Read the Policy - VC's and D&O Insurance

10/1/2002

Lloyd S. Harmetz

MoFo News Item

It's no secret: today's venture capitalists seek to have their portfolio companies obtain director and officer (D&O) insurance policies. This is especially true when the VC appoints one or more members to the board of directors. Many forms of venture financing documents in use today include a covenant that obligates the company to purchase and maintain a D&O policy.

Although this trend is spreading in both Israel and the U.S., venture capitalists may not be focusing on all of the material issues that need to be considered in this area. True, VC's may be part of the discussion as to which insurance carrier should be selected, the amounts of coverage, and the price of the policy. However, other key terms of the D&O policy may not address all of the special needs of a VC and its board representative. In fact, the insiders of the portfolio company who usually negotiate the terms of the D&O policy do not always have the same interests as the VC's representatives. This conflict of interest creates the possibility that the final policy terms will be disadvantageous from the VC's perspective.

The purpose of this article is not to describe all of the material terms that could or should be contained in a D&O policy. (See the [sidebar] for a summary of several important D&O insurance terms.) Rather, this article seeks to highlight some of the key D&O insurance questions that tend to have a disproportionate impact upon a VC. A VC and its representatives should be considering these issues when the time arrives to review a portfolio company's plans with respect to D&O insurance.

Question 1: Can the misstatements of another director or officer be imputed to the VC's director?

A company's executive officers have greater access to corporate information, and are more likely to be aware of any inaccuracies in a company's representations, than the outside directors. Accordingly, these individuals are more likely to have responsibility for any misrepresentations made by a company, whether such misrepresentations are made in the company's D&O insurance application, or in other documents, such as a securities prospectus. VC board representatives do not want to risk losing their D&O insurance coverage in any of these situations due to misstatements by a corporate officer, who has better access to information.

As a result, VC's should ask whether a proposed D&O insurance policy contains so-called "severability provisions." For example, if insurance coverage is denied due to a misstatement in the policy application, such misstatements should only be attributed to the executive officers responsible for the misstatement, or to the company itself; however, coverage should continue for the outside directors who do not share equal responsibility for such misstatements. (Similarly, venture capitalists should resist insurance applications that request all directors to sign the application; an application of this kind may increase the likelihood that a misstatement in the application could be used as grounds to deny coverage to an outside director.)

On a similar note, it is customary for D&O policies to have so-called "wrongful act" exceptions. For example, a director or officer will not be entitled to coverage if the loss resulted from his or her fraud. Here too, VC's should seek for severability provisions that would prevent a corporate officer's fraud from resulting in the VC representative's loss of coverage.

Question 2: Can the company's failure to cooperate with the insurer be held against the VC's representative?

D&O policies often contain "cooperation clauses" that require the insured parties in certain situations to furnish information to the insurer, such as when the insurance company is considering the reasonableness of a proposed litigation settlement offer. In most cases, the officers of the insured company, and not the outside directors, will possess the information that the insurance company is seeking. That being the case, it is important for VC's to review the policy to ensure that any failure by the company to furnish information to the insurer under the policy, or to otherwise cooperate, will not result in a loss of coverage for its representative on the board.

Question 3: Does the policy encourage the company to promptly reimburse outside directors for their losses and expenses?

Before answering this question, let's introduce some terminology. Modern D&O policies, particularly those provided by major U.S. carriers, include two different types of coverage:

� Direct payments by the insurer to an officer or director. This form of coverage applies in situations where the company is unwilling to, or prohibited from, indemnifying an officer or director. This form of coverage is sometimes called "A-Side" coverage, or "individual" coverage. An insurance company might be required to make payments under this coverage, for example, when a bankrupt company cannot satisfy its own indemnification obligations to its officers and directors.
� Reimbursement payments by the insurer to the company. This form of coverage applies in situations where the company does make indemnification payments to an officer or director. If these payments are covered by the policy, the insurer will reimburse the company for the indemnification payments that it has made. This form is sometimes called "B-Side" coverage, or "corporate reimbursement" coverage.

In practice, B-Side coverage generally involves higher deductibles and retention amounts for the insured parties than A-Side coverage. Accordingly, a company may have an incentive, where possible, not to indemnify a director directly, and to cause the insurer to do so under the A-Side coverage. Management of a company might try to avoid satisfying the company's indemnification obligations to its officers and/or directors in order to avoid these higher deductibles and retention amounts. If this occurs, the consequences may be adverse to a VC and its board representatives, because it adds another potential step before the director may recover its litigation and related expenses. It may cause delays in an outside directors' reimbursement payments, while the insurer and the company squabble over the characterization of the payments to be made.

One remedy to this problem is provided by some insurance companies themselves: their policies contain a "presumption of indemnification" provision in their policies, which is designed to require the company to provide the indemnification. These insurers seek to ensure that a company's corporate indemnification decisions are not made in order to maximize the level of coverage provided under the policy in this manner. A VC may properly ask whether a proposed policy contains a provision of this kind, and seek its inclusion if needed.

Question 4: What is the extent of an outside director's D&O coverage?

Typical language in a D&O policy often restricts coverage to situations in which an outside director is sued solely "in his or her capacity as a director." This type of provision might be too narrow where other possible actions against a VC's representative can be envisioned. One typical example would be a situation in which a director is planning to sell shares of the company's stock in an underwritten offering or a shelf registration statement. He or she may have originally received these shares in the same financing round as the VC itself made its purchase, and may be entitled to registration rights. In such a case, in the event of any material misstatement or omission from the relevant prospectus, the director might be sued under the U.S. securities laws not only in his or her capacity as a director who signed the registration statement, but also in his or her capacity as a "selling shareholder." In this type of situation, a policy limiting coverage to actions arising due to the individual's position as a director may be too narrow. Provisions of this kind should be tailored to the types of relationships that outside directors have with the relevant company.

In addition, a VC's board representative may not be expected to serve as a long-term member of a management team. He or she may leave the board at the time of an IPO, at the time of a company sale, or at the time that a more significant investor takes priority over the current investors. Accordingly, VC's should ensure that the coverage provided under a D&O policy for claims relating to facts and circumstances during the director's tenure will extend to such director even after such individual has departed from the board, or after the completion of any merger transactions with other companies. Former directors sometimes receive unpleasant surprises in the form of a plaintiff's complaint long after they have stopped serving the company.

Question 5: Are the exclusions from coverage appropriate? (Read the fine print.)

A standard D&O policy will have a long list of exclusions from coverage. Many of these exclusions are fairly standard, and a company and its directors will often have to live with them. Some of these exclusions include:

� the insurer will not pay losses consisting of fines and penalties;
� the insurer will not pay for losses arising from acts outside the scope of the directors' corporate duties;
� the insurer will not pay for losses that are caused by the director's receipt of improper payments;
� the insurer will not pay (at least under the D&O policy) liabilities arising out of environmental claims.

Several types of exclusions should be subject to negotiation by the VC. For example, a "dishonesty exclusion" bars coverage for losses arising out of the director's improper conduct. Ideally, this form of exclusion should require a final judicial adjudication before it can be used to deny coverage -- a showing of facts by the insurer, no matter how compelling at first glance, should not be sufficient to deny coverage.

In addition, special attention should be given to the so-called "insured vs. insured" exclusion. This fairly customary exclusion was originally designed by insurers to prevent improper claims coverage by a company and its affiliates, where one insured party under a policy, such as the company itself, brings a legal action against another covered party (such a director), in a situation where the two parties can collude to cause a payout under the policy. To properly protect outside directors, these clauses should be narrowly tailored to make sure that they do not inadvertently exclude coverage in a so-called "derivative" action permitted under the laws of many jurisdictions, in which shareholders bring an action for recovery against an officer or director in the name of the corporation itself. A second important exclusion with respect to this type of provision would be claims brought by a bankruptcy trustee, so as to provide protection to the directors in the event claims are raised in the bankruptcy context. Although each of the parties-in-interest in such an action may technically both be insured parties, it is not necessarily appropriate that a director would not be subject to coverage.


Question 6: Is the company's policy consistent with the demands of any policies maintained by the VC?

A recent trend in the D&O insurance market has been the creation of new policies for VC's. These policies are designed to cover losses and expenses incurred by the VC's representatives as a result of their service on the boards of portfolio companies. This is a new market, and it may take some time before any standard types of terms emerge. If a VC has a policy of this kind, it would be wise to review the terms to see whether it imposes any requirements upon the terms that must be maintained by a portfolio company. For example, a VC's policy may only provide for payment if other sources of insurance payments are exhausted, including the policies of the relevant portfolio company. It is possible that such a policy could require that the terms of the portfolio company's policy will automatically provide the first level of insurance coverage, whether or not the VC representative has a source of insurance other than the company's policy.


Question 7: Is a proper officer of the company taking responsibility for D&O insurance coverage?

VC's should not assume that all of the proper homework has been done prior to finalizing a D&O policy. Has quality counsel for the company reviewed the terms of the policy, or investigated whether there are any charter or by-law provisions, or unique state law or regulatory issues, that might bar the company from obtaining the desired D&O policy?

In addition, who prepared the application? Experienced insurance counsel or insurance professionals? As discussed earlier, misrepresentations in the policy application could serve as grounds for the insurance company to deny coverage, or to rescind the policy entirely.

Going forward, does the company have appropriate personnel in place to administer the policy when it is in place? Unfortunately, companies often risk their coverage by not properly complying with the administrative terms of their policies. Claims must be notified on a timely basis (with proper amounts of detail), as well as certain events such as registration statement filings and some types of major transactions, such as mergers and acquisitions. Some policies require notification to the carrier if insured directors are placed on the board of newly-formed subsidiaries; if such notice is not delivered, the insured director may not be covered from liabilities arising from his or her position with that new entity. In addition, policies must be renewed from time to time, and as a policy approaches the end of its term, a company may need to work rapidly to obtain a new policy on a timely basis in order to prevent any lapse in coverage. The value of a D&O policy may be substantially reduced if the VC is not confident that its portfolio companies have proper personnel in place to ensure that coverage will not be lost.


Conclusion

D&O insurance policies have evolved over time, and most providers use very different forms of insurance agreements. As a result, it is critical that qualified individuals consider the needs of a company with respect to D&O insurance, and carefully review all of the material terms. VC's should join in this process to protect their own needs, and the interests of their board representatives. During periods when D&O insurance is in short supply, and providers are loathe to write generous policies, a VC's ability to negotiate the provisions may be limited. However, due to the special interests of VC's, it is hard to understate the importance of working to ensure that a D&O policy will provide the desired protection.


Key Provisions of D&O Insurance

In reviewing the terms of a D&O policy, companies and VC's should pay attention to the following important terms:

Limits and deductibles: for what portion of a loss are the insured parties responsible?

Insureds: which individuals, and which corporate entities (and predecessors and successors) are covered? Is there "entity coverage" for the company's losses in, or settlements of, litigation?

Transactions covered: are IPO's and follow-on offerings covered? M&A transactions?

Claims covered: does the policy cover administrative proceedings and investigations, as well as law suits? Does the policy cover actions in both the U.S. and Israel?

Employment practices claims: does the policy cover wrongful termination, harassment, discrimination and related employment claims?

Exclusions: what types of claims are carved out of the policy?

Payment of loss: will the insurer advance claims before a final judgment or settlement?

Discovery period: after the termination of the policy, can the insured parties seek coverage for claims arising during the period of the policy? For how long after termination?

Selection of counsel: who decides which lawyers can control the defense of a claim?

Allocation: how will the insurer allocate insurance payments where some related losses are covered by the policy, while others are not?

Cancellation: under what circumstances can the insurer cancel the policy?

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