No one likes buying insurance, but it’s a necessary part of building a business and protecting its assets. Most founders understand the need for all sorts of insurance coverage, including workers’ compensation, property & casualty, payroll, and employment & professional liability coverage. But what about Directors’ & Officers’, or D&O insurance? Many entrepreneurs know surprisingly little about this coverage, often concluding that it’s unnecessary if you’re not a member of the Fortune 500. This oversight can be an expensive mistake since even non-meritorious lawsuits can result in substantial, non-reimbursable fees and expenses which few entrepreneurs or small companies can afford.
As a former public company general counsel, as well as a securities fraud litigator who has negotiated settlements under a variety of policies, I am intimately familiar with the ins and outs of D&O insurance. The following overview is intended to help companies navigate their own needs:
Purpose of D&O insurance
D&O insurance protects corporate directors, officers, and, in some cases, employees from liability to third parties who claim they have been harmed by the company. For start-ups, the most common reason to get D&O coverage is to protect officers and directors from liability for potential claims by investors based on declines in the value of their investment due to alleged misconduct. These policies also usually provide protection in cases arising from governmental or regulatory investigations and proceedings. (While most policies exclude coverage for “knowing” misconduct, they usually cover conduct that is negligent, grossly negligent, or even reckless).
When to purchase D&O insurance
While D&O insurance is typically a “must-have” for almost every publicly traded and/or highly regulated company, most private companies probably don’t need D&O insurance until either (a) they’re trying to attract independent Board members, who typically want protection from personal liability, or (b) they begin selling securities to unaffiliated third parties, including convertible debt, preferred stock, or SAFE notes. Essentially, the decision to buy D&O insurance depends on your risk of future claims and how much those claims are expected to cost. The likely merits of any future litigation generally should not figure into the decision since it is so expensive to defend even the most frivolous lawsuits.
Choosing the right product
As you would expect, there are various types of D&O insurance products, which are commonly known by industry names that can create considerable confusion for non-insurance professionals. Of the available options, “Side A” coverage is typically sufficient for many start-ups with limited resources. “Side A” coverage protects individual directors and officers, but not the company itself. In other words, if a shareholder sues the company only (but not any of its officers or directors), this insurance will not cover the claim in most circumstances, nor will the carrier advance legal expenses.
Although Side A coverage does not cover the company’s duty to indemnify its officers and directors for actions taken on behalf of the company1, it does protect individuals against claims brought against them personally, and usually covers legal and other defense costs incurred by these individuals without applying any deductible2. In certain circumstances, Side A coverage may also cover defense costs in cases where the company fails to satisfy its indemnity obligations to its officers and directors, although, in such cases, the carrier will likely pursue reimbursement from the company aggressively.
Scope of D&O coverage
Determining how much insurance to purchase typically depends primarily on the company’s capitalization structure, the trading price or value of its securities, and the nature of the industry in which the company operates. Public companies operating in highly regulated industries whose stock prices are subject to large fluctuations are likely to need significantly more coverage than privately held start-ups. That said, companies should avoid “over-covering” themselves, which can unintentionally encourage meritless litigation by creating a target for opportunistic plaintiffs. What’s right for your company will ultimately depend on a thorough evaluation of your likely exposure, which requires good, experienced legal advice.
Finally, the price of your D&O policy will depend on the amount and type of coverage you need – the more coverage, the more expensive. Many start-ups probably require only a limited amount of Side A coverage in their early stages, which will usually provide substantial asset protection at a reasonable price. Retaining an independent insurance broker who is highly experienced in all facets of D&O coverage – expertise that most business insurance brokers do not possess – will help to ensure that you get the right coverage at the best price. An experienced general counsel can also play a supporting role when negotiating coverage and premium rates by explaining to insurance carriers the company’s risk mitigation efforts to date (e.g., incorporating in a jurisdiction that limits the ability of shareholders to bring fiduciary breach lawsuits), as well as characteristics that limit the company’s exposure to federal securities fraud litigation in the case of public company.
Like many legal issues, D&O coverage is often the last thing on the mind of a start-up founder. Nevertheless, addressing early on whether your company needs D&O coverage will likely pay large dividends down the road, while also protecting your hard-earned investment in the near-term. It’s just one more area where every start-up could use the help of a good, experienced general counsel. If you have questions about D&O insurance or would like to discuss risk mitigation strategies for your company, please contact Robert Gans at rgans@scalefirm.com.
Robert Gans is a highly experienced public company general counsel who brings a unique perspective to his clients, having spent much of his early career prosecuting securities fraud, accountants’ liability, and corporate fiduciary actions on behalf of large, sophisticated investors. Leveraging this breadth of experience, Bob advises companies of all sizes, including startups, on a wide range of legal issues and risk management strategies, including corporate governance, commercial and strategic transactions, M&A, compliance and other matters.
1 “Side B” coverage will fund these indemnity obligations, while “Side C” coverage protects the company against claims brought against the entity itself.
2 A substantial deductible generally applies to Side B and Side C coverage.
