D&O Insurance: Why on Earth Would a Private Company Need It?
As insurance coverage lawyers, we hear this question all the time. In the current economy, where everyone is trying to control expenses, private companies must weigh the cost of directors' and officers' liability insurance (commonly known as D&O insurance) against the risks of not having it. In order to make an informed decision, managers need to understand what those risks are, and whether they and their companies can afford to assume those risks uninsured.
For public and private companies alike, D&O insurance generally covers insureds for claims made against them by third parties for losses they claim were caused by management's acts, errors, omissions, misstatements and misleading statements. As in all insurance, D&O coverage is subject to the policy's limit of liability, exclusions and other conditions. (For a thorough discussion of these complex issues, please see the three-part series titled "The Devil Is in the Details.") Accordingly, the list of third parties that could bring a claim against management of a private company is similar to that for a public company, including shareholders who are not involved with management; banks, creditors and other holders of debt; employees and labor unions; government agencies; and customers and vendors that relied on management's representations before giving favorable terms. In other words, virtually anyone who relies on what management says or does potentially could claim that they lost money because of that reliance. Although the list of potential claimants is much longer for a public company (millions of shareholders, for example), how long does the list have to be in order for a private company to deem the risk unacceptable?
In the event of a claim against individual managers, those individuals would ask the company to indemnify them for their defense costs and damages (if any). Most state laws and corporate bylaws permit or require companies to provide such indemnification. But the cost of defending such claims, and settling them, could be overwhelming. And in the case where a company, due to financial problems or otherwise, is unable or not legally permitted to indemnify, the individual managers are personally exposed.
For most private companies, the risk of such claims is low. The important question, though, is whether such a remote risk would be so severe as to threaten the net worth of the individual managers, the business itself, or both. Private companies often are incubators for cutting-edge business models and products, or for creative investment strategies. With innovation, however, comes risk. In addition, a private company and its guiding executives typically are closely identified with each other, meaning the executives are not insulated from personal and financial injury the way they would be at a public company. For many private companies and their executives, the cost of defending such claims alone could be devastating.
All of this begs the real question: What are the D&O insurance coverage needs of a private company? Here are a few of the factors that may help provide an answer:
- The company's reliance on debt financing
- Whether there is a plan for succession of management
- Whether there is a plan for succession of ownership
- The percentage of ownership in the hands of nonmanagers
- The quality of the relationships with investors and creditors
- The level of control and oversight senior management has over the statements and representations being made by lower-level personnel
- Whether the company is in a line of business that makes it susceptible to class-action litigation
The following fictional case studies are intended to help private companies better understand why D&O insurance might make sense as an element of their risk-management portfolios.
Scenario One: Earnings Were Overstated and the Line of Credit Is
Up for Renewal
ConsultCo is a technology consulting company that has experienced significant growth. Over the last few years, ConsultCo has acquired several smaller firms using a combination of debt financing and equity grants.
Recently, the auditors have raised concerns about the timing of the recognition of income for long-term consulting contracts. As if that weren't enough, one of ConsultCo's biggest customers has defected with several years remaining on its contract. These problems have triggered covenants in ConsultCo's credit agreements, impairing its access to working capital. When ConsultCo misses a payment on its loan, the bank sues, alleging (among other things) fraud and negligent misrepresentation on the part of ConsultCo's management.
These troubles lead to a decline in the value of ConsultCo's equity. In turn, former employees of companies that were acquired by ConsultCo file a series of lawsuits that allege fraud and negligent representation.
Even for a private company like ConsultCo, a well-drafted D&O policy could help defray some of the costs of defending these suits. Although certain standard exclusions might limit the scope of coverage, good negotiating at the underwriting stage (for example, making sure that the standard fraud exclusion only applies if there is a final and nonappealable adjudication of fraud) could make a D&O policy a valuable asset for ConsultCo.
Scenario Two: Why King Lear Needed D&O Insurance...
and Good Estate and Succession Planning
Myron and Irving Happy founded HappyFamilyCo more than 80 years ago. Over time, the business prospered and became a diversified holding company. Ownership in HappyFamilyCo is divided between the children of the founders and a trust for the benefit of the grandchildren and great-grandchildren.
As is sometimes the case in multi-generational family businesses, one side of the family is dedicated to the company and the other side enjoys the benefits of the family wealth while showing no commitment to the business. Irving's son and daughter (the "doers") have run the company since the deaths of their father and uncle, and their respective children and grandchildren have been groomed to assume leadership upon their pending retirement. On the other hand, Myron's two children (the "slackers") have led lavish lifestyles with no interest in hard work, and it appears that their children and grandchildren share the same sense of entitlement.
Now, however, because the youngest heirs will soon reach the age of majority, effective control of HappyFamilyCo soon will pass from Irving's family of doers to Myron's slacker descendants. Not surprisingly, Irving's successors are upset that the business they have worked so long and hard to build is about to be controlled by their irresponsible relatives.
Efforts to reach unanimous family agreement to create multiple share classes were unsuccessful, but the trustee and Irving's side of the family were able to cram down a new ownership structure with voting and non-voting shares that will permit control to remain with Irving's side of the family. (It goes without saying that the family waited a bit too long to face their difficult estate and succession planning issues.)
Upon reaching the age of majority, two of Myron's slacker great-grandchildren receive nonvoting "Class B" stock. They promptly sue the company, their aunt and uncle, the board members and the trustee, seeking damages and other relief for alleged self-dealing, conflicts of interest, breaches of their respective duties and fraud.
A D&O policy could have helped protect the directors, especially if care had been taken at the negotiating stage to define who is an insured and who is not, and to limit the scope of the standard exclusion for claims based on personal profit or advantage to which the insured was not entitled.
Scenario Three: Trust, but Verify
VendCo is a family-owned company that places vending machines in various businesses, schools and government buildings pursuant to contracts that govern the allocation of the money collected by the machines.
One of VendCo's longtime employees is a driver who happens to be a high-school football teammate of the company's president. Unbeknownst to management, however, this driver has been skimming cash from collection boxes for quite some time. But that's not all. The driver also has been running a side business out of his truck selling illegal bodybuilding supplements to high-school athletes and receiving-dock workers. But the story doesn't end there. Eventually, the driver is arrested for selling human growth hormones in a sting operation at a local high school. Soon thereafter, VendCo's customers begin complaining about the collection shortages. The story culminates with a media frenzy, as the State's Attorney brings civil and criminal charges against VendCo and its president, alleging that the driver's distribution scheme could not have taken place without their complicity. The complaint further characterizes the company president as a drug kingpin hiding behind a veneer of respectability.
Over the years, VendCo has provided the family with a comfortable living in a nice suburb. The company, however, has never been so profitable that the family can afford the defense counsel required for such a high-stakes case.
Putting aside the media attention, VendCo and its president could have benefited from D&O insurance. If coverage had been in place, the claim would have alleged that VendCo and one of its officers committed wrongful acts in their insured capacities. Not only that, but many private-company D&O policies come bundled with other types of coverage, including coverage for losses arising out of employee dishonesty. Such a policy would certainly have come in handy for VendCo.
Scenario Four: If I'm So Smart, Why Am I Surrounded by
A group of college friends, who share a love for actuarial and statistical analysis, started CleverCo. They put their unusual passion to practical use by obtaining seed money to buy out structured tort settlements for a discounted lump sum. In a recessionary economy, their business flourished.
With the profits from their first endeavor, the company branched out into the life-settlement business, buying life insurance policies from elderly people and speculating on the life expectancy of those policyholders. CleverCo was careful to comply with all applicable regulations governing these types of transactions. Notwithstanding their compliance, class-action lawsuits started coming in, alleging that CleverCo fraudulently induced and/or pressured elderly customers to enter into economically unfavorable transactions. The causes of action included violations of state insurance laws, breach of contract, fraud, unfair trade practices and negligence.
D&O insurance would have helped in this scenario, especially if the exclusions for fraud were subject to "final adjudication" language and if the company had negotiated favorable language with respect to the allocation of defense costs.
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As these examples underscore, even private companies face the risk of liability arising out of their decision-making. This is especially true in the current economic environment, where litigation has become more and more likely.
What should a private company do to understand and manage this type of risk? Start by talking to your accountants, lawyers and insurance brokers about whether your business can afford to defend itself and its managers in the event of such a lawsuit.