Privately-Held Companies and Directors & Officer’s Insurance: Why Not?

Insurance Risk Management

Selling a tightly-held company on the virtues on Directors & Officer’s Liability insurance (often called “D&O”) can be a difficult task and can often be made more difficult by an imperfect understanding of what the policy is designed to cover (beyond the obvious shareholder claims).  There are inherent risks in owning a company, regardless of the number of shareholders that company has. Outside parties, including: customers, vendors, suppliers, regulators and creditors, can take a keen interest in how a company is being managed and may choose to sue or otherwise intervene as a result.

It is critical that a private company with D&O claims exposure call for a broader risk management effort than they may have previously determined, as claims can be both frequent and expensive. A comprehensive D&O policy is one of the best ways to conduct due diligence and mitigate the risk of high claims.

As Chubb noted in its 2016 Private Company Risk Management Survey Report, more than a quarter of all companies reported experiencing a claim in the last three years (see attached). The average reported loss was $387,000. Among companies responding to the survey that do not buy D&O insurance, the average reported loss was almost $400,000.

According to the report, private companies that have experienced D&O losses reported an average reported loss of $387,000, and a maximum reported loss of $17 million.

Of the private companies that experienced a D&O loss:

  • 96% suffered a financial loss
  • 42% incurred a loss of productivity or man-hours
  • 36% faced a negative impact to morale/company culture
  • 31% suffered a negative impact to their brand or reputation or both

The top reasons a private company did not purchase D&O insurance include the following:

  • 33 % believed D&O coverage was not necessary because their business is privately held
  • 33% had no historical experience with such claims and therefore did not purchase D&O insurance
  • 30% believed coverage was not necessary because their business is family run

So, what kind of claims scenarios can privately-held companies (as well as not-for-profit risks) expect other than shareholder suits? Let us take some of the possible claims scenarios for companies that may experience financial difficulty as well as those that are more successful.

There are some common problems that start-up or fledgling companies can encounter where D&O coverage is both relevant and essential. Below are some examples of allegations of mismanagement that have led to hefty defense costs.

  • Bankruptcy Trustee: A bankruptcy trustee for a company files a lawsuit against the company’s Directors & Officers, alleging that the company’s insolvency stemmed from its Directors & Officers gross mismanagement and breach of fiduciary duty. Specifically, the bankruptcy trustee alleges that the company’s Directors & Officers engaged in certain self-interested transactions and financing prior to becoming insolvent, which were detrimental to shareholders and creditors.
    • Settlement and defense exceeded $1 million
  • Start-up Liability: One of three tech entrepreneurs who jointly developed a certain type of software, which was just starting to flourish, allegedly cancelled the company’s state registration without authority, shut down the existing company, and started up a new one without the other two founders. The intellectual property was then moved from the old company to the new one. The two former founders filed suit against the new entity, its Directors, Officers, and also the venture capital firms involved, for misappropriation of trade secrets, breach of fiduciary duty, aiding the breach of fiduciary duty, fraud and conspiracy.
    • Though other insurance was also involved, defense of the start-up company and its Directors and Officers exceeded $1 million.
  • Creditor Claim: The plaintiff filed a complaint against individual Directors & Officers of a company, alleging that its CEO, CFO, & COO conspired to use the plaintiff’s services to furnish, install and repair the company’s equipment knowing that it was insolvent and was planning to file for bankruptcy protection. Causes of action included: (1) fraud, misrepresentation and non-disclosure; (2) deceptive trade practices; and (3) civil conspiracy.
    • Total settlement and defense of the individually names defendants exceeded $100,000
  • Creditor Claim: A non-profit organization under severe financial constraints took out a bridge loan that was personally backed by a board member. The creditor alleges that the organization is in default on the debt and demands immediate payment.
    • Defense Costs Exceeded $30,000

But there are other potential claimants out there, even for companies with a more robust balance sheet. There are several claims scenarios that could befall a privately-owned and operated company.

  • Joint Venture/Counterclaim: A company that had an arrangement to import and market home appliances sued the Chinese business partner who manufactured their appliances after the products proved to be defective. The products overheated and triggered fires in consumers’ homes, which totaled approximately $20 million in property damage. The company asserted fraud with the allegation that their business partner was aware of the dangerous design and manufacturing defects before they entered into their agreement. The business partner counterclaimed against the company and its officers for breach of fiduciary duty and breach of contract, alleging that they improperly converted $30 million from them based on purportedly fabricated invoices. The company eventually prevailed against their business partner at trial.
    • Defense of the counterclaim approached $2 million
  • Business Partner: A company chose not to renew a contract with its supplier due to bad blood between both parties. The company thought that the supplier was overcharging them and considered them to be thieves. In response, the company allegedly used information that they had obtained in an audit of the supplier to start up its own competing venture, which then supplied both this company and others in the industry with competing products. The supplier alleged defamation/business disparagement, negligence, fraud and civil conspiracy, among other allegations.
    • Settlement and defense approached $1 million
  • Family Shareholders: Following the death of a partial owner of a company, his shares in the company were bequeathed to his children. The children/shareholders had then noticed that their share of the profits was drastically reduced from what their father was receiving while he was still alive.  The children alleged breach of fiduciary duty, conspiracy and fraud against the Directors & Officers.  Specifically, they alleged that once the Directors & Officers were no longer under the watchful eye of their father, they allegedly began to drain the profits of the company through self-dealing, large personal purchases and other unscrupulous activities.
    • Defense and Settlement Exceeded $500,000
  • Non-Entity EPL: The plaintiff had agreed to help form and then work for a company as its Chief Operating Officer. He alleges that his employment was terminated without cause. Further, it is alleged that the company hindered his attempt to find new employment by telling third parties that the plaintiff is prohibited from using trade secrets and intellectual property that allegedly belong to the company. A complaint was filed against the company, a Director and Officer, which included causes of action for breach of contract and unfair and deceptive trade practices.
    • Defense Costs and settlement for the individually named defendant exceeded $180,000

Randy Gowdy

President