businesses, profits in 2005 have risen spectacularly, and the Main Market index established in 2004 at 1000 units rose by about 30%. Despite the effects of oil price hikes, the Cypriot economy has so far withstood inflationary pressures and prospects for the CSE in 2005-6 seem quite bright. Having in mind that a variety of external factors have led the economy to a 4% growth rate, while the general economic environment seems promising for listed companies it would be interesting to examine whether internal changes in Cypriot listed companies have led to an improvement of governance standards, not so much in terms of the level of compliance with corporate governance regulations, but more on the extent of training of directors. The level of expertise and experience on company boards could mean the difference between success and failure. Hence the following hypotheses have been set to guide the analysis. These hypotheses are relevant to the research questions put forward previously and are to be answered by the responses to the questionnaires. 1.4 HYPOTHESES 1. Directors’ awareness of their duties: The Cyprus corporate environment has not matured enough to enable directors to have sufficient awareness of their duties and possible liabilities. The small size of listed companies, the absence of a “compensation culture” among stakeholders and the family nature of the vast majority of listed companies prevent adequate training of directors, especially non-executives. Directorships are frequently taken as part of a general tendency to help friends who control listed companies, with Cypriots considering it an honour to be asked to serve on a board. Effectively issues of personal liability and potential threat to personal financial solvency are regarded insignificant, if considered at all. It goes without saying that in such an environment directors’ remuneration is expected to be considerably inadequate, especially in the absence of D&O insurance. 2. Do directors buy D&O and do they understand the available cover? The personal experience of the researcher in the Cyprus insurance market alone would suggest that the take-up of D&O on the CSE would be limited. Many businessmen consider insurance in general a necessary evil, despite their companies’ limited access to capital. Therefore it remains to be seen whether they are willing to spend additional funds on D&O cover. As far as the second part of the question is concerned and given the considerable absence of insurance education2 among corporate insurance buyers, widespread awareness on D&O terms is not to be expected. 3. Is there a functioning D&O market with widespread availability of cover? Is there adequate capacity? Is there potential for growth? Having in mind the size of the island, one would not expect a functioning D&O insurance market in the sense that there is a number of Cyprus domiciled D&O insurers. However given the established physical presence of the global leader in this line of business (AIG) on the island along with the possibility of access to the London Market through brokers, the supply-side of the market should not be problematic. 2 This absence of insurance culture is to be attributed equally to both sides of the market. Insurers in Cyprus have not yet embraced the idea of educating their corporate clients in the process of improving risk management. 4. Do auditors encourage their clients to buy D&O cover? What is the effect on their professional liability risk management of under-insured clients? Having in mind the size of the market, and the intensity of competition among accounting firms3, commercial reasons are probably holding auditors from pressing for widespread D&O cover. However the relative absence of a compensation culture and the immaturity of laws and regulations in the local capital market are likely to have prevented claims for negligence in cases of corporate wrongdoing. Nevertheless it would be interesting to investigate auditors’ attitudes towards establishing a corporate governance system that requires D&O cover for directors. 1.5 PROJECT OUTLINE This section has provided an introduction into the Cyprus economic environment and has generated the research questions and hypotheses that will guide the main body of the project. The following chapter will introduce the theoretical background behind D&O liability, the rationale for insurance and a brief critique of the whole system. Particular importance will be placed in identifying key issues where Cyprus differs from other western environments and especially the UK. Chapter 3 proceeds to outline the methodology behind the primary research. It presents the process followed to conduct the surveys and assesses the credibility and validity of the results in the light of potential sources of bias. Chapter 4 analyses the results from each of the classes of questionnaires to allow the synthesis of approach that will follow in Chapter 5, where key findings will be summarised and possible suggestions for the future of the Cyprus D&O environment will be presented. 3 All of the “Big Four” have operations on the island 2 THE D&O ENVIRONMENT The introduction provided a brief explanation of why legal systems have opted out of “pure enterprise” liability. This section will present this idea in a more analytical way in order to introduce the rationale for directors’ liability and the use of insurance as a risk transfer mechanism. Particular emphasis will be placed on identifying key differences of the law in Cyprus in relation to other Common Law countries and especially the UK. One final aspect to be considered is a critical evaluation of a system based on D&O liability insurance in the light of fears for a crisis. The conclusion that D&O insurance, despite its inherent susceptibility to moral hazard and market cycles, stands out as the most cost-effective means of transferring board-room risk will be carried forward to following sections of the project that will present experience from the Cyprus market. 2.1 WHY SHOULD DIRECTORS BE MADE PERSONALLY LIABLE? There is a plethora of reasons as to why directors should be made personally liable. Finch (1994, p.882) in fact provides a very detailed account of the arguments for such an arrangement. Accountability of wrongdoers and deterrence are in the forefront of this school of thought, which argues that a system of “pure enterprise liability” has significant flaws especially when the legal entity has insufficient funds to meet its obligations. Along these lines personal liability leaves corporate risk in the hands of the people most suitable to manage it, the company’s directors. It also induces a “gatekeeper role” on non-executive directors, who now have an incentive to monitor the performance of managers and executive directors, while it improves the prospect of compensation to wronged parties by bringing “the pocket of the wrongdoer within the range of the victim”. Such an arrangement is obviously beneficial for victims in case of insolvency arising from abuse. This is not to say that such an approach does not have any limitations. Personal liability runs the risk that innocent directors are sued in speculative class actions. This eventuality has been confirmed through experience from the U.S. 4, and is a scenario that Directors with exposure in the North American region fear the most. In effect a system of personal liability that intends to allow efficient corporate risk management, could introduce risk aversion and over-deterrence. It could therefore be the case that a system of “pure enterprise liability” might perform better than a system of personal liability if directors care about their professional reputations and have a stake in the company. Of course nobody can guarantee either the integrity of directors or constant availability of funds to compensate wronged parties. Therefore arguments in favour of “pure enterprise liability” collapse if we consider the possibility of a company being declared bankrupt, having failed to compensate potential victims. 4 Especially through strike suits organized by law firms specializing in the field of corporate negligence and crime. 2.2 DIRECTORS, OFFICERS AND THE CYPRUS LEGAL SYSTEM Cyprus, an ex-British colony, is a common law country. It retained this legal system after its independence in 1960, while decisions taken in English courts post- independence are not binding and do not establish precedent, albeit they are frequently used as guidance. The Companies Act, which in turn sets the basis of Directors’ duties, has also been influenced by its English counterpart. Therefore the local definition of a Director is identical to the one in English Law and refers to any person in accordance with whose directions and instructions the company acts. Officers are considered agents of the company and could be managers at various levels. The duties of directors arise from Common Law and statutes. In Common Law a director is considered an agent of the company and trustee of its assets, while an executive director has additional duties that arise from his services as an employee. Effectively directors have the same basic duties towards the company (their principal) as other agents5; to act in good faith and to exercise due care and skill. In Cyprus the main statute that lays down directors’ duties and obligations is the Companies Act, which is very similar to its UK counterpart. Additional duties are imposed by Stock Exchange and Capital Market Laws and Regulations and EU Directives on a variety of issues including product liability and Health and Safety at Work. Although in the UK it has been estimated that there are, apart from the Companies Act, around 250 statutes under which Directors and Officers could be personally liable, such task has not yet been performed in Cyprus. Following the island’s accession to the EU in May 2004 an array of statutes were enacted into law, therefore one would expect a similarity in the extent of liability between the two countries. One interesting aspect of Cyprus Law is with regards to indemnity provided to directors by the company. Section 197 of the Cyprus Companies Act prohibits the company from providing indemnity to its directors. The same provision used to exist 5 Other examples of principal-agent relationship are client-accountant, client-insurance broker, client- solicitor. in the UK and caused confusion on the legality of D&O insurance as a means of indemnifying directors. As far as Cyprus is concerned, the only report that exists on the compatibility of Cyprus Law with Common Law D&O insurance does not suggest that Section 197 renders D&O insurance illegal (Triantafyllides & Sons, 2003). Having in mind relevant experience from the UK, the legality of D&O is not threatened by this provision, nevertheless if the law was tested in a Cypriot court the outcome might be different. Hence D&O insurers in Cyprus may have to press for clarification of this section of the Companies Act in order to prevent a future disputed claim. 2.2.1 POTENTIAL CLAIMANTS The considerable duties of directors establish a variety of potential claimants. The company, itself, can sue directors among others for breach of fiduciary duties and breach of the duty to exercise due care and skill. Although Directors in Cyprus do not generally owe a personal fiduciary duty to shareholders, potential lawsuits could arise from negligence in advising on merger and acquisition, when directors have a duty to be honest and not mislead. The likelihood of derivative action 6 is also present, yet due to the relative novelty of the island’s capital market, no high profile case has been recorded. Other potential sources of action are creditors, especially in case of liquidation and wrongful trading7, subscribers for and purchasers of securities, employees and other third parties (both in contract and tort). Analysing in detail how such actions could arise in great detail is beyond the scope of this project. However it would be useful to identify, which of the possible sources of action is perceived by directors as the most likely. In effect a relevant question has been included in the directors’ survey analysed in Chapter 4. 2.3 THE RATIONALE FOR INSURANCE 6 Where shareholders sue directors in the name of the company. 7 Section 311 of the Companies act places unlimited liability on directors for company loans is liquidation establishes that the company was wrongfully trading to defraud creditors. It has been established that duties of directors and officers are multifaceted, their liability is personal and sources of possible legal action are numerous. Unlike shareholders, who can invest in any company they wish, they are undiversified risk bearers and effectively a large claim against them could lead to financial destruction. A possible alternative to insurance might be for directors to command greater fees for bearing a small probability of catastrophic personal liability. Having in mind that liability on company boards is joint and several, and hence directors could be sued for negligent actions of their colleagues, one should not overestimate the ability of individuals, irrespective of their financial status to handle uncertainty. Especially in the case of Cyprus, where we have so far assumed that a number of directors may not be aware of the spectrum of their duties and potential liability, it would be dangerous to maintain a system where individuals, who cannot assess their risks fully, are not given the chance to transfer them at the expense of an insurance premium. On the other hand insurance seems, on the face of it, well equipped to diversify low probability-high impact risks at a relatively small premium. At the same time the availability of cover prevents excessive risk aversion by directors and encourages effective risk management at board level. Another by-product might be the ability to recruit more competent directors at more economical terms. 2.4 THE D&O POLICY The D&O liability insurance policy provides cover for losses arising from “wrongful acts” committed by Directors and Officers of a company. These include breach of duty, breach of trust, neglect, error, misstatement, misleading statement, omission, libel, slander, breach of warranty of authority and wrongful trading. The policy has three different kinds of cover referred to as Side A, B and C. Side A indemnifies directors for personal claims against them, Side B provides company reimbursement for indemnifying its own directors, while Side C (the entity cover) mainly provides cover against liability of the company as such. Securities actions and employment related claims, if not excluded from the policy, would be met by Side C. Typical exclusions include fraud and dishonesty, fines, penalties and punitive damages, the insured v insured exclusion8 and risks covered under other policies, while policies are usually written on “claims-made” basis. Such wordings cover claims made during the policy or the extended reporting period provided, hence alleviating the effects of long-tails by making cover entirely retrospective. Policies may be endorsed with a Retroactive Date Clause, which will limit cover to the period between the retroactive date and the date of expiry of the policy. As far as policy structure is concerned it would be interesting to see whether Cypriot D&O underwriters have formed their policy wordings based on Cyprus Law, or whether they have adapted policies used abroad9. A hypothesis we could make at this point could be that the novelty of such cover in Cyprus and the limited size of the market may suggest that a policy formulated entirely for Cypriot risks may not be commercially worthwhile, especially for multinational D&O underwriters. A Common Law wording, which applies to an EU risk like the UK is likely to be considered sufficient. This hypothesis is tested in the underwriters’ surveys and will be analysed in Chapter 4. 2.5 IS D&O A CORPORATE TIME-BOMB? There is a school of thought among academic lawyers that D&O insurance is a particularly problematic risk transfer mechanism. They argue that it is very complex, involving a very small number of insureds and a potentially large number of claimants, which is promoted using aggressive marketing and exaggeration(Parsons, 2000, p.84). They add that D&O insurance is susceptible to various forms of moral hazard. In effect there is the risk of ex-ante moral hazard by directors, on whom the availability of insurance may induce less vigilance in the course of performing their duties. Ex-ante moral hazard may exist when wronged parties decide on legal action on the basis of presence of insurance cover. In such a situation D&O insurance might become a “target” instead of a “shield” (ibid). 8 When the company sues one of its officers/departments. For example an insurance company sues its underwriting director after it realizes that excessive risk taking had been taken on a bad portfolio of risks. 9 Parsons (2001, p.18) implies that the use of Common Law wordings in continental Europe in the past, led to D&O policies initially being insufficient to accommodate the differences in legal and corporate structures. Policy wordings used in Germany and other European countries have by and large been adapted to the needs of local markets They also argue that the presence of insurance cover might encourage courts to expand directors’ liabilities. However Parsons (ibid) counteracts this argument by reminding that courts should ignore the presence of insurance when determining liability. The situation is analogous in Cyprus. Where insurance is expected to have an effect is in affecting the course of future legislation and court awards. Such developments have already been witnessed in Cyprus, where courts10 have contributed to considerable claims awards inflation in the compulsory liability lines (Motor Third Party and Employer’s Liability). The general argument on moral hazard is played down when we consider that it affects virtually all insurance lines. Shifting risk to insurers has long altered insureds’ incentives in various degrees. Hence insurers responded by restricting cover, introducing excesses and applying variable premiums depending on claims experience. When we take into account the relevant inability of the average director to bear uninsured losses, the adverse effect of D&O insurance on his incentive to avoid a loss is quite small and can be controlled by increasing deductibles. Also negligence might lead to loss of a significant directorship, loss of earnings, reputation and earning capacity. These considerations run along with the restrictions imposed by D&O policy conditions. Another argument against D&O concerns the stability of a D&O based system. This view is based on the volatility of the insurance market cycle and was stimulated by the mid-1980s liability crisis in the U.S. It is true that insurance markets are susceptible to cycles. Equally true is the fact that more concentrated insurance lines like D&O11, where insurers have more power to dictate premiums, often have more volatility in premiums than more competitive lines such as property. Therefore in such market conditions changes in terms of D&O cover may be considerable. However sudden drops in insurance capacity and rises in premiums do not come out of the blue. They are usually the result of lengthy periods 10 According to the local Insurers’ Association 11 Parsons (2001, p.28) estimates the number of D&O carriers to be 60 in the US, 30 in the UK along with 15 Lloyd’s syndicates. The market is very concentrated with AIG underwriting over 25% of policies and claiming to have over half the companies in the Times 1000 as clients. of price competition and a combination of sudden catastrophes and changes in the macroeconomic environment that affect the asset side of insurers’ balance sheets. In any case it is very likely that a sharp rise in premiums is preceded by a period of relaxed terms and aggressively priced cover and will usually be short lived12. Perhaps it is rather melodramatic to claim that a system based on D&O is a time bomb. The proportion of companies’ revenues paid as insurance premiums is not such that would suggest that in a hard market D&O cover would be unaffordable. In fact as Priest (1987, p.1557) suggests the probabilistic nature of D&O risks and the fact that they usually involve low probability-high severity losses makes them more amenable to pooling than gradually occurring losses such a gradual pollution. Risks that may be denied cover altogether in a hard market are likely to be companies that show a very relaxed attitude to corporate governance, risk management and directors’ training. On a general note, a crisis in D&O insurance is most likely to arise from a period of numerous corporate collapses. Since insurers are the largest institutional investors, some of them will stand to lose out both from the claims they may be called to pay on D&O policies as well as the decline in the value of their assets from corporate failures. Hence, apart from the underwriting considerations reducing the likelihood of a D&O crisis, insurers in general are likely to affect the level of risk by pressing for more transparency and better corporate governance (Parsons, 2000, p. 85). In a period where more and more risk securitisation is taking place, D&O could be a prime candidate for such solutions. Although the risk of a catastrophe13 is rather remote, when compared to property insurance, nevertheless risk securitisation could do a lot in improving capacity and confidence in underwriting. The availability of considerable capacity would work towards providing more adequate cover for directors of large companies14 and reducing the likelihood of substantial D&O terms’ deterioration after a period of adverse claims experience. 12 Similar circumstances in product liability and medical malpractice in the 1980s were short-lived. 13 In the sense that there are numerous claims against a number of companies at the same time. 14 It is indicative that in the case of Equitable Life in the UK, six executive and nine non-executive directors face a GBP3.3 billion lawsuit for negligence and breach of good faith. Having in mind that their D&O policy only covered GBP5 million in total, the defendants’ estates may be in danger not only in the event the case is lost, but also if there is a lengthy court process. 2.6 SYNTHESIS This section aimed at introducing the D&O environment. It began by outlining the rationale for personal directorial liability as opposed to a system of “pure enterprise liability” and went on to introduce the main provisions of the Cyprus legal system with regards to this issue. Section 197 of the Companies Act was identified for potential clarification as it prohibits the indemnification of directors by companies. It then proceeded to identify potential victims of directors’ wrongful acts and presented the rationale for insurance as well as an outline of the main provisions of a typical D&O policy. It was established that D&O liability risks, entailing low probability/high severity losses, are well suited for diversification through insurance pools. A critical discussion on the likelihood of a crisis in the D&O insurance market, then, concluded that in spite of the small number of insurers competing in this line of business, a lengthy crisis is unlikely to take place for a variety of reasons. If a sudden deterioration in terms occurs it is likely to be the result of a lengthy period of under pricing along with a sudden change in claims experience and/or insurers’ investment income. Risk securitisation could provide both underwriting stability as well as additional capacity. 3 METHODOLOGY (With regards to the directors’ questionnaire) 3.4 DIRECTORS’ QUESTIONNAIRE (APPENDIX 3) Questionnaires to underwriters formed the basis of this project. They consisted of twenty-one questions exploring issues of varying importance, including individual demographic characteristics, experience as directors, awareness of their duties, potential liability and D&O insurance. Those who do not buy15 D&O insurance were prompted to skip the relevant part of the questionnaire and proceed to the following section, which involved an assessment of the most likely source of a law suit against a director, a question to identify directors that faced legal action in the past, and a final section on respondents’ thoughts on the future of D&O liability and insurance. On the other hand, directors that have D&O cover were prompted to complete an intermediate section referring to issues such as the market they buy their cover from, the extent to which they understand the policy and the effect it has on their confidence as board members. In sampling the population of directors in the Cyprus Stock Exchange, a quota sampling technique was preferred to the standard random sample for both methodological as well as logistical reasons. As far as the latter is concerned, it was beyond the capabilities of this project to obtain a random sample from the population of directors serving on listed company boards in Cyprus and proceed to sending them individual questionnaire within the time limits involved. Even if such a task were performed, the researcher would have little control over the response rate and the return of questionnaires in time to perform the necessary analysis. The methodological issues involved in taking a random sample would perhaps be more important. On 19 July 2005 the capitalisation of the stock market in Cyprus was CYP2,543 million. Having in mind that the two largest commercial banks16 constituted approximately half the market’s capitalisation and the Bank of Cyprus alone one third, a random sample might entail the risk of under representation of the market drivers of the local stock market. This risk becomes more obvious if one considers that 20% of listed companies are investment companies17 and another 20% are tourism and leisure companies. A random sample would probably not only underestimate the views of directors of the largest companies on the island but also create bias by including an excessive number of responses from companies of the aforementioned two sectors. 15 Either at individual or at board level. 16 The Bank of Cyprus and the Cyprus Popular Bank (Laiki Bank) 17 Most with very low market capitalization and paid share capital One might argue that a more appropriate method would be to take a weighted sample from each sector according to the ratio of directors in the particular sector in relation to the total population of directors of companies listed on the Cyprus Stock Exchange. However given the fact that small and medium enterprises (SMEs) are less likely to deal with directors’ liability and D&O insurance, a sample that would include an asymmetrically large number of directors of SMEs would reduce the external validity of the results. In effect conclusions drawn from the views of Cypriot directors on D&O might not be comparable to views of directors in countries with similar economic development yet larger populations/markets and hence greater average listed company size. As a direct consequence of the above considerations a quota sampling method was used to target directors in the 25 companies with the largest market capitalisation on 19 July 2005. The ratio of individual sectors in the sample was similar to their size in the composition of the CSE. The number of questionnaires sent out to directors amounted to 220, including members of the Cyprus Association of Directors (CyAD)18. Questionnaires were sent either to company Secretaries or to individual directors19 in a sealed envelope, along with the introductory letter of the CyAD and a pre-paid envelope. They were answered anonymously with the exception of three directors, who included their names at the end. They are not personal acquaintances of the researcher, and since the inclusion of their names does not affect the results in any way, their responses were included in the analysis. 18 There was a number of members of the CyAD, who received questionnaires and were not in the original sample (15). They were included to complement the inherent problems of variability of quota sampling, however given that the response rate was 25%, and assuming that the same proportion of such directors responded, their views are unlikely to have introduced any significant bias to the overall results. 19 Where individual addresses were available. 4 FINDINGS The previous chapters laid the foundation for the main body of the analysis. Therefore this section aims at comparing the research questions and hypotheses set in the introduction with the results of primary research. Each of the questionnaires will be analysed separately and the main themes and findings will be presented20. 20 The complete sets of findings are available in the Appendix. The findings confirm the majority of initial hypotheses. A considerable proportion of directors do not fully understand the spectrum of their duties and the extent of their liability. Therefore it is not surprising that the degree of take-up of D&O liability insurance and the understanding of available cover is limited. The results indicate that the D&O environment in Cyprus is still in its infancy. However as directors become more aware of the potential liability that could arise from their participation on a listed company board and as the level of legal action against them rises, one should expect considerable growth in demand for D&O insurance21. 4.3 DIRECTORS’ RESPONSES (APPENDIX 6) Questionnaires to underwriters formed the basis of this project, as they will facilitate testing the hypotheses that stimulated the research. They consisted of twenty-one questions exploring issues of varying importance, including individual demographic characteristics, experience as directors, as well as awareness of duties, potential liability and D&O insurance. The number of questionnaires sent out to directors amounted to 220 and 56 responses were received by the closing date set in advance22. One of the respondents failed to answer any questions on two of the four pages of the questionnaires and effectively his response was excluded from the analysis. Therefore the response rate recorded for directors’ questionnaires is 25%23, considered adequate to draw important conclusions. The initial hypothesis that a considerable number of directors are not fully aware of their duties and potential liabilities was confirmed. Only 42% of respondents 21 This is confirmed by the responses of a sub-class of Directors, who had previously faced legal action. They stated that the availability of D&O insurance would play an important role in their decision to join the board of a listed company and/or their remuneration in the future. 22 A small number of replies is still expected to arrive by post, however due to the time constraint involved in the submission of the project such responses will not be considered. As mentioned in the chapter on methodology, respondents were allowed three weeks to respond. However due to complications in the logistics of the survey process and the fact that August is a holiday period in Cyprus, it is likely that a small number of questionnaires were not answered because the directors were on holiday throughout the period of the research. 23 55 out of 220 questionnaires sent out. answered a question on the laws and regulations governing directors’ duties sufficiently well, while only 47% of respondents acknowledged the full extent of their potential liability. The observations confirm the views of auditors that training and information provided to directors is inadequate and provide considerable feedback to the Cyprus Association of Directors to assist the development of its future agenda with regards to board level risk management. One would expect that in an environment with such a deficit in understanding the pitfalls of being a director of a listed company, awareness of risk transfer mechanisms like Directors’ and Officers’ liability insurance would be very limited. This belief was proved wrong, as directors showed awareness of this type of insurance. As far as predictions for the future are concerned, directors in Cyprus are anticipating pressure through increased liability. In effect the observation that the availability of D&O would influence their decision to accept a directorship in the future and/or their remuneration was not surprising. 4.3.1 HYPOTHESES REVISITED 5. Directors’ awareness of their duties: The Cyprus corporate environment has not matured enough to enable directors to have sufficient awareness of their duties and possible liability. The small size of listed companies, the absence of a “compensation culture” among stakeholders and the family nature of the vast majority of listed companies prevent adequate training of directors, especially non-executives. Directorships are frequently taken as part of a general tendency to help friends who control listed companies, with Cypriots considering it an honour to be asked to serve on a board. Effectively issues of personal liability and potential threat to personal financial solvency are regarded insignificant, if considered at all. It goes without saying that in such an environment directors’ remuneration is expected to be considerably inadequate, especially in the absence of D&O insurance. 6. Do directors buy D&O and do they understand the available cover? The personal experience of the researcher in the Cyprus insurance market alone would suggest that the take-up of D&O on the CSE would be limited. Many businessmen consider insurance in general a necessary evil, despite their companies’ limited access to capital. Therefore it remains to be seen whether they are willing to spend company funds on D&O cover. As far as the second part of the question is concerned and given the considerable absence of insurance education24 among corporate insurance buyers, widespread awareness on D&O terms is not to be expected. 4.3.2 DIRECTORS’ DEMOGRAPHICS AND EXPERIENCE Boardrooms in Cyprus are dominated by mature men. It is indicative that 85% of respondents were more than 40 years old and 89% were male. This was to be expected in such a small and young capital market. As women gradually progress to higher-level managerial positions, it should be anticipated that their share of directorships would rise. As far as experience is concerned the results are rather mixed. 41% of directors have accumulated more than seven years of experience with the respective values for those with 5 to 7 years at 15%, those with 2-5 years at 29% and with less than 2 years experience at 13%. A point to note is the relative under-representation of directors appointed during the stock market bubble of 1999-2000. During that period there were numerous IPOs and company board reorganisations. The burst of the bubble was followed by a wave of resignations of directors, especially from boards of companies that did not live up to the expectations of investors. This could be a partial explanation on why directors appointed 5-7 years ago have a smaller share in respondents relative to those with more than 7 or 2 to 5 years experience. 24 This absence of insurance culture is to be attributed equally to both sides of the market. Insurers in Cyprus have not yet embraced the idea of educating their corporate clients in the process of improving risk management. Experience as a director (in years) Less than N/A two More than 2% 13% seven 41% Two to five 29% Five to seven 15% 4.3.3 AWARENESS OF DUTIES AND LIABILITY The findings confirm the initial hypothesis that a number of directors might not be aware of the variety of their duties or the laws and regulations, through which they are established. When enquired on which legislations govern their duties, and given the following choices: a. The Companies Act b. Laws on Employment c. Health and Safety Laws and Regulations d. Stock Exchange and Capital Market Laws and Regulations e. All of the above f. All of the above and a lot more g. None of the above h. I would prefer not to answer only 42% of respondents gave (f) as the correct answer. What is perhaps more worrying is the fact that 29% answered only (a) and/or (b). Which legislations govern your duties towards the company? All of the above and a lot more 29% 42% The Companies Act and/or Stock Exchange and Capital Market Laws and Regulations 29% Any others In the following question, directors were invited to assess their liability from participating in a listed company’s board. They were given five different choices. Only 47% of respondents answered that their liability is unlimited. 36% acknowledged that their liability extends beyond the company’s capital while a worrying fact was that 13% of respondents were not aware of the extent of their liability and 4% think that their liability is limited to the company’s share capital. What is the extent of your liability as a director? I have no liability 0% My liability is limited to the company's share 13% 4% capital 36% My liability extends beyond the above 47% My liability as a Director is unlimited I am not aware of the extent of my liability These results confirm both the auditors’ view and our initial hypothesis that directors are not provided with adequate training and information. One justification could be that the Cyprus corporate environment has not matured enough to enable directors to have sufficient awareness of their duties and possible liabilities. The small size of listed companies, the absence of a “compensation culture” among stakeholders and the family nature of the vast majority of listed companies prevent adequate training of directors, especially non-executives. Directorships are frequently taken as part of a general tendency to help friends who control listed companies, with Cypriots considering it an honour to be asked to serve on a board. Effectively issues of personal liability and potential threat to personal financial solvency are of minor importance25. It is likely that such issues will surface as the local capital market matures. The intention of the Cyprus Stock Exchange to establish a common trading platform with its counterpart in Athens, along with the welcome increase of liquidity for the local market, is likely expose a number of Cypriot boards to the risk of litigation from global institutional investors. Therefore educating directors, and especially non- executives, on their duties and liabilities is of paramount importance if they are to be able to manage the risks that arise from their participation on company boards26. 4.3.4 D&O AWARENESS AND PURCHASING PATTERNS One would expect that in such a young capital market awareness of Directors’ and Officers’ liability insurance and especially its use as a method of risk transfer would be limited. Taking into account the insight provided by the previous section on the level of understanding of directors’ duties, one could be even more pessimistic. Nevertheless findings suggest the opposite. Despite the considerable lack of understanding with regards to directors’ duties, 87% of respondents expressed familiarity with D&O insurance, with 49% of respondents actually buying cover. The fact that two respondents stated that they do not know 25 It goes without saying that in such an environment directors’ remuneration is expected to be considerably inadequate, especially in the absence of D&O insurance. 26 This is an area where the contribution of the Cyprus Association of Directors could be of major importance. whether they have D&O insurance or not could either be a random anomaly in our data or an indication that a small number of directors are not adequately informed on board level risk management activities at all. The small number of respondents opting for this answer does not lead to safe conclusions. Do you or your company buy D&O insurance? 2% 4% Yes 49% No I do not know 45% N/A Out of the 26 respondents that carry D&O insurance, only three directors stated that they buy Employment Practices Liability cover (11%) and ten (37%) stated that they do not know. This results were more or less expected as Cyprus has not to date developed a litigious environment in employment relations. Trade unions are powerful in key sectors including the government, banks and tourism, and industrial relations are usually guided by collective agreements. Therefore it is not a surprise that individual employment disputes are a rarity, and even when they exist, it is likely that they are settled out of court. Do you buy Employment Practices Liability cover? 11% 37% Yes No I do not know 52% The results are more confusing with regards to the question on whether directors have Environmental Impairment Liability (EIL) cover. Only 3 state explicitly that their firm buys such cover (11%), while 59% of respondents who have D&O cover do not know whether they have EIL cover and the remaining 30% explicitly state that they do not have such cover. Environmental culture is still developing on the island. Due to the absence of heavy industry, there has been little serious pressure on companies for environmental risk management. Companies that have traditionally adopted environmentally friendly operations are either branches of multinationals or companies that place importance on corporate social responsibility. The most obvious threat for companies in terms of environmental risk management comes from compliance with EU Directives, with which 29% of all respondents expressed no familiarity. This is another area in which companies should endeavour to educate their directors, especially in the light of the new EU emissions trading initiative. On the specifics of D&O insurance, respondents stated that it is placed either in London (63%) or in Cyprus (37%), while most of them expressed satisfaction for the availability of cover (89%). Most of the business is placed through brokers (59%), which corresponds to the proportion of business placed in London. The proportion of business placed in Cyprus confirms findings on the absence of D&O brokers from the local market as the remaining 37% is bought either direct or through banks. How do you place your cover? 4% 4% Insurance Brokers 33% Direct to insurers Through a bank 59% N/A Another important issue explored is the effect D&O cover has on directors’ confidence. An argument against systems with personal directorial liability is that the residual responsibility of directors makes them risk-averse. Hence decisions are taken not to maximize companies’ performance but to minimise risk for decision makers. Our findings do not provide support for this argument. 75% of directors who have D&O cover feel at least confident. Only 7% believe that the availability of cover makes them risk averse27, while for 14% it makes no difference. 27 It is beyond the scope of this project, however it would be interesting if a follow-up study explored the source of risk aversion for these individuals. One possible reason might be fear of non-renewal of the policy on case of bad claims experience. In such a case D&O would have failed to provide a safety net for efficient board level risk management. On the contrary it might have created another source of risk aversion. The availability of cover makes directors 7% 4% 4% Very confident 14% Confident No difference Risk averse N/A 71% One of the most important findings of primary research was with regards to whom directors perceive as the most likely source of legal action against them. Directors considered shareholders as the most likely source of legal action (58%). Creditors were the second in preference with 11%. The remarkable finding from this question was that nobody considered employees the most likely source while only 2% expressed preference for the company, as such. Who do you consider the primary source of legal action against Directors? 11% 2% The Company itself 11% Shareholders Employees Creditors 18% 58% Other third parties 0% N/A As far as employees are concerned our findings confirm the relevant conclusions made with regards to the relative lack of interest for Employment Practices Liability (EPL) insurance. Employees have a contractual relationship with the company and not individuals. Therefore in a case of unfair dismissal, the wronged employee would issue proceedings against the company, and not individual directors. Having in mind that EPL lawsuits on issues like sexual harassment have not spilled over to Cyprus yet, it is not surprising that directors feel shielded from legal action by employees. The observation that only 2% of directors consider the company, itself, as the most likely source of legal action was probably the most unexpected. Directors owe their duties primarily to the company. Even in the case of corporate failure, when shareholders may be likely to issue proceedings against directors, they would rarely be allowed to do so directly. Hence they might have to borrow the company’s name in a derivative action. In effect the fact that shareholders were chosen as the primary sources of lawsuits was somewhat puzzling. Another odd observation was that only 11% of respondents considered “other third parties” as the most likely source of legal action. The way the question was framed allowed for such “third parties” to include any regulatory or governmental authority. Having in mind that Gen Re (2004, p.3) indicates that about one third of legal proceedings against directors are issued by regulatory or governmental bodies, the level of response received for this option was less than expected. 4.3.5 THE FUTURE OF D&O LIABILITY IN CYPRUS Respondents were asked to assess the future of D&O liability in Cyprus. 98% of them replied that directors’ liability would expand in Cyprus in the coming years, with 54% predicting that it will expand vastly and the remaining 44% that it will expand moderately. None of the respondents replied that it will either be reduced or remain the same. In the future Directors' Liabilities in Cyprus will 2% 0% 0% Expand vastly 44% Expand moderately Not expand 54% Be reduced N/A It is not therefore surprising that when asked whether the availability of D&O insurance cover would influence a future decision to join a listed company’s board and/or their required level of remuneration, 80% replied affirmatively. This could be interpreted as an indication that directors are beginning to understand the changing environment in Cypriot D&O liability. Effectively D&O insurance seems to have passed the initial stage of awareness, with directors now more in need of specialised information and training. It is also indicative of possible future growth in demand for D&O insurance. Would the availability of adequate D&O insurance cover affect a future decision of yours on whether to join a company board and /or your required level of remuneration? No 15% N/A Yes 5% 80% 4.3.6 A SPECIAL SUB-GROUP Question 19 prompted the respondents to state whether they had ever faced a lawsuit as directors of a listed company. Twelve respondents answered positively; hence a sub-group was formed and their responses across the questionnaire were revisited to isolate any trends. Of those twelve only one had not expressed sufficient awareness of the duties of a director, while ten of them consider shareholders the most likely source of legal action, with the remaining two choosing the “third party” option. Half of them do not have D&O insurance cover at the moment; nevertheless all twelve of them admitted that the availability of D&O insurance would influence their decision to accept a directorship in the future and/or their required level of remuneration. This confirms international experience on the demand for D&O liability insurance. It is most likely to expand in an environment where legal action against directors is growing. Hence the finding that directors with personal experience of a lawsuit are more likely to appreciate the importance of this type of insurance policy is perhaps indicative of the future of the Cyprus D&O insurance market. As the levels of litigation grow, directors will increasingly turn to D&O insurance for board level risk transfer. 4.4 SYNTHESIS This chapter presented the results from three questionnaires to Cypriot auditors, D&O insurers and directors respectively. The findings confirm most of the initial hypotheses, especially with regards to the possibility of gaps in directors’ understanding of their duties and potential liabilities. Such deficiencies have arisen mainly from the lack of training and information on individual level and have been preserved by the immaturity and size of the local capital market. There is widespread awareness of D&O insurance among directors and considerable technical expertise among local insurers. However further development is held back by the lack of local broking expertise. Hence considerable business is placed direct to insurers, with consequent lack of independent advice to directors. Shareholders are considered the most likely source of a lawsuit against directors, while the observation that experience of legal proceedings is likely to boost demand for D&O insurance was confirmed. Auditors seemed well versed in the Cypriot D&O environment and willing to support D&O insurance as part of an improved corporate governance regime, while insurers showed consistency with international underwriting practices and confirmed their ability to contribute towards improving board room risk management. The following chapter will revisit the conclusions of primary research in order to assess the future of the Cyprus D&O environment and provide possible recommendations and stimulus for future research. 5 CONCLUSION 5.1 PURPOSE AND METHODOLOGY The aim of this project was to analyse the Directors’ and Officers’ Liability environment in Cyprus. Relevant theory from western Common Law countries was presented, followed by survey research on three main stakeholders of the D&O scene, namely directors, auditors and local insurers. Three types of questionnaires were sent out, depending on respondents’ status and role. The two local D&O insurers were included as well as the “Big Four” accountancy firms, whose views would provide indications on the extent of development of D&O litigation and insurance expertise on the island. A quota sample was then taken from the larger companies of the Cyprus Stock Exchange and questionnaires were forwarded to their directors. The response rate from directors was 25%, while three of the accounting firms and both insurers were happy to respond. The satisfactory level of response ensures high internal validity for any conclusions made. Effectively the results, along with recommendations made at the end of this chapter could be used to assist the improvement of boardroom risk management in the future. As far as external validity is concerned, results could be applicable to countries of similar size and economic development. 5.2 MAJOR FINDINGS Responses confirmed our basic hypothesis, that directors do not fully comprehend the full spectrum of their duties and potential liability. Even though a considerable proportion among them seemed well informed a considerable 13% of directors were not aware of the extent of their liability and a further 4% think that their liability is limited to the company’s share capital. At the same time 58% of respondents found difficulty in identifying the variety of laws and regulations that govern their duties. These findings are particularly worrying. In a system that imposes personal liability on directors, incomplete awareness of the risks of participating on a company board is likely to result to insufficient remuneration and ineffective D&O liability risk management. The findings are perhaps indicative of the general local culture on directorships. The small size of listed companies, the absence of a “compensation culture” among stakeholders and the family nature of the vast majority of listed companies prevent adequate training of directors, especially non-executives. Directorships are frequently taken as part of a general tendency to help friends who control listed companies, with Cypriots considering it an honour to be asked to serve on a board. Effectively issues of personal liability and potential threat to personal financial solvency are regarded insignificant, if considered at all. The fact that directors’ financial solvency is put at risk when joining a company board should be deep rooted in their decision on whether to accept an offer for a directorship, especially in the absence of D&O insurance. An interesting fact was that the sub-group of directors who had faced legal action in the past were well acquainted with the general concepts. They acknowledged the extent of their liability as well as the source of their duties. It is therefore evident that exposure to litigation forces awareness of directorial risks. Contrary to expectation awareness of Directors’ and Officers’ Liability insurance was remarkable. 87% of respondents expressed familiarity with this type of insurance with 49% actually buying cover28. One should however have in mind that the sample involved directors from the largest companies of the Cyprus Stock Exchange. It should therefore be expected that relevant figures across the totality of CSE listed companies are likely to be smaller. Moreover respondents expressed a definite belief that their liability will expand in the future, hence it was not surprising to note that 80% of them would consider the availability of D&O liability cover a decisive factor on whether to accept a future directorship. 28 The availability of insurance also has a positive effect on their confidence. Auditors confirmed the general lack of training to directors and appeared willing to support further development of D&O insurance on the island. They did not seem as vigilant as their counterparts in other countries in pressing for formal D&O insurance structures and this could be attributed both to the lack of a “compensation culture” among Cypriot stakeholders and competition with smaller accountancy firms that may be willing to take accounts without considering whether the client has D&O cover or not. Insurers seem technically able and adopt internationally established methods. The presence of two D&O market participants, as expected, restricts choice and capacity. Hence the majority of business is placed in the London Market through international brokers. Local brokers are admittedly absent29 from this line of business and almost all local policies are placed direct to insurers and through banks. Effectively directors lack a valued source of advice. 5.3 THE FUTURE OF D&O IN CYPRUS Directors’ and officers’ liability in Cyprus is not yet considered an issue of vital importance and D&O insurance has not yet received widespread acceptance as a method of transferring board room risk and a useful ingredient of the corporate governance regime. The situation could be influenced in the future by a variety of factors. Primary candidate sources are regulatory changes, EU Directives and general legal changes. Although their impact is impossible to estimate at this point, it is likely that further tightening of the D&O environment in the EU is unlikely to leave Cyprus unaffected. 29 Brokers are usually able to add value in a functioning market, where they perform a variety of tasks ranging from providing access to a sufficient number of insurers, negotiating cover, advising the client, administering the policy and assisting in claims settlement. Local brokers have not, to date, developed expertise in D&O insurance and hence are unlikely to be able to perform any of these tasks. Even if there was expertise, the scope of their services would be limited by the size of the local market. Another possible source could be the opening of the local capital market. At the moment there are little restrictions to foreign investors in the CSE, however the level of liquidity of the market artificially restricts their presence. Plans to establish a common trading platform with the Athens Stock Exchange are well under way. In effect large Cypriot companies will have more exposure to litigation from a variety of sources including foreign institutional investors and consequently the importance of D&O liability risk management is expected to rise. The gradual separation of ownership and control in many medium sized companies is also likely to put D&O on the agenda. At the moment, the majority of medium businesses on the CSE are controlled by their founding families or partners. Therefore the risk of legal action from shareholders is minimal as executive directors of companies are usually the major shareholders, and in effect have maximum incentives to prevent corporate failure30. As the said companies grow, the shareholding power of such individuals will be eroded, and the proportion of shares held by institutional investors will rise. D&O risk will rise accordingly. A final determinant for the growth of D&O risk may indeed be the availability of D&O liability insurance itself. This may seem absurd to someone with no background in insurance. Liability insurance, including D&O, has always been susceptible to moral hazard, a behavioural concept, which describes the change in the incentive of the insured to be careful once he has secured cover31. Moral hazard tends to magnify claims and its effects are usually ameliorated by leaving considerable residual risk to the insured, through deductibles and further restrictions in cover. In the case of D&O, the case of moral hazard may not be as strong as in other liability classes. Directors usually have genuine interests in preserving their reputation and professional security and have a lot to lose in the case of corporate litigation. The effect of D&O availability, itself, on future of claims is hence limited to a considerable extent. 30 At least in theory. 31 Ex-ante moral hazard refers to change in behaviour before a loss occurs. In the case of D&O directors could be less vigilant because of the fact that their liability is insured. Ex-post moral hazard refers to the insured’s unwillingness to limit the extent of the loss, once it has been manifested, due to the fact that he is insured. In D&O this could mean that the director may refuse to take corrective actions before the loss is magnified. 5.4 RECOMMENDATIONS The main finding of the project was that a significant number of directors, despite awareness of D&O insurance, do not understand the spectrum of laws and regulations that govern their duties. In effect they underestimate both their potential liability as well as the risk for their personal financial solvency. One should also bear in mind that respondents were all directors of the largest listed companies. Therefore one could expect a greater informational deficit in smaller companies. In view of our findings there is considerable scope for training directors. Demand for such training should at this stage come from them as a group and not from external sources, such as corporate governance requirements. The role of educating directors on the magnitude of their duties could be assumed by a number of entities, yet a combination of fundamental information, provided in an organised manner by the Cyprus Association of Directors, and company specific information provided by the companies themselves with the use of professional consultants would be most appropriate. There is also scope for insurers to contribute by providing feedback from claims in seminars or conferences32. As pressure for more transparency and better corporate governance intensifies, such individuals are likely to be in a better position to assess the risks and benefits from their participation on a company board. Another measure to promote better boardroom risk management would be to include D&O as a prerequisite for compliance with the Code of Corporate Governance. Such measure would encourage more uniformity in D&O risk management among companies. One drawback is that it could create a two-tier system within listed companies; as for some of the smaller companies compliance may be uneconomical. During the process of the research it became evident that a number of individuals participate in the boards of various companies. A complication that could arise would be if some of those companies do not provide D&O cover for their directors. In effect there could be demand for policies to cover the liability of individual directors across 32 Could also benefit by participating in educational initiatives through increased client loyalty. a number of companies. This type of cover is offered to directors of small and medium companies abroad and could also be adapted to the needs of the Cyprus market. As far as the Companies Act is concerned it would be useful to clarify the indemnity section in Article 197, which prohibits indemnification of directors by the company. The same provision used to exist in the UK and caused confusion on the legality of D&O insurance, but was subsequently amended. Hence there is rationale for local D&O insurers and the Association of Directors to press for clarification of this section of the Companies Act in order to prevent a future disputed claim. 5.5 FURTHER RESEARCH Due to the scope of the project it was impossible to explore a number of issues, which might be of interest to stakeholders of the Cyprus D&O environment. One interesting parameter to explore would be the relationship of risk and remuneration of directors. One would expect that being a director in a large Cypriot company would entail more responsibilities, greater risks and hence significantly greater remuneration, especially if the company does not secure D&O cover. It was not possible to test this hypothesis within the scope of this project; hence further research could shed more light in this domain and provide more information on the determinants of accepting a proposed directorship in Cyprus. Little information has been collected on the claims side of local D&O insurance. A future study could explore experience and trends in local claims. At the same time little emphasis was placed on the impact of EU accession on directors’ duties and the need to comply with EU Directives. This, along with the empirical effects of the introduction of the corporate governance code, could be an interesting topic for research. Finally a follow-up study on the issues explored in this project would be useful in monitoring the evolution of Directors’ views and the local D&O insurance market.