One hundred and twenty-five million dollars plus defense costs.
Are your fund’s indemnification provisions tight enough-and its balance sheet strong enough-to withstand that hit? Venture capital and private equity firms are asking themselves that question in the wake of the closely watched lawsuit by the Connecticut State Treasurer against Theodore Forstmann and Forstmann Little & Co.
The world has changed. A public pension fund can be an extremely nasty plaintiff, as can a dethroned founder or a wounded portfolio company. And venture capitalists can be inviting targets.
For these reasons as well as others, the number of venture capital and private equity firms purchasing liability insurance has grown from a handful in 1998 to several hundred today. To understand why, it is helpful to understand the types of liabilities to which general partners of venture capital and private equity funds are exposed.
Portfolio Company Claims
Increasingly, general partners and their funds have been sued for fraud, breach of contract and securities law violations (federal and state) relating to the fund’s investments in, or dealings with, portfolio companies. In these cases, plaintiffs typically allege that the fund dominated or controlled the board of directors of the portfolio company and then abused that power for its own self-interest to the detriment of the portfolio company and its other stockholders. A variation on this theme can be found in lawsuits brought by disgruntled portfolio company employees who have been fired.
When these types of claims are brought, individual managers of the fund, as well as the fund itself, are often named as defendants. Naming these individuals as defendants is argued to be justified on the basis that they are the ones who actually exercise the control, make the decisions and deal with the parties who claim to have been damaged. Under various “controlling person” theories, these individuals may face the same degree and magnitude of liability exposure as the venture capital and private equity fund itself.
Even successful venture capital firms experience a 50% or higher failure rate in their investments. If the venture capital or private equity firm is not successful in realizing significant returns on its remaining investments, disgruntled investors may review the investment decisions by the general partners to determine whether they adhered to the promised investment guidelines. Even if a portfolio company investment was within a fund’s guidelines in terms of industry and investment stage, LPs may maintain that the unsuccessful investment was the product of inadequate or negligent due diligence by the fund managers.
Limited partners have sued the general partners of private equity and venture capital firms for alleged breaches of the terms of the partnership agreement resulting from failures to follow investment guidelines. There also have been cases involving alleged improper execution of in-kind distributions of the stock of portfolio companies to the limited partners. Furthermore, some limited partners have alleged claims under the Investment Advisors Act of 1940 with respect to the valuation of portfolio company securities by venture capital firms.
Although these claims may be of questionable validity, the legal fees spent to defeat them are substantial. And there is always the risk of drawing a dumb judge or a less-than-sympathetic jury.
To address these potential liabilities, venture capital and private equity insurance policies have been developed. These policies typically offer directors and officers (“D&O”) coverage as well as professional indemnity or errors and omissions (“E&O”) coverage.
D&O coverage under these policies is designed to operate at two levels. First, with respect to the fund itself, these policies provide for “A Side” coverage. A Side coverage is insurance for the individual general partners of the fund with respect to claims that are either non-indemnifiable under the fund’s indemnification provision or as to which the fund chooses not to indemnify. While A Side coverage will not protect anyone from a final court adjudication of his or her own fraud or other intentional misconduct, typically it will provide coverage for conduct that is negligent or grossly negligent so long as such conduct is not indemnified by the fund.
A Side coverage may also provide for the advancing of costs of defense and coverage of settlement costs even for cases involving allegations of fraud or other intentional misconduct, so long as such allegations are being contested. In most cases, the A Side coverage provides for first dollar insurance without any self-insured retention or deductible to be payable by the individual general partner.
These policies also provide for “B Side” coverage. B Side coverage is insurance that reimburses the fund itself for payments it makes pursuant to its indemnification obligations to its general partners. B Side coverage typically has either a self-insured retention or a deductible.
In addition to this D&O coverage at the fund level, these policies provide in varying degrees for D&O coverage with respect to claims asserted against the general partners arising out of service as a member of the board of one of the fund’s portfolio companies. Usually, these policies provide that this D&O coverage is excess to any D&O insurance that the portfolio company itself has purchased. Some of these policies further provide that their insurance is also excess to any indemnification obligation that the portfolio company might have.
E&O coverage is intended to address liabilities arising from decisions made by the general partners with respect to the management of the fund itself. An example would be the valuation of a portfolio company investment. When structured properly, the E&O coverage should also address potential liabilities arising from services rendered by the venture capital or private equity firm to portfolio companies. E&O coverage should apply to both the general partners individually, as well as the firm itself.
Another important component to these policies is employment practices liability coverage. During difficult economic periods, representatives of investment firms become even more active in the management of their portfolio companies. This deepening involvement often serves as a nexus for claims by either terminated or disciplined employees (particularly if they are founders) for alleged violations of federal and state law. Accordingly, employment practices liability coverage is an important component to a venture capital or private equity liability policy.
Before You Buy
When considering the purchase of these policies, a venture capital or private equity firm should first retain the services of an experienced insurance broker knowledgeable in this area. An experienced insurance broker will assist the firm in considering the financial strength of various insurance companies and provide insight into the carriers that have the greatest understanding of VC and private equity investing. This understanding is helpful in considering not only the insurance needs of VC and private equity firms, but also how the insurers respond to claims.
In this regard the venture capital or private equity firm might well consider meeting with a claims representative of the insurance carrier it is considering. Though the underwriters may be knowledgeable about the product and coverage it affords, if a claim is ever asserted, it is the carrier’s claims department that will be the principal contact point for the insured. Therefore, a face-to-face meeting with a claims representative prior to purchasing the policy may be helpful.
With respect to the policy itself, the venture capital or private equity firm should consider various structures for the total amount of coverage to be purchased. For example, it may be less expensive to buy a primary policy with a lower limit and then achieve the total amount of insurance desired through purchases of excess policies that sit on top of the primary policy. Usually, these excess policies “follow form” to the primary policy and therefore have the same provisions with regard to coverage. Furthermore, the decisions of the primary insurer with regard to whether coverage for a particular claim exists and how the claim will be handled are given significant weight by the excess insurers, although not controlling.
Finally, venture capital and private equity firms should understand that the insurance companies offering this type of insurance are looking to establish a larger relationship with the venture capital or private equity firm. More specifically, insurance companies offering this type of coverage hope that venture capital or private equity firm will at least recommend, if not require, that its portfolio companies buy their directors and officers insurance from the same carrier. Likewise, the carriers also hope that they will be given the first opportunity to quote on a representations and warranties insurance policy in an event that a portfolio company or some part thereof is sold or securities coverage in the event that a portfolio company is taken public.
Rather than purchasing the venture capital or private equity insurance policy as stand-alone coverage, venture capital and private equity firms should explore what financial incentives are available from the carrier if the relationship is developed further.
For better or worse, the genteel relationships between general partners, their investors and portfolio companies have become a thing of the past. Both the types and size of liabilities that general partners face today reflect that transformation. Thus, the purchase of this type of liability insurance may be prudent.
Attorneys John D. Hughes and Stephen O. Meredith are Partners at law firm Edwards & Angell. Hughes is a member of the firm’s Insurance and Reinsurance Department. His email is email@example.com. Meredith is a member of the firm’s Private Equity & Venture Capital Practice Group and can be reached at firstname.lastname@example.org.
One hundred and twenty-five million dollars plus defense costs.