Directors and Officers (D&O) Insurance. It’s going to come up at some point during the life of a start-up and that point is usually when an investor, director, key client, or strategic partner insists that the company have it. Your company may already have a number of other insurance policies, like commercial general liability, property insurance, or employment practices liability insurance, each of which applies only to certain types of claims. D&O insurance applies to claims that the directors and officers did something wrong when managing the company and for which they can be personally liable, e.g. a breach of their fiduciary duties. It usually provides coverage for certain of the company’s wrongful acts as well, e.g., the company is being sued either on its own or together with directors or officers. D&O coverage is often required by venture capital investors because it provides a level of financial protection if the directors are ever sued for something they did or didn’t do. Those individuals want to know that they can tap into a D&O policy (rather than their own bank accounts or the assets or insurance policies of the VC firm they may represent) to pay any settlement, award, or legal fees relating to a claim asserted by a shareholder, client, regulator, or other third party.
To provide further context, here are some examples of claims generally covered by a D&O policy (although the precise coverage offered by a policy is always dependent on its specific terms):
- You and your co-founder convinced investor Joe to purchase a minority interest in your company. Five years later, Joe sues you, your co-founder, and your company saying that you fraudulently induced him to be an investor with inflated data and that you’ve been squandering the company’s assets ever since.
- A minority shareholder has sued the board of directors claiming that they breached their fiduciary duties in approving a down round financing where two of the directors were representatives of the VC firm participating in the down round.
- A major client of the company sues senior officers and the board alleging that there was a pattern of intentional theft of the customer’s source code by several company employees, and that the board failed to detect and deter this behavior.
D&O insurance would typically pay the defense costs, settlements and other losses, like a judgment or a verdict, above the retention/deductible and up to the limit of liability, for claims that it covers (although certain kinds of losses like a fine or multiplied damages may be excluded). For the most part, D&O insurance is indifferent to whether the claim is true or not. A notable exception to this occurs when it has been determined, usually after all appeals have been exhausted, that the insured entity or person has committed fraud.
Now, let’s answer some questions about D&O insurance to help prepare you for the day when you are asked about it:
Why is it needed if the company already indemnifies its directors and officers? Indemnification, which is an obligation of the company to reimburse a director or officer for costs or losses she or he suffers as a result of action taken as a director or officer, is only as good as the company’s finances. If things with the company aren’t going so well and there isn’t enough capital, indemnification from the company can be worthless. In this situation, the directors and officers need the protection offered by a D&O policy. A D&O policy is also used by the company to finance its indemnity obligations because the policy responds when those obligations are triggered (and once the retention/deductible has been met).
How does my company buy D&O insurance? Here’s where you need to hire an insurance broker that is very experienced in the D&O insurance marketplace. She or he needs to have a deep understanding of the insurers in this market, their policies, and the performance of those policies. The most efficient way to find a broker is with a referral (possibly from your lawyer). Once you have retained a broker, you provide her or him with an insurance application listing basic information about your company, including its finances and capitalization table. You will also need to disclose whether you are aware of any circumstances that may result in a claim. Armed with information about your company, your broker will canvas insurers that it thinks may be interested in underwriting your D&O insurance. The insurers that are interested will provide a quote for a 1-year policy term. Your broker will review the various quotes and the key terms of each with you.
Aren’t D&O policies standard across the different insurers? While all D&O insurance aims to cover similar types of claims against a similar set of people, not all D&O policies or insurers are alike and you should press your broker for information to help you compare the quotes. Questions to ask include:
- What has been your experience with each insurer for claims?
- What is each insurer’s credit rating?
- What happens to coverage if the officer completing the application made a misrepresentation about the company’s business?
- Does the policy have any language covering payment of claims when the company is insolvent?
- How does the policy handle claims of fraud?
- Will the policy respond to regulatory or administrative investigations?
- Are there any important differences between the exclusions in each policy?
If you don’t like the answers to any of these questions, ask your broker if there is room for negotiation on the policy language. Also, you should be aware of risks that may be unique to your industry and ask your broker if language can be added to the policy that is specific to those risks.
How much D&O Insurance should my company get? We all wish there was a simple answer to this one but there isn’t. The usual range for early stage companies is $1 million to $3 million, and this range increases as the company grows. The precise amount of insurance to buy depends on a variety of factors, including the following:
- The minimum amount you need may be specified by an investor (in the Insurance section of an Investors Rights Agreement), key client (in an RFP or service contract), or business partner (in a joint venture or similar agreement).
- Risk factors surrounding your company may suggest that you should buy an amount that is on the higher end of the range. Examples of risk factors include: (a) your industry is heavily regulated, (b) there are stockholders not represented on the Board of Directors who don’t get along with, or are overly critical of, the company, (c) the company’s operations have grown significantly in a short period of time, or (d) the company is expected to have a significant transaction, such as an acquisition, within the next 12 months.
- Benchmarking data provided by your broker, which shows how much insurance other companies are buying, provides guidance on what is typical for your industry. Your broker can also obtain quotes at various limit amounts and retentions/deductibles, so you can compare pricing at different levels.
Ultimately the company will have to decide how much D&O insurance to buy based on the relative risk as weighed against the cost of the policy. The Board of Directors needs to be involved in this decision. Consider scheduling a Board meeting to review insurance and inviting your broker to attend so that the Board can review the quotes obtained by the broker, listen to her or his insight, and ask questions, before making any final decision.
Anything else I should know about D&O insurance? It doesn’t cover everything. It doesn’t cover bodily injury or property damage, which are risks covered in a commercial general liability policy. It doesn’t cover a claim that your company breached a contract. It doesn’t cover in-fighting amongst the company (known as the Insured vs. Insured exclusion), i.e., the company sues a director for breach of loyalty when it alleges that he stole a business opportunity away from the company for his own benefit. Another thing about D&O insurance is that you have to remember you have it and not forget to file a claim when something arises that might be covered. If you delay or forget to consult with your broker about filing a claim, your claim could end up being denied. This is because a D&O policy is a “claims-made” policy, meaning it only responds to claims that are made during the policy term. So if you receive a demand letter and you expected that the matter would “go away” but instead it escalates into full-blown litigation a couple years later, and file an insurance claim at that point, your claim will be denied because the policy that existed when you received the demand letter has long since ended. Put another way, you failed to file the insurance claim when the claim against the company or its directors and officers was first made.
Equipped with the key information about D&O insurance, you’ll be ready for it when it inevitably is raised by an investor, director, client, or strategic partner. Here’s hoping you never need to use it.