D&O coverage considerations when your company is private

Why private companies need a robust D&O program

In today’s complex business landscape, organizations face a series of evolving and emerging risks that can impact their risk profile and potentially expose their directors and officers to significant liabilities. Without the proper insurance coverage, the personal assets of a private company’s leadership may be in danger.

Despite the potential challenges, many private companies may underestimate the exposure to their leadership teams due, in part, to the belief that disgruntled shareholders represent the only significant source of liability to a director or officer. As a result, private companies may not purchase directors’ and officers’ (D&O) liability insurance.

However, shareholder lawsuits represent only a portion of all reported lawsuits brought against directors and officers. Many other types of D&O lawsuits are brought by other parties, including employees, customers, creditors, vendors, competitors, and regulators. These legal risks exist regardless of the number of shareholders or whether the company is private or public.

Understanding potential exposures for private company directors and officers

In an increasingly litigious environment, where stakeholders, employees, and regulatory bodies may pursue legal action for a range of issues — from financial mismanagement to breaches of fiduciary duty — directors and officers insurance serves as a safeguard against potential financial losses.

Many exposures present potential liabilities to the personal assets of directors and officers of privately held companies, and this extends to the personal assets of their spouses and estates. These include:

Claims by employees. Claims alleging harassment, discrimination, and wrongful termination against the company itself and the directors and officers. A properly designed private D&O insurance program — that includes employment practices liability (EPL) — can respond to these claims against the entity and individual insureds.
Claims by customers, clients, and consumer groups. Common allegations include harassment, discrimination, violation of civil rights, contract disputes, misleading statements, and false advertising. In addition, clients can also become claimants in the event the company becomes financially impaired.
Claims by the government. Whether as part of an enforcement action or in response to regulatory violations, government entities — such as the Department of Justice (DOJ), the Federal Trade Commission, the Securities Exchange Commission (SEC), or State Attorneys General — can file claims against companies and their directors and officers. These can relate to qui tam whistleblower suits, antitrust enforcement actions, kickback schemes, or quid pro quo relationships with government officials.
Claims by competitors, suppliers, and other contractors. Common allegations include anti-trust violations, unfair competition resulting in lost business by the competitor, and infringement of patent, trademarks, and trade secrets.
Claims by other third parties. Claims vary, from those relating to environmental contamination to employee health and safety. Additionally, privately held and non-profit corporations can face investigations and claims by certain regulatory agencies, including the Securities Exchange Commission (SEC) and the Department of Justice (DOJ), with respect to suspected or actual wrongdoing.
Claims by shareholders/lenders. Suits brought by private shareholders, bondholders, or other investors or lenders. Claims can include alleged misrepresentation and inadequate or inaccurate disclosure in financial reporting of private placement materials. Because a private company’s financial data is often not readily available, these stakeholders rely heavily on the materials and statements made by private companies. Other examples of shareholder claims affecting private companies include:
- Breaches of the duty of care related to the way the directors and officers handle the sale of a corporation or how they missed a great business opportunity for the corporation.
- Breaches of the duty of loyalty with respect to deals the corporation enters into with companies owned in whole or in part by one or more of the directors and/or officers.
Mergers and acquisitions (M&As). A private company can enter into an M&A as the buyer or seller. D&O insurance can help protect against potential claims, including:
- Disgruntled shareholder suits.
- Alleged financial misstatements or misleading statements about the company’s revenue sources/market share.
- Failure to perform appropriate due diligence when making an acquisition.
- Bankruptcy resulting from a failed transaction.
- Claims from past creditors and/or vendors of the acquired company.
Succession planning and corporate governance. Many private companies are run by, or have founding members and sometimes family members, closely involved in the day-to-day operations through their ownership stakes in the company which could result in:
- Proxy disputes when founders are pushed out of their leadership roles.
- Legal disputes among family members when they are a part of an ownership trust that is involved in the operation of a company or potential transactions.
- Poor succession planning leading to leadership vacuums and/or disputes in the event of a sudden change in leadership due to illness or death.
Capital raises/initial public offering (IPO). As a private company evolves, many organizations choose to pursue funding raises or an IPO. This crucial milestone introduces new capital and often new ownership. However, the interplay of legal disclosures and the influx of new stakeholders increases the organization’s exposure to shareholder litigation. In particular, IPOs represent a significant shift in risk profile, frequently resulting in new underwriting requirements from the D&O insurance market, as well as adjustments to pricing, coverage limits, retentions, and overall coverage.

A well-structured D&O program provides essential liability protection for the personal assets of directors and officers in the event they are sued for alleged wrongful acts while managing the company.

Additionally, having D&O coverage can enhance a company's ability to attract and retain top executive talent, as it demonstrates a commitment to protecting leadership from personal liability.

Legal standards of conduct for directors and officers of privately held companies

The applicable legal standards of conduct for directors and officers of privately held companies are identical to those of publicly held corporations. All directors and officers are subject to three basic duties in performing their responsibilities:

Obedience
Loyalty
Diligence

Purported breaches of these duties can lead to claims against directors or officers of privately held companies and non-profit organizations.

Is the company obliged to indemnify its directors and officers?

Though a company’s by-laws usually provide some type of indemnification to its directors and officers, there are many situations where corporations are unable (or unwilling) to provide such indemnification. Examples include:

Inability to indemnify. A company going through financial insolvency or with insufficient cash flow might not be able to indemnify its directors and officers.
Unwillingness to indemnify. A new management team, including following a corporate takeover, might not be willing to indemnify current or former directors and officers.
Derivative claim. In certain jurisdictions indemnification is not permitted in cases where a claim is brought on behalf of the corporation.
Interpretation of “good faith.” In many jurisdictions a corporation is not obligated to indemnify its directors and officers if the director or officer did not act in “good faith.”
Agreement not to indemnify. Some organizations have bylaws that preclude indemnification for certain acts, which commonly include alleged fraud or intentional misconduct by a director or officer.

These scenarios underscore the importance of a robust D&O insurance program since this presents the only protection for an individual’s personal assets.

Why do private companies need D&O insurance?

To protect the personal assets of directors and officers and those of their spouses and estates.
To protect the income statement and balance sheet of the company.
To attract and retain qualified outside directors.
To establish a relationship with an insurer before a potential IPO.
To avoid diverting management attention to protracted and costly litigation.
To provide risk transfer for a broad range of exposures for the company.

What do private company D&O policies cover?

Private company D&O policies afford coverage to the board of directors, executive officers, and employees of a corporation for claims made against them in their capacities as such. These policies further afford coverage to the corporate entity for purported breach of duty, negligence, error, misstatement, misleading statement, or act or omission in the performance of their duties to manage the company.

Often, private company D&O policies include broad coverage for claims involving violations of employment practices laws, thus sometimes minimizing the need for a separate standalone EPL policy. Program limits and coverage provisions should be assessed on an annual basis.

It’s good to note that private company D&O policies typically provide substantially broader coverage for the entity than a public company D&O policy. A public company D&O policy generally only provides entity coverage for securities claims; on the other hand a private company D&O policy provides broad entity cover for all claims brought against the company. The entity coverage in a private company D&O policy is generally only limited by the exclusions in the policy.

Risk to specific types of entities

While most private companies can face challenges that could impact their directors and officers, businesses working in specific industries may be exposed to particular risks that should be considered when developing a D&O program.

Healthcare/managed care

These entities may be at increased risk of employment practices liability claims, especially in cases where a doctor has lost his or her privileges at a hospital, which can occur after a consolidation of healthcare organizations or an acquisition of a multi-physician practice by a healthcare organization. These claims typically come in as a hybrid D&O and EPL claim.
Companies that have gone through a merger or acquisition may be a target for anti-trust claims. Joint ventures and purchasing cooperatives created in this space have also raised the concern of increased antitrust activity surrounding these entities.

Higher education

Higher education institutions face numerous challenges, including the risk of financial distress, partially due to a drop in college enrollment and higher operating costs. Higher education institutions with hospitals carry the same exposures as a standalone health system, such as anti-trust, D&O, and EPL claims brought by doctors, to name a few.

Private companies in financial distress

Financial distress often brings negative repercussions to private companies, in the same way it would to public companies. These businesses may face claims of misrepresentation or breach of fiduciary duty brought by secured creditors (lenders, banks, financers, and board-represented equity holders) and unsecured creditors (vendors and equity holders with no board representation) against the company, its board, and its officers.

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