D&O coverage considerations ahead of an IPO

The private business you started years ago has grown steadily and you’re now considering taking it public. What risks should you look out for during your journey to becoming a public company?

Going public is a significant milestone that can offer many financial benefits, including:

Enhanced liquidity, providing greater access to more sources of capital for growth and expansion, at lower costs.
The ability to use publicly traded equity to attract and retain company officers and key personnel, as well as fund mergers and acquisitions activity.
Enhanced company image.
An exit strategy for early investors.

However, an initial public offering (IPO) is also the riskiest day in the life of a corporation, due to the significant disclosures and risk factors that the company must include in its primary registration statement, known as Form S-1.

Risks persevere beyond the IPO process; becoming a public company materially changes a company’s risk profile and adds significant exposure to the personal assets of its directors and officers. Having comprehensive directors and officers liability (D&O) insurance in place to address the heightened securities exposure is critical.

Road show risks

The journey from private to public company brings several new risks and exposures. Exposure to securities liability typically begins with the company’s IPO road show, or even as a business makes legal, tax, and operational decisions leading up to a road show. Investors rely heavily on statements made during road show presentations and on any information provided within the road show prospectus. Allegedly misleading statements made during this time can lead to claims post-IPO.

If a company has D&O insurance in place prior to an offering, it is usually written on a private company policy form, with coverage typically tailored to provide broad entity coverage for a variety of exposures, as opposed to entity coverage provided to public companies, which is limited to securities claims.

Private company D&O policies typically do provide road show coverage for a company’s pre-IPO activities as it prepares to go public; while this is helpful, it can also create continuity coverage issues if a company changes insurers once it goes public.

Post-IPO exposures

Public companies are subject to greater regulatory scrutiny than private companies, and must comply with extensive securities laws designed to enhance public trust and corporate governance. Disclosure requirements for public companies create significant liability. All statements made during a road show or contained within the prospectus and any subsequent public disclosures of material information should be carefully considered.

One of the biggest IPO risks is that the stock does not perform well after its offering. In this event, lawsuits could be filed against the company and its directors and officers, alleging mismanagement, misrepresentation in the prospectus, or other claims. Such lawsuits are almost always based on the strict liability provisions of Section 11 of the Securities Act of 1933 (see below). Under this law, any material misrepresentation — even if negligently made — could form the basis of liability against a corporate director or officer.

Depending upon the severity of the problem and the drop in the stock price, an IPO could also draw the attention of state and federal securities regulators and other enforcement agencies, which could also result in concurrent regulatory investigations, further increasing the overall costs.

Common post-IPO trigger events leading to securities claims include:

Accounting restatements
Earnings failing to meet projections
Announcement of products or services failing to perform as expected or being delayed
Investigations by the Securities and Exchange Commission, Department of Justice, or other regulators into corporate or individual director or officer conduct
Internal investigations based on whistleblower complaints
Inadequate disclosure regarding mergers, acquisitions, and divestitures

Relevant federal legislation

Securities offerings are governed by the Securities Act of 1933, while ongoing trading in a company’s stock is governed by the Securities Exchange Act of 1934. Under Section 11 of the 1933 Act, directors and officers are held to a strict liability standard in the event of a materially misleading statement in their company's prospectuses. In contrast, Rule 10b-5 of the 1934 Act makes it illegal to commit fraud or deceit or omit to state a material fact in connection with the sale or purchase of securities. It also requires a six-prong test to determine negligence, a much higher standard to prove liability than in a Section 11 suit.

Passed in the wake of several high-profile incidents of corporate wrongdoing and accounting fraud, this law requires internal controls for financial reporting to be established and maintained. The overall intent was to improve corporate governance, accountability, and responsibility. The law also requires compensation clawbacks for chief executive officers and chief financial officers in the event of financial restatements.

Building an effective D&O program

Before launching an IPO, businesses should work with their insurance advisors to build a D&O insurance program that addresses their critical risks before, during, and after an offering. Businesses can follow a simple timeline that can minimize time and effort while better ensuring robust coverage is in place. In building D&O programs ahead of IPOs, companies should work with their insurance advisors to:

Assess limits needed and suitable program design based upon tailored benchmarking and securities class action claim modeling.
Obtain initial insurance quotes using the draft prospectus and latest financial statements.
Schedule face-to-face meetings with underwriters before road shows to finalize competitive quotes.
Look out for potential continuity issues related to the company’s pre-IPO preparation and its go-forward coverage as a public company, which could lead to insurers denying coverage on the grounds that a different policy should respond.
Consider including coverage for the issuer’s indemnity obligations to its underwriters in connection with the offering.
Determine whether coverage for the ancillary lines, such as employment practices liability, fiduciary liability, cyber, and crime, is properly placed.
Determine if any locally admitted D&O policies are needed outside the US.

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