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Director and Officer Liability Insurance: A Business Necessity
By Scott Helmer
Private companies often underestimate their need for director and officer (D&O) liability insurance. When they do, it can put the company and its key players at significant financial risk. Today's tightening credit market and expanding notions of employment practices liability have created fertile ground for certain types of actions against directors and officers, but a soft insurance market has made coverage more affordable. Consequently, it is an opportune time for private companies to take a closer look at D&O coverage.
Consider this scenario: A group of entrepreneurs develops a plan to build an ethanol refinery in the Midwest. They find investors who contribute $10 million in seed capital. The entrepreneurs add another $10 million from their own pockets. Try as they may, they just can't secure the necessary additional, permanent financing to get their start-up off the ground. The project dissolves, but the seed capital is gone. The investors file a lawsuit to recoup their losses, even though the capital they invested was spent for legitimate reasons and they knew of the risks involved. They allege the entrepreneurs breached their duty of care and failed to properly manage the project. Whether the investors prevail, those entrepreneurs will be on the hook for defense costs and possibly much more.
A scenario like this might not make headlines, but it illustrates one example of why private companies—and not just publicly held firms—need D&O coverage as part of their insurance package. The directors and officers of private companies bear many of the same responsibilities and face the same risks as their counterparts in publicly traded corporations. Without the right D&O policy in place from the inception of any business, both the company, and its directors and officers, are taking unnecessary financial risks.
D&O Basics
D&O insurance is designed to cover claims based on the actions of a company's directors and officers. In private companies, these individuals often are active, hands-on business executives. They wear many hats, from hiring and firing manager, research and development guru, to dealmaker-in-chief. Because they are likely to do such a wide array of tasks and be deeply involved in daily business operations, their actions are more likely to be called into question by shareholders/investors, employees, competing companies, customers or governmental agencies.
The cost of defending claims of wrongdoing can quickly add up, even if an allegation does not result in a legal judgment or settlement. Sometimes the costs are more than a business can absorb, and bankruptcy results , or the claimant looks to the personal assets of the directors and/or officers, if the company itself cannot, or will not, pay or provide indemnification to the individuals named in a claim. This puts private companies' directors and officers, and their spouses and estates, at financial risk.
Individuals who serve as directors and officers are becoming more aware of their personal risks in their corporate governance roles. An annual survey by Towers Perrin, a global professional services firm, reported that in 2006 public and private companies—more than 65 percent of those surveyed—received a record number of inquiries from potential board members who were concerned about their current D&O liability insurance. Companies may find that they need to provide appropriate D&O coverage in order to attract the right individuals to serve in key positions.
Sources of Liability
D&O insurance can help to protect a company and its directors and officers in a variety of situations. New causes of action seem to be created all the time, but the following describes an essential few that private companies should consider.
Claims by shareholders/investors
Aggressive capitalization is common in the energy sector, creating risk as soon as a company is formed and investors' money is starting to be pulled together. This illustrates the importance of having adequate insurance coverage from business inception. As the credit market tightens, deals will be harder to put together, increasing the potential for these types of claims.
Shareholder claims can also be based on allegations of misrepresentations, inadequate disclosures, conflicts of interest, misdealing and mismanagement, and sometimes occur in connection with mergers/acquisitions. Here's an example: Start-ups in the energy sector are sometimes formed with the intention of running the business for a few years, and then selling to a larger company or conglomerate. If shareholders aren't pleased with the sale price, but perceive that key executives got a sweet deal, a lawsuit can result.
Claims by competitors
These could be based on directors'/officers' roles in contracting and negotiating, or involve trade secret controversies filed by a competitor after a failed merger/acquisition or employee jumps ship to work for the other firm.