Political risk: An increasingly important consideration for Directors and Officers

By AXA XL’s Bonnie Chow and Ewen McKay

What are corporate directors’ responsibilities for identifying, managing and mitigating political risk? AXA XL’s Senior Underwriter for Political Risk, and Product Manager for Management Liability, outline the issues in Australia

Publicly listed companies strive to appoint corporate directors whose knowledge, experience, and stature within the business community will help steer the company toward a sustainable future. However, the role is becoming increasingly complex and uncertain as ongoing regulatory efforts and an evolving risk landscape broaden corporate leaders’ oversight accountability.

Act with care and diligence

According to the Australian Institute of Company Directors (AICD), corporate directors “are responsible for the overall governance and strategic direction of an organisation”. They are also expected “to act with care and diligence”. However, for various reasons, including the pandemic and the fractures that are starting to appear in our interconnected global economy, the business issues directors commonly have to deal with, such as defining the strategic direction, improving operating efficiency and managing talent, are becoming increasingly intricate. The fact that corporate boards meet only occasionally and directors depend on information distilled for them by management creates additional challenges for directors charged with recognising threats to the firm’s financial condition or reputation and proposing or endorsing prudent actions to minimise and mitigate potentially debilitating risks.

Moreover, as in other developed countries, directors in Australia can be held personally liable for actions they take or don’t take that impact shareholder value. This is why virtually all publicly listed companies in these countries carry directors and officers’ liability (D&O) insurance to cover losses, including defence costs, stemming from lawsuits or regulatory actions alleging “wrongful acts”.

However, in recent years, regulators have become more assertive, shareholders and employees more vocal and the capital markets more volatile. At the same time, new risks have emerged, and existing risks have become more prominent. As a result, more and more actions have been filed against corporate directors by a wider assortment of plaintiffs and for a broader set of alleged wrongdoings. And the evidence suggests that these trends will only intensify going forward.

Going where the opportunities are

That broader set of alleged wrongdoings includes failing to adequately consider political risk, especially when the company is looking to invest in less stable, developing countries or already has operations there. While political risk can be a particular challenge for energy resource and mining companies, as we outline below, corporate directors for companies in other sectors should also be mindful of this issue.

Around 40 percent of the publicly listed companies on the Australian Securities Exchange (ASX) are energy resource and mining firms. For many of these, their most significant asset tends to be a mining lease or concession where the resources haven’t been confirmed or the operation hasn’t gone into production yet. In other words, the investors are betting that the lease will eventually produce a profitable revenue stream.

A significant proportion of these leases are in less developed countries in Central/Southeast Asia or Africa. Australian mining companies have considerable experience and expertise, but most of the available resources here are already in production. If they want to grow, they have to go where the opportunities are.

For many companies, these projects have been a success; however, in some cases, the scenario that unfolded wasn’t so rosy, at least for the mining company and its investors.

Our previous assumptions are no longer valid

One scenario: The government terminates the lease with the Australian company and either nationalises the operation or re-issues the lease to a local company. This is most likely to occur after the mine has gone into production since the government has little incentive to take over a project that has yet to generate revenue.

Another scenario: A regional or national government withdraws its support for the project and decides to shut it down. That can occur during the development phase or after the operation has gone into production.

In either case, the company’s most significant asset—whether that is a potentially valuable lease or a producing mine—is now worthless.

While such incidents aren’t common, they also aren’t rare. This raises three questions.

First, are political risks likely to increase or decrease? Although political instability and social unrest declined sharply during the pandemic, they will likely start to surge again as we return to some semblance of “normal” life. The factors fuelling instability before the pandemic, including growing income inequality, escalating competition for natural resources, and the fearsome effects of climate change, are only becoming more acute. Thus, it seems likely that these and other forces will continue to create numerous challenges for governments worldwide, especially—although not exclusively—those in less developed countries where the governance systems can be relatively immature.

Second, could directors face shareholder suits if a government’s adverse actions, or other forms of political risk like civil unrest or labour strife, wipe out most or all of the company’s value? Potentially, yes, the political risks associated with operations in another country are clearly part of their “care and diligence” responsibilities.

Does that also mean, in turn, that directors should insist that the firm take out political risk policies for their foreign assets to indemnify it against such risks? The answer here is less clear-cut; it depends.

The appropriate response often will be, no, it isn’t necessary. For instance, an Australian company seeking to open a new mine in New Zealand almost certainly doesn’t need political risk insurance. However, in some cases, it would be imprudent not to secure political risk insurance for overseas assets. That applies particularly to investments in historically unstable countries or controversial projects.

Also, if a shareholder suit is filed, the alleged wrongdoing is likely that the directors “should have thought of that” or “should have done something but didn’t”.

This is where the “business judgment rule” comes in. That is a provision of Australia’s Corporations Act 2001, which acknowledges that directors have to make “business judgments” and delineates the factors for justifying those judgments in light of their “care and diligence” requirements. These include:

• making the judgment in good faith for a proper purpose;
• informing themselves about the subject matter of the judgment to the extent they reasonably believe to be appropriate; and
• rationally believing that the judgment is in the corporation’s best interests.

In the context of political risk, the business judgment rule suggests that, before investing in another country, a company’s directors and management need to assess the socio-political environment, including the historical background, competing interests and potential flashpoints. That often requires input from multiple sources. As Ian Bremmer, the founder and president of the Eurasia Group, put it, “Political risk analysis is more subjective than its economic counterpart and demands that leaders grapple not just with broad, easily observable trends, but also with nuances of society and even quirks of personality”.

Another common approach for satisfying the business judgement rule is via peer comparisons. How are your peers handling similar situations? If peer companies with similar risk profiles are taking out political risk insurance and you aren’t, that could raise reasonable questions from the shareholders if there were a loss.

To recap: As conditions globally become more volatile, directors for companies with investments in less stable, developing countries should consider taking out an appropriate level of political risk cover or be prepared to document why they believe it wasn’t warranted. Although this applies especially to energy resource and mining companies, directors for companies in other sectors with investments in such countries also should be mindful of the political risks in those countries and their potential exposure to shareholder actions in the event developments in a country destroy shareholder value.

About the authors:

Bonnie Chow is a Senior Underwriter specialising in Political Risk & Trade Credit. Bonnie has been working in the insurance industry for 16+ years, and her prior experience includes banking & finance, project finance and regulatory compliance. Bonnie is based in Sydney and can be reached at bonnie.chow@axaxl.com; Ewen McKay is Product Leader – Management Liability for Australia. Ewen’s insurance career spans over 35 years underwriting and broking Financial Lines insurance. Ewen is based in Sydney and can be reached at ewen.mckay@axaxl.com.