Designing D&O Coverage for a Growth Environment

There is a seemingly ever-growing legal threat being faced by corporate executives, fueled by the multitude of entry points with which risks can penetrate and give rise to a severe loss. Whether a board is faced with personal exposures for the first time, navigating increasing regulatory responsibilities, or the vehicle being used to accomplish an IPO or acquisition is bringing about unique challenges, the shield provided by directors and officers (D&O) coverage design needs to remain intact in its ability to respond and insulate effectively. Given the complexity at hand, effective coverage can only be afforded through comprehensive business acumen on the part of policy point of sale administrators.

With merger and acquisition activity rising in various sectors, combined with the expectation of a long overdue rebound in the U.S. IPO market, an increasing number of directors and officers will face challenges navigating unfamiliar governance requirements and exposures. Additionally, fuel for transactional activity is being provided by the increased access to capital experienced by startups, providing for new growth and scaling opportunities.

The newly popular mechanisms through which capital is being sourced and distributed include facilities such as online crowdfunding models built on a securitization framework of old, albeit lacking the registration process of the federal securities laws. This has prompted governing bodies such as the SEC to regulate such activity through the adoption of crowdfunding rules via provisions to the JOBS Act, which came into effect in 2016. Although beyond the scope of this article, crowdfunding practices can lead to concerns of exposing directors and officers to numerous liabilities, such as an exposure to material misrepresentations or omissions contained in such offerings.

In addition to these factors is the multitude of startup incubators providing support through tutelage and/or angel investors who are ultimately seeking gains on their vested interest through the success of these businesses. This will in turn positively influence the survival rate and success of more businesses, which are able to experience true scaling and later stage funding opportunities.

Once in this position, regardless of whether the company desires to pursue further growth while remaining private or prefers to explore public options with an IPO strategy, the new exposures tied to these expansion efforts need to be fully recognized and effectively monitored in order to maintain responsive D&O coverage.

It should go without saying that prior to any pre-IPO activity, a properly designed and adequate tower of private company D&O limits should already be in place, which will need to be properly assessed, manuscripted and tailored by a broker in order to then provide coverage for pre-IPO activities. Private company D&O specifically excludes these pre-IPO exposures, so securing proper protection for these activities is paramount.

With the forecast of an increased penetration into the ranks of later stages of funding by an increased number of companies, capital markets activity will seemingly only continue to contribute a high percentage to the current levels of D&O claims.

SPAC — M&A Vehicle

I am fortunate to have gained a unique and comprehensive optic in my years in capital markets, through which to identify the unique exposures to liability inherent in these arenas. Experience on multiple sides of a transaction affords a wider perception of risk with which to design and implement coverage.

When the American Stock Exchange began the attempt to bolster IPO listing activity through listing an acquisition vehicle known as a Special Purpose Acquisition Corporation (SPAC) in 2005, it realized massive success.

A SPAC is a publicly traded investment vehicle that raises funds through an IPO for the purpose of conducting mergers and acquisitions (M&A). Among the many IPO listings I have handled was the Endeavor Acquisition SPAC IPO, which later executed on a successful business combination with the U.S. clothing manufacturer American Apparel.

With a renewed resurgence in popularity of SPAC IPOs of late, the vehicle is continuing to attract higher quality management and advisors, which are using the structure for larger deals in a myriad of sectors. The D&O coverage market is responding in kind, by providing the necessary options with which a knowledgeable broker can tailor coverage in order to suit several unique exposures.

The structural design of a SPAC creates difficulty in synchronizing a standard D&O policy period with the expiration of the fund and/or any additional time allowed for the completion of a transaction. SPACs are governed by varying time frames of between 18 to 24 months with which to consummate a business combination, with up to an additional six months available to complete the acquisition after a Letter Of Intent is executed.

These conflicting time frames require broker negotiation on policy renewals or possible extensions needed to maintain coverage continuity.

Additionally, resulting from a SPAC’s required minimum 80 percent usage of net asset value in the acquisition, any transaction will therefore trigger a change in control event, ceasing coverage for all claims arising after the transaction in most policies. This will then require “run-off” coverage to be purchased, which will need to be negotiated before the expiration of the current D&O policy.

This run-off coverage is critical in order to provide coverage for directors and officers for claims arising from events after the change in control takes place.

Because the majority of funds raised in the IPO (90 percent on average) are held in trust prior to an acquisition, the limited available assets make it necessary to determine whether the trust would be accessible if needed for payment of policy retentions in the event of a claim.

The governing documents and state laws will lead to this determination, and coverage will need to be tailored as a result. Individual directors and officers, found in situations where corporate loss can assume and exhaust coverage limits, may be able to use Side A DIC coverage in a drop down function in a situation that requires preservation of coverage limits for personal use.

When pairing the limited time frame SPACs have to compete an acquisition with the minimum capital utilization requirements, one can assume liabilities might arise from potential conflicts of interest. The pressures founders face locating a quality target by expiry, paired with the mandate to use a minimum 80 percent of new asset value for the transaction, can foster the possibility of over-paying for a target company.

With the recent move to a no vote/tender offer structure, if shareholder value becomes damaged after a bad acquisition, disenfranchised shareholder sentiment becomes a possibility, opening the door for shareholder derivative action claims.

The explosion of merger objection lawsuits resulted in 93 percent of M&As being challenged in 2014, according to a 2015 report by Cornerstone Research. Because of this development, “bump up” or “price change exclusion” language needs to be carefully reviewed by target company policyholders.

Therefore, the directors will want to ensure they perform proper due diligence on the combination target and enclose material guidance in an unbiased manner in the disclosure document to shareholders. This will help avoid any duty-of-care claims and fulfill business protection rule qualifications.

Lastly, being that SPACs can be utilized in a broad spectrum, it is critical that directors and officers coverage be tailored to the specific business sector of the acquisition target. D&O carriers can differ on exclusionary preamble language, with some utilizing broad “based upon, arising out of, directly or indirectly” omnibus language, and others using narrower, “for” language. This language can determine whether coverage will respond to many of the suits brought in the next section.

Derivative Actions

While the threat of derivative action claims increased in the mid-2000s during the options backdating scandal tied to favorable strike price issuance and proxy reportage practices, a real exposure to directors and officers exists today with an increasing number of litigation triggers.

Corporate shareholders bring derivative action suits against directors with the suit being brought on behalf of the corporation, typically attempting to remedy fraud, mismanagement, self-dealing and/or dishonesty. Derivative action suits also can stem from many other corporate activities. Actions have alleged waste of corporate assets and unjust enrichment surrounding acquisition activity, breach of fiduciary duties following product recalls and compensation disputes, and/or for misleading statements during the IPO process.

The new and increasing cyber security threat is also creating new exposures for directors and officers with the likelihood of facing a securities class or shareholder derivative action following a data breach becoming a distinct possibility. Although actions brought against a corporate board due to a cyber breach have yet to see much success, with recent suits against large multinationals and household names seeing dismissals, the law surrounding these issues continues to evolve. Although previously not considered a D&O exposure, it is now essential that the terms in a D&O policy concerning cyber/IT security be carefully reviewed, as many policies can contain an expressed exclusion for breach events as a result of this environment.

Cyber liability threats are exposing corporate directors and officers to scrutiny concerning both the actions taken to fulfill their duty to defend the company prior to an attack and to liabilities arising after the breach and stemming from the proper handing and execution of requisite disclosure practices. The ever-growing threat of liability caused by cyber attacks underscores a risk that corporate compliance duties present. The SEC’s adage of “sunlight makes the best disinfectant” will inevitably lead to more responsibilities to comply with stringent disclosure rules.

While the directors and officers coverage market has continued to make strides in an effort to provide solutions for these challenges, it is essential for a broker to partner in the growth strategy of the client, in order to identify all of the past, present and future exposures.

Topics Lawsuits Cyber Auto