New Italian insolvency law will impact D&O coverage

Introduction

After almost 80 years, the Italian Bankruptcy Law (Royal Decree no. 267 of 1942) will be replaced with the new Code of Business Crisis and Insolvency, introduced by Legislative Decree no. 14 of January 12, 2019 (the New Insolvency Code). The New Insolvency Code, which represents a radical change in the approach to companies in distress, will be fully effective as of August 15, 2020. The main purpose of the New Insolvency Code is to shift away from the removal of failed or failing enterprises from the market towards the maintenance of goodwill and avoidance of the loss of value that results from liquidation. The reform changes the emphasis of insolvency from irreversible distress towards prevention and management. This is achieved through the encouragement of developing sound business principles to the management of the company in a state of ‘crisis,’ legally defined for the first time as a flexible concept: the status of being in a financial situation in which it appears probable that irreversible insolvency will occur.

Changes introduced by the New Insolvency Code

With the goal of helping to prevent insolvencies generally, and providing support to companies in financial distress, the New Insolvency Code:

• establishes a new duty to have an internal system in place that performs the functions and takes on the  responsibility for overseeing the financial condition of the company (internal monitoring). This will ensure the ongoing monitoring and periodic assessment of the company’s financial status; and
• requires the establishment of new business-support entities by regional chambers of commerce, to assist businesses in distress (external support mechanism).  A company that is in a crisis situation must begin an alert procedure with the relevant business-support entity, which will then give the company advice and assistance to help manage the situation of financial distress.

Other significant reforms introduced by the New Insolvency Code include:

• modification of the structure of the insolvency procedure to enable a unified assessment of the financial condition of the company at the outset of the procedure; and
• changes in some aspects of “managerial liability” under the Italian Civil Code, including the liability of directors and officers (with consequences for D&O insurance policies).

It is important to note that while the New Insolvency Code will not become effective until August 15, 2020, the new changes to the Italian Civil Code relating to managerial liability were effective from March 16, 2019. Apparently, these effective dates were decided by the legislature so that relevant professionals would have some time to understand and become comfortable with their new responsibilities in advance of the new insolvency regime entering into force.

One of the new duties that a director (regardless of his or her delegated power) will have to take on, for example, is the responsibility that the company has an accounting and administrative structure in place that will enable any potential financial crisis or issue to be flagged early enough so that the situation may be effectively addressed. Directors therefore, who have management-related responsibilities, might have to assume certain responsibilities beyond pure management: i.e. activities that seem to have a corporate compliance nature, relating to control and supervision.

Another new duty for directors will be to ensure the timely start of the external-support alert procedure mentioned above. These are non-judicial procedures aimed at facilitating the handling of negotiations between the business in distress and its creditors.

How the changes introduced by the New Insolvency Code might impact D&O policies

The changes introduced by the New Insolvency Code relating to the duties of directors will likely have an impact both on the triggering of directors and officers (D&O) policies as well as on their coverage.

In particular, the potential liability of directors will be assessed by considering their conduct and actions prior to the first signs of corporate distress, and also by considering how quickly and effectively they in put in place the remedies for prevention and management of distress.

The changes introduced by the New Insolvency Code may have an impact on the outcome of claims brought by receivers against the directors of a company relating to the alleged unreasonable continuation of commercial activities during a period in which the directors of the company should have ceased such activities. As is widely known, recent cases in the Italian courts have determined that the receiver must prove that such transactions were conducted in breach of the requirement to cease trading, and must also identify the harmful consequences of such trading, thereby establishing that it should not be a presumption that all commercial activities conducted during a ‘crisis’ period will amount to illegitimate conduct.

Instead, the New Insolvency Code introduces a presumptive criterion for the quantification of damages in instances when a company should have ceased business activities because it was in a ‘crisis’ situation. The introduction of this presumptive criterion works to the advantage of the receiver plaintiff (and to the disadvantage of the director defendant).

Specifically, the New Insolvency Code provides that damages will be calculated using a differential between the net worth of the company at the time when the directors should have ceased trading (and should have brought the accounting books of the company into court) and the net worth of the company at the time that the directors resigned or launched insolvency procedures. In effect, this new criterion results in a switch in the burden of proof relating to the quantification of damages, giving an advantage to the position of the receivership and disadvantage to the position of the directors.

Given that the New Insolvency Code introduces new responsibilities and greater liabilities for directors, and that the burden of proof is reversed in cases relating to the quantification of damages to the detriment of the defense of directors, we anticipate that premiums will increase.

Another impact on the insurance market generally relates to the risk indicators applied at the underwriting stage. For example, should underwriters require disclosure of the launch of internal crisis management measures in addition to external measures?

Finally, D&O insurers may wish to consider the same circumstances (relating to the launch of the internal and external mechanisms) within the context of deeming clauses. Indeed, the inception of internal and external procedures could be seen as a relevant circumstance, as is generally admitted to date for the declaration of bankruptcy.