Portfolio D&O Insurance Can Leave Outside Directors in the Cold –

It is not uncommon for venture capital partners to be sued in their capacity as directors of portfolio companies. The lawsuit against Benchmark Capital earlier this year is just a single, very public example of the type of litigation that directors of public and private portfolio companies are experiencing.
These claims are expensive for the firm and create personal liability for the individual serving as director. Directors may take some comfort if their portfolio company buys directors and officers (D&O) liability insurance but, more likely than not, this comfort will be fleeting if the director is ever sued. The fact is that most D&O Liability policies of this type provide far less protection against individual liability than VC firms often attribute to them.
Avoiding the risk by not taking a board seat is rarely an option, since serving as a director is often a core part of the value a firm brings to its investment. So, for most firms, this risk of personal liability arising out of outside directorships is a necessary part of the business. Accordingly, here are some fairly inexpensive and easily implemented techniques that can be used to better manage the risk of personal liability arising out of outside directorships:
Scrutinize Details
Unfortunately, many board members fail to inquire if the D&O policy purchased by the portfolio company provides more than minimal protection. It is critical for a director to be proactive at the outset, and to negotiate the terms and requirements of a portfolio company’s D&O policy.
VC firms face a variety of exposures at the portfolio company level which obviously cannot be insured, including overall investment success/failure. A D&O policy purchased by the portfolio company, however, can provide coverage for certain actions and decisions made by the portfolio company and its management that contribute to the business’ overall success or failure.
Most VC firms require D&O insurance on the term sheets negotiated with their portfolio companies, but few include specific or detailed coverage requirements. An enormous amount of time and due diligence goes into investing in a certain portfolio company. Shouldn’t the same, detailed consideration be given to the term sheet requirement that the portfolio company buy D&O coverage, especially with your personal liability at stake?
Astute outside directors should establish a protocol relative to the D&O coverage purchased at the portfolio company level.
Term Sheets
To the extent possible, basic D&O coverage requirements should be outlined in the term sheet, and, at a minimum, include:
* Coverage to be Provided. Make sure the coverage fits the exposure. Private company coverage differs from public company coverage in that it typically includes coverage for employment-related matters (i.e., discrimination, wrongful termination, harassment) or other management liability coverages (i.e. fiduciary liability, crime or professional liability). Claims involving other coverage components can impair or exhaust limits available for outside directorship protection for D&O claims.
* Required Limits of Liability. Don’t leave this open to interpretation. The existence of the different coverage sections mentioned above, the many parties considered “insureds” and expenses incurred to defend the portfolio company and its directors and officers all contribute to impair or exhaust policy limits. Make sure the required limit is enough to protect you, and request “split limits” endorsements in private company coverages so that the D&O coverage has its own dedicated limit in the policy.
* Quality of Insurer. Make sure your portfolio company’s insurer will be solvent in the future to pay claims, by insisting that it be AM Best-rated A or better. Also, consider how the insurer will handle different insured parties’ requests to use their own defense counsel. Complicated claims scenarios involving many defendants can arise. Make sure you’re not in a position where you’re forced to use the insurer’s counsel as it may or may not be your first choice.
Take Part in Decision
D&O policies differ from one insurer to another, so there is no “standardized” approach to buying D&O insurance, creating a potentially hazardous situation for outside board members. How do you know that the coverage purchased reflects the best terms and conditions available to the portfolio company? Without beginning a new career as a D&O specialist, you can make an assessment by considering some of the most important, negotiable elements of a D&O policy:
* Representations, Severability and Non-rescindable A-Side Coverage. An insurer can void a policy if the application it relied upon from the portfolio company is determined to contain misrepresentations (whether you’re aware of them or not), so make sure the policy is fully severable for insured persons. Keep in mind that severability does not mean the insurer cannot rescind a policy. Therefore, it is equally important to make sure that the insurer provides “non-rescindable Aside coverage” which means that an insurer cannot take away coverage for innocent directors or officers where no other indemnification is available to them.
* Personal Conduct Exclusions. All D&O policies contain exclusions for both fraud and personal profit to which one wasn’t legally entitled, but how these exclusions are worded determines whether coverage would apply in the event of a claim. Forms that address these exclusions with “in fact” wording are perilous as the insurer could negate coverage based upon the mere allegation of such personal conduct. The policy should be amended so the personal conduct exclusions would only apply once it has been determined through “final adjudication in the underlying action” that fraud or personal profit actually occurred. As most cases will settle prior to any judicial proceeding, an insurer is then unable to deny a claim based upon such personal conduct exclusions.
Important Policy Definitions
What constitutes a “claim” under a D&O policy is critical, as it’s the gateway to the rest of the policy. This definition needs to be broad enough to trigger coverage as early as possible to catch matters that may not be elevated enough to be a “written demand for monetary or non-monetary relief” or “civil, criminal, arbitration or administrative proceedings.” An example of this would be investigations against insured persons. If possible, obtain coverage for investigations against the company as well.
Make sure that the definition of “loss” incorporates coverage for punitive and exemplary damages to be determined by the laws in the “most favorable venue”, in addition to the standard components of damages, judgments, settlements and defense costs. Depending upon the nature of a specific claim, punitive damages can be an expensive aspect of settlement.
Watch for Policy Restrictions
Many insurers will exclude claims relating to “professional services” that a portfolio company may provide. Depending upon how it is written, the existence of this exclusion could effectively negate any coverage provided by the portfolio company’s policy. Ideally, no such exclusion should apply, but if it is a requirement, make sure it carves out claims brought by shareholders or for securities claims.
Watch for any “Failure to Maintain Insurance” exclusion. It could negate coverage for claims associated with a portfolio company’s failure to buy (1) certain types of coverage to address aspects of its risk profile or (2) “adequate” coverage to address such risk profile. Don’t accept these exclusions.
D&O policies for private companies will likely contain an IPO exclusion. Make sure the exclusion isn’t broad enough to negate coverage if an IPO fails to go off.
Insolvency is a significant source of claim, typically brought by the appointed trustee against former management. An insolvent company doesn’t have money to indemnify so the policy proceeds are extremely important. But isn’t the trustee now considered an insured as “the company”? Amend the policy to state that claims brought by a bankruptcy trustee will specifically covered.
Put yourself at the head of the line. If there were a claim involving insured persons as well as the insured entity, the policy should specify that the insured persons would receive policy proceeds first, followed by the insured entity.
Backstop with VCAP
The best approach to protecting your personal wealth is solid D&O coverage at the portfolio level, supported by a VCAP policy purchased by the firm.
If the portfolio company does not have insurance to protect you and cannot indemnify you, a VCAP policy will provide coverage for your capacity as a portfolio company outside director. VCAP also provides significant protection relative to litigation involving “control person” liability. This would not be covered by the portfolio company’s D&O insurance.
Find a Qualified Broker
Many portfolio company D&O programs are insufficient because the portfolio company’s insurance rep may not have D&O expertise. Simply put, it’s hard to negotiate the best possible D&O terms when you don’t know what to ask for. If necessary, assist your portfolio company in choosing a qualified insurance broker, not one who is their neighbor, friend or brother-in-law.
Every portfolio company presents a different risk profile. D&O underwriters provide their best terms when they fully understand all elements of a company’s operations and financials. More information is best.
Pamela W. Mason, AAI, is Management Liability Practice Leader at Mason & Mason Technology Insurance Services Inc. in Whitman, Mass. She is a founding member of TechAssure, the endorsed broker of the National Venture Capital Association. She can be reached at pammason@m-mins.com.