Expert Analysis

Pre-IPO Companies Should Upgrade Their D&O Coverage

Well in advance of an initial public offering, late stage startups are now regularly adding high-powered, independent directors to their boards.

These companies often not only have prospects for high valuations, but also face global regulatory and compliance risks, as well as related party transaction issues, that call for a board with more sophistication and experience with navigating fiduciary duties than a group that consists solely of founders and employees of the lead venture capital investors.

While the proliferation of stockholder class actions against directors of publicly traded companies has driven directors of these companies to insist upon enhanced layers of directors and officers, or D&O, insurance to protect them from exposures to these suits, the same cannot be said of private company directors.

In the public company realm, the number of these suits in each of the last two years is double that of each of the prior several years and the costs of D&O insurance for publicly traded companies has similarly doubled.

But what about the world of private companies, especially the late-stage startups that are managing a growing spectrum of risks while taking more rounds of capital contributions at high valuations? Most directors and officers of late-stage startups would be surprised to learn that their D&O insurance may follow the standard terms for private company D&O coverage and therefore omit coverage for private suits and enforcement actions claiming securities fraud. How significant is this omission from the coverage of private company D&O policies?

As the U.S. Securities and Exchange Commission’s enforcement division recently announced, “[T]here is no exemption from the anti-fraud provisions of the federal securities laws simply because a company is nonpublic, development-stage, or the subject of exuberant media attention.” Echoing this sentiment, one of the leading securities class action plaintiffs firm, Robbins Geller, has been promoting an initiative titled, “Reining in Unicorns: Protecting Pensioners and Entrepreneurs From Fraud.”

Two factors support this focus by the SEC and the plaintiffs bar. First, startups are risky businesses by definition. They regularly rely on unproven technology and are susceptible to being driven by a culture that deprioritizes internal controls.

Second, the shareholder base of late-stage startups, thanks in part to changes in SEC rules, has expanded to include a broad group of a significant number of family offices, pension funds and traditional actively managed funds, none of which has tolerance for being misled and all of which have the wherewithal to prod the SEC enforcement division and the plaintiffs’ bar to get involved.

These two factors make for a chemistry that is ripe for the assertion of securities fraud claims.

The most common securities fraud claims against startups involve alleged failures to adequately disclose risks and problems of the business’s technology to those buying shares of the company. For example, the SEC, followed by class action plaintiffs’ counsel suing on behalf of investors, claimed in 2018 that Theranos Inc. had failed to disclose the flaws in its blood testing technology.

Another recent pairing of an SEC enforcement action and a private investor suit claimed that fiduciaries of Lucent Polymers Inc. fraudulently induced the acquisition of its securities by overstating the capability of the company’s technology to “turn garbage into gold.”

Last year, the SEC settled an enforcement action against Silicon Valley startup Jumio Inc. for overstating the revenues of the company as part of a plan to facilitate the sale of shares by the founder.

In addition, we are aware of pending private suits and SEC inquiries into allegations of misstatements and omissions in connection with private financing rounds of other high profile, venture-backed companies.

Other areas ripe for securities fraud claims are those of employee benefits and M&A. There have been a number of suits against private companies for material misstatements and omissions in disclosures to employees when the company is buying back their equity or equity awards as a means for providing the employees with liquidity.

Moreover, suits have been brought against private company targets in the merger context based on allegations of material omissions from the information or proxy statement provided to the target company’s stockholders in connection with the stockholder approval of the merger.

As companies scramble to raise money to keep themselves afloat during the pandemic, there is a meaningful risk that they will cut corners on disclosure and understate risks that will later come back to haunt them. On the flip side, there is a risk that companies will fail to inform their employees sufficiently of their positive prospects when buying back stock and equity awards from these employees while the runway to a future IPO gets longer.

Against this background, directors and officers of private companies, especially late-stage startups, should consider purchasing enhancements to their company’s D&O insurance policy that make it much more like a public company D&O insurance policy and much more likely to cover these new risks confronting private companies and their directors and officers.

We are not recommending that these directors and officers seek to have their private companies entirely replace a private company policy with a public company policy. Instead, we are recommending consideration of the following modifications to the private company form.

First, and most importantly, directors and officers need to insist on removal of the standard private company D&O policy exclusion for securities fraud investigations, enforcement actions and private investor claims.

Second, directors and officers need to insist that the private company’s D&O policy gives the private company, rather than the insurance company, control of the defense and settlement of any securities fraud investigation, enforcement action or lawsuit. This can be accomplished readily by insisting that the insurer’s duty-to-defend provisions are removed in favor of provisions requiring the insurer to pay defense costs on behalf of the insureds.

Finally, the amount of the D&O insurance limits of liability should be examined, and likely increased in many instances, based on the risks of securities investigations, enforcement actions, lawsuits and associated defense costs and settlement payments.

In the absence of appropriate D&O insurance, the indemnity and expense advancement undertakings that these companies offer their directors and officers is only as valuable as the credit of the company itself. Moonshot prospects and valuations often go hand in hand with weak balance sheets that are unable to withstand the type of material adverse developments that trigger securities fraud suits.

Venture capital fund employees who serve as directors at their portfolio companies will have the benefit of indemnities and insurance from their funds. But the new influx of high quality, independent directors, as well as executive officers, will be left to rely solely on the strength of the target company’s balance sheet and the areas covered by the company’s D&O policy.

 

Ethan Klingsberg is a partner and head of U.S. corporate and M&A at Freshfields LLP.

Tim Burns is a partner and founder at Burns Bowen Bair LLP.

Vinita Sithapathy is an associate at Freshfields.

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.

 

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Time’s Insurer Fights Coverage Of $6.9M Deal, Defense Costs

By Daphne Zhang | June 9, 2020

Mutual Insurance Co. has urged a New York federal judge to toss a suit brought by Time Inc. demanding $6.9 million in indemnification of settlement and defense costs for class actions accusing the magazine company of deceptive marketing, saying that Time’s “intentional” unfair business practice is not covered by its policy.

Mutual claimed Monday that the global media liability policy it sold to Time only covers claims for “negligence,” but magazine subscribers have alleged that Time “knowingly” and “willfully” engaged in false advertising for automatic payment renewals, so Time’s practice was not “negligent” and Mutual has no obligation to cover its costs.

In the motion, Mutual said its policy specifically excludes coverage for unfair business practices and false advertising, both of which were alleged by Time’s readers. The insurer added that the consumers sought restitution of subscription fees as a result of Time’s allegedly false marketing, but that the policy does not pay for any loss in the form of “restitution.”

Time called Mutual’s move for summary judgment “an ambitious and unachievable goal” in its motion for partial summary judgment also filed Monday, claiming that a big part of the settlement payment constituted “loss” under its policy with Mutual. The magazine company demanded that “at a minimum” Mutual must pay for a significant part of its $4.98 million settlement expense.

Time and its subsidiary Synapse Group Inc. were sued by two California residents in May 2016, alleging that Time enrolled them in automatic subscription renewal without their consent and failed to inform them of the higher charges as required by California Law, according to court filings. The magazine readers told California state court that Time used Synapse as a marketing agent to indirectly trick them into annual renewals after the initial free or discounted offers.

The class representatives’ counsel filed another complaint against Synapse in June 2018, alleging that Synapse was aware of consumer complaints but still engaged in false marketing. Four months later, Time and the class representatives reached a settlement that required Synapse to pay $4.9 million.

Time first sought coverage from Mutual in June 2016, a month after it was first sued by the magazine subscribers. Mutual denied its claims a month later, saying the policy did not cover restitution and excludes coverage for unfair business practices, false advertising and disputes over fees.

Time sued the insurer in July 2018 seeking indemnification for its defense costs, and amended the complaint in 2019, after approval of the class action settlement, asking for coverage of more than $6.9 million from the two class actions.

In Monday’s motion, Mutual said it has no duty to reimburse Time and Synapse for the $4.98 million settlement payment and $2.18 million in defense costs since the consumers were only trying to recover “restitutionary damages.” The policy specifically stated that covered loss does not include restitution, it added.

Time countered on Monday that “irrespective of whether the policy definition of loss excludes coverage for restitution,” Mutual must still pay all of Time’s loss and defense costs in a legal proceeding as dictated by the policy, adding that the two class actions have caused it serious financial risk.

The media company said that under New York law, an insurer’s duty to defend is “exceedingly broad,” and Mutual should provide a defense whenever “the allegations of the underlying complaint suggest a reasonable possibility of coverage,” as its allegations already have.

Time also struck back at Mutual’s contention that neither action against Time and Synapse “contained a cause of action for negligence,” so it would not provide indemnification.

The consumers’ allegations trigger coverage since Mutual had agreed to pay legal proceeding expenses from “negligence, including any actual or alleged error, omission, misstatement” of the policyholder, Time argued.

The media company said that it was accused of failing to show offers in a “clear and conspicuous” manner as well as failing to provide an acknowledgment of subscription terms and cancellation policy. Those allegations are plainly “an alleged ‘error,’ ‘omission,’ or ‘misstatement,'” it claimed.

The magazine company added that Mutual’s arguments that the policy exclusions bar coverage do not apply. The policy exclusions are only relevant to “antitrust, price-fixing, and restraint of trade” claims, and the consumers never alleged such claims against Time, the media company said.

Additionally, “the false advertising exclusion applies only to intentional conduct” and “several of the complaints’ allegations do not allege that Time intentionally violated California law,” it said in the motion on Monday.

Mutual had argued that at the core of the consumers’ class suits are “allegations that Time and Synapse violated multiple consumer protection laws by engaging in unfair business practices,” and California enacted a law in 2006 specifically targeting marketing practice like Time’s ongoing charging of consumers’ payment cards without their explicit consent. So there is no question that the companies engaged in unfair business acts and false marketing, both of which were excluded under the policy, Mutual said.

Representatives from both parties did not immediately reply to requests for comment.

Mutual Insurance Co. is represented by William Joseph Brennan and Jacob Jonathan Palefski of  Kennedys CMK LLP.

Time and Synapse are represented by Jesse Bair and Timothy W. Burns of Burns Bowen Bair LLP and Jalina Joy Hudson of Perkins Coie LLP.

The case is Time Inc. v. Mutual Insurance Company Limited, case number 1:18-cv-06835, in the U.S. District Court for the Southern District of New York.

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