Private Companies Need D&O Coverage Too

No one would seriously consider serving as a director or officer of a public company unless the company had director and officer liability insurance.

But many private companies do not have such insurance, even though directors and officers of privately-held companies may be sued for a wide variety of claims. These companies should therefore strongly consider purchasing D&O insurance.

Potential Claims

Directors and officers of private companies, like public companies, can be sued by shareholders unhappy with their investment, or who feel that they are being financially oppressed since they own a minority interest in the company. They may claim that private placement materials were misleading, or they may be unhappy with the management’s performance or dividend policies. They may feel that a merger or acquisition was completed at an unfair price.

While the “good faith” defense for directors recently withstood an assault in the Disney case out of Delaware, other director defenses such as the “business judgment rule” have been subject to some erosion in recent years, as courts are second guessing directors more often.

Even though most provisions of the Sarbanes-Oxley Act do not apply to private corporations, that law has had the effect of raising awareness concerning the standards of corporate governance and the expectations of management for all businesses.

Creditors’ suits are also a concern. When a business enters the so-called “zone of insolvency” some courts have ruled that management has a fiduciary duty to creditors, providing a new basis for liability. In addition, claims may be initiated against private companies and their management by disgruntled customers, by competitors alleging unfair competition, tortious interference or anti-competitive practices and by governmental bodies.

Other plaintiffs could be employees alleging harassment, discrimination, retaliation or wrongful termination and a host of other civil rights violations. Private company D&O policies are typically packaged with employment practices liability (EPL) insurance which covers these claims.

In recent years, an average of 80,000 such claims have been brought against employers annually. Discrimination claims include those based on race, sex, age, disability, national origin, religion and pregnancy, with thousands of cases in each category every year.

Since management of private companies is often closely involved in the day-to-day operations of a business, they are particularly vulnerable to these types of suits. They also are less equipped financially than their public company counterparts to implement all of the human resource protocols used to reduce EPL exposure.

One-fifth of the employment practice cases recently brought to trial resulted in a plaintiff’s award of $1 million or more, with significant increases in the average verdict in recent years. Most employment claims end up being settled with a payment to the employee, regardless of merit. Even where the company and its management are blameless, the cost of defending a lawsuit can be significant.

Will You Be Indemnified?

Most bylaws provide that the company will pay the expenses incurred by management in defending and settling lawsuits. In some circumstances, however, the company’s bylaws or state or federal law may prevent the company from indemnifying its directors.

This could be the case if a director settles or loses a derivative lawsuit, or in other cases where the board cannot determine that a director acted in good faith and in the reasonable belief that his actions were in the best interest of the company.

In some cases, the company will not have sufficient assets to honor its indemnification obligations or may be prohibited by a bankruptcy court from using corporate assets for indemnification. The D&O policy may be able to make payment in those circumstances.

Cost of Policy

Private company insurance is substantially cheaper than public company insurance, in part because their policies exclude coverage for public offerings. The cost as well as the amount of insurance needed will vary depending on a company’s size, the nature of its business, the number of shareholders, the degree of board representation, the number of employees, and the company’s litigation history.

As a general matter, companies with a clean record and good practices can expect to pay between $3,000 to $10,000 per million dollars of coverage (the first million is the most expensive).

Companies with a checkered history or with more outside investors can expect to pay twice as much. Typically, most small privately held companies with revenues under $25 million carry a $1 million limit of liability, companies with revenues between $25 million and $100 million carry between $5 million and $10 million and companies over $100 million will carry limits up to $30 million or more. Closely-held companies can carry relatively low retentions without resulting in significantly higher premiums.

What Should Policy Contain?

Directors and officers should seek a full “severability” clause because policies can be rescinded based on misrepresentation in the application or fraud (before or after the policy is issued).

This provision preserves the coverage for innocent individuals where another insured engaged in misrepresentation or fraudulent conduct. The provision should state that the knowledge of one director will not be imputed to other innocent directors. Some severability clauses also contain “non-rescindable” coverage for individuals who did not know of the facts which were misrepresented to the insurance carrier.

Carriers have now broadened their available coverages to include antitrust, tortious interference and similar common law claims. Policies do not provide individual coverage for illegal benefits and other criminal or fraudulent activity. Some D&O carriers will fund the defense for such claims until a final adjudication after all appeals, while other carriers cut off coverage after the first trial level judgment.

Since some courts have held that the D&O policy is an asset of the bankrupt estate, it is good to have an “order of payments” provision, which provides that payments are to be made first to management and then to the company. Another desirable provision says that the “insured vs. insured” exclusion does not apply to claims against the directors by the bankruptcy trustee.

Michael J. Bohnen is a partner in the Boston law firm of Nutter
McClennen & Fish LLP (www.nutter.com) where he represents public and private companies in the areas of corporate and securities law, concentrating on mergers and acquisitions and finance.