Limitations of Liability for Managers under German Law and Consequences for D&O Insurance

To minimize personal liability risk, decision-makers in Germany are increasingly seeking supplementary solutions, particularly agreements on liability limitation and indemnification. The design of such agreements and their impact on D&O insurance coverage will be explained in more detail below.

1. Definitions

A distinction must be made between (contractual) liability limitation and (contractual) indemnification.

1.1 Liability Limitation

A liability limitation is based on an agreement between the debtor (here, the manager) and the creditor (here, the company), according to which the debtor is only liable for a breach of duty in the event of damage from a certain degree of fault (e.g., gross negligence). If the debtor breaches a duty with a degree of fault below the agreed level (e.g., the manager acts with slight negligence), the creditor (the company) has no claim for damages.

1.2 Indemnification

An indemnification, on the other hand, is based on an agreement between the debtor (manager) and any third party. In the agreement, the third party agrees to be liable for the debtor's debt to the creditor (the company) up to a certain degree of fault. If the manager breaches a duty and the degree of fault is below the agreed level, the third party, not the manager, provides compensation to the company according to § 267 German Civil Code (BGB). From the company's perspective, nothing changes compared to the legal situation without indemnification. From the manager's perspective, indemnification is practically equivalent to liability limitation.

1.3 Distinction from Liability Waiver, General Settlement, Compromise, and Discharge

The forms of contractual liability limitation and indemnification mitigate liability in the sense that the manager is initially only liable to a limited extent for certain degrees of fault.

Other forms modify the manager's liability only after it has arisen. For example, the company and the manager can agree on a liability waiver in the event of loss (after liability has arisen). However, the possibility of such a liability waiver is largely limited in some corporate forms (e.g., § 93 para. 4 sentence 3 German Stock Corporation Act – AktG). So-called general settlement agreements (e.g., in termination agreements) are essentially equivalent to a subsequent waiver.

A waiver effect can also be achieved – at least in some corporate forms – through a discharge of the manager by the shareholders. However, in a public limited company (AG), the discharge does not include a waiver of compensation claims (§ 120 para. 2 sentence 3 AktG).

Furthermore, liability can subsequently be reduced by a compromise between the company and the manager (§ 779 BGB). In some corporate forms, the possibility of a compromise is also significantly limited (§ 93 para. 4 sentence 3 AktG).

2. Liability Limitations

2.1 Function and Applications

Liability limitation often involves an agreement made at the beginning of the collaboration between the company and the manager. It is usually recorded in the employment contract or the articles of association before any loss occurs. According to such an agreement, the decision-maker is only liable from a certain degree of fault, for example when acting grossly negligent. The company then has no claim for damages against the manager if he causes loss only through slight negligence.

Whether such a liability limitation is permissible under German corporate law depends on the corporate form:

Liability limitations for the members of the management bodies of a public limited company (AG) (executive board members and supervisory board members) are largely prohibited under the Stock Corporation Act (§ 93 para. 4 sentence 3 AktG). Although this provision, according to its wording, only concerns the waiver of and compromise on liability claims against the management bodies, the prohibition also applies to all measures that act like a compromise or (partial) waiver of the company's claims for damages against its organs. Therefore, a prior agreement between the company and the decision-maker on a liability limitation is inadmissible.

For a limited liability company (GmbH), there is no corresponding legal regulation in Germany. The shareholders of the GmbH can generally dispose of the company's claims for damages in advance. Exceptions apply to claims due to prohibited repayment of contributions or due to prohibited acquisition of own shares (§ 43 para. 3 German Limited Liability Companies Act – GmbHG). A waiver of liability for intentional misconduct by the managing director is also invalid according to § 276 para. 3 BGB. 

Outside the mentioned exceptions, the details of a permissible liability limitation in advance are disputed. We will address the question of whether a limitation of the managing director's liability for gross negligence is possible under section 4.

2.2 Consequences for the Company's D&O Insurance

Liability limitation agreements can affect the scope of coverage of a D&O insurance policy. The general principle of liability insurance is: coverage follows liability. If the managing director's liability to the company is limited by a liability limitation agreement or if there is no liability at all, the D&O cover might be limited as well. An insurer would argue: any indemnification of the managing director from the company's liability claims by the insurer is only possible to the extent that the managing director is liable for the damage caused by his breach of duty. This argument is not easily dismissed, as D&O insurance is a liability insurance that necessarily presupposes the insured's liability.

However, the manager's liability (and thus the D&O insurer's coverage obligation) may exist if the manager committed the breach of duty with conditional intent (dolus eventualis) by "accepting" the breach of duty. Liability limitation for intent is excluded by law in § 276 para. 3 BGB. The liability limitation would then not apply, but the manager's claim against the D&O insurer would still be valid.

If the company argues with conditional intent regarding the manager's breach of duty, this argument is risky. Coverage for knowing (deliberate) breaches of duty is – unlike breaches of duty with conditional intent – explicitly excluded in almost all German D&O policies. It then depends on the differentiation between conditional intent and knowledge.

In newer policies, there are so-called (sublimited) own loss clauses, according to which the company can achieve compensation for its loss from the D&O insurer even with existing liability limitation agreements. According to these clauses, it is irrelevant whether an enforcement of the claim in the internal relationship with the manager is possible at all.

3. Indemnification by Third Parties

3.1 Function and Applications

Indemnification is an agreement made before any loss occurs between the manager and any third party (usually, but not necessarily, a shareholder). The third party agrees to indemnify the manager against certain claims for damages from the company. If a loss event occurs for which the decision-maker is liable, the indemnifying third party pays the damages (possibly directly) to the company.

Unlike liability limitation, indemnification does not endanger the company's assets in a public limited company (AG) and is therefore permissible. The argument that indemnification might encourage the decision-maker to engage in riskier behavior does not hold, as this would also apply to D&O insurance, which is undisputedly permissible in Germany.

Indemnification is also generally possible in a limited liability company (GmbH). However, care must be taken in the design of the agreement to ensure that the managing director does not find himself in a conflict of interest due to the indemnification. Otherwise, the indemnifying shareholder could use the managing director for his individual purposes by pointing to the indemnification.

3.2 Consequences for the Company's D&O Insurance

Indemnification of a manager by a third party (against claims from the company) does not generally affect coverage. Indemnification does not legally eliminate liability, and the insurer is thus not exempt from providing coverage. Instead, indemnification means that the fully liable manager does not pay the damages himself, but the third party compensates for the damages (cf. § 267 BGB) – usually subordinately to the D&O insurer, i.e., only if the insurer does not pay.

The insurer cannot refuse to pay by relying on the (subordinate) indemnification agreement between the manager and the third party. Otherwise, a manager who protects himself against the risks of his activity through an indemnification agreement would be worse off than an inexperienced manager who "only" relies on the D&O insurer's coverage. The Federal Court of Justice (BGH) stated in its rulings on D&O insurance on April 13, 2016, that the company (in this case a GmbH) is generally free to decide whether and to what extent it will hold the manager personally liable for incurred damages and which assets of the manager it will access in the context of an enforcement. If liability insurance exists, the company can bring claims for damages against the manager solely to access the manager's coverage claim against his liability insurer. The insurer cannot argue that the insured event has not occurred because the manager is not really (personally) threatened with a loss of assets which his liability insurance is intended to protect him against. 

4. Liability Limitations and Gross Negligence

It is disputed to what degree of fault the liability of the management body member can be limited – whether the liability limitation applies only to slight negligent breaches of duty or also to gross negligence. Indemnification or limitation of liability (if legally permissible) is allowed for slight negligence while a waiver of liability for intentional misconduct by the managing director is indisputably inadmissible according to § 276 para. 3 BGB. But there is disagreement about whether liability limitation is also possible for gross negligence (which is between slight negligence and intent).

The degree of negligence is usually assessed by the courts, and German courts apply high standards of care to decision-makers. If liability limitation is only possible for slight negligence, the decision-maker would face an incalculable residual risk. In our view, liability limitation is therefore also possible for gross negligent breaches of duty.

5. Conclusion

Liability limitations and indemnifications are regularly used by companies and decision-makers in Germany to minimize their personal liability risk. Such agreements typically complement existing D&O insurance coverage in favor of the manager. 

However, care must be taken to formulate the agreement clearly and adapt it to the corporate structure and interests of the respective company. At the same time, the company's D&O insurance coverage should take existing liability limitations for management body members into account. Liability limitation agreements can lead to a lack of compensation for damages.

Authors: Dr. Fabian Herdter, Dr. Friedrich Isenbart.

This is the translation of an article that was first published in: Die VersicherungsPraxis 08-2018