Applying the ‘but-for’ test when determining appropriate D&O insurance coverage

Jean-Paul Rudd - Partner, Adams and Adams

This is because D&O policies are designed to cover wrongful acts related to executive actions or fiduciary duties, rather than contractual disputes, which are better suited to general liability or professional indemnity policies.

US case study

Occasionally, policyholders may argue that a claim does not fall within the scope of the contractual liability exclusion. A recent example is Paraco Gas Corporation v Ironshore Indemnity Inc. (2024 US App.).

Paraco Gas Corporation purchased D&O insurance from Ironshore Indemnity Inc, covering certain acts of its directors and officers. When shareholders sued two officers for transferring shares in violation of shareholder agreements, the officers sought coverage.

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Ironshore denied the claim, leading Paraco and the officers to seek a court ruling on coverage. The court ruled that the claims arose from obligations under the shareholder agreements and fell within the policy’s exclusion for contractual liability. Paraco argued that one claim, based on the board’s failure to act in the shareholders’ best interests, should be covered.

However, the court applied a broad interpretation of “arising out of” and used a “but-for” test. Because the claims were based on the shareholder agreements, coverage was excluded.

South African position

Similarly, in South Africa, the “but-for” test for factual causation is well-established and frequently applied in insurance disputes and other legal matters. This test determines whether the loss or harm would have occurred but for the specific act or event.

However, establishing factual causation is only the first step. Legal causation must also be proven to show that the harm is sufficiently connected to the act in a way that justifies holding the party liable. Legal causation involves assessing whether the harm is too remote or whether it falls within the scope of liability.

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In insurance contexts, courts may consider whether the loss or harm was a foreseeable consequence of the act or whether it can be attributed to an intervening event that breaks the chain of causation. The combined analysis of factual and legal causation ensures that claims are evaluated fairly, considering both the direct and indirect consequences of an insured’s actions.

Conclusion

The exclusion for contractual liability in D&O policies serves to limit coverage to wrongful acts related to executive actions or fiduciary duties, not contractual disputes.

Cases like Paraco Gas Corporation v Ironshore Indemnity Inc. demonstrate how courts strictly apply these exclusions, often interpreting them broadly.

Understanding how such exclusions are interpreted, particularly through tests like the “but-for” test, is essential for ensuring appropriate coverage for directors and officers.