Why do you need Directors & Officers Insurance?
Many companies who look for D&O coverage do so because they’re going through an institutional round of funding. What they may not realize is that the policy they’re buying has more utility than just letting you cross an item off your term sheet to-do list.
The VC wants you to have this policy in place for two main reasons. First, if they are going to take an ownership stake and put someone on your board, they’re going to want to be sure that their employee is protected from legal liability. Second, if a dispute develops between you and them, the VC wants to know that you have the capital required to absorb the legal costs without mortgaging the future of the entire company.
Acting Board Member
If you are going to act as an officer or board member, you’re going to have a fiduciary duty to your investors. This means they can hold you liable if they feel you breached that duty.
D&O insurance can be a critical protection even if you don’t have investors. Competitors can make allegations such as unfair trade practices, tortious interference or fraud allegations that aren’t covered by a general liability policy.
Over a quarter of all private companies experienced a D&O-type loss according to a Chubb report. The average total cost for companies without D&O insurance is $394,000 following these types of losses. The highest reported loss clocked in at over $17,000,000.
D&O insurance protects the company and its executives from certain claims made against them. The insurance will pay for the defense against certain lawsuits as well as any subsequent judgment or settlement action brought against an insured.
What is Directors & Officers Insurance?
Historically, D&O policies were really just designed to protect the personal assets of those key individuals but the scope has since expanded. Companies can now indemnify their executives against covered claims and then turn to their D&O policy for reimbursement. If the company itself is named in a suit, the policy would defend the corporate entity in addition to its leadership.
Most of the insurers we work with will extend the coverage to employees and volunteers outside the board of directors as well. These include external advisors, scientific advisory boards and employed lawyers.
The types of claims that are covered involve an individual’s actions and decisions (or failures to act/decide) in his or her capacity as a leader of the company. This can include allegations of breach of fiduciary duty, mismanagement of shareholder voting procedures, unfair trade practices, misrepresentation, securities violations in connection with private placements, and failure to comply with regulations/laws (to name a few).
Coverage can also be expanded to offer additional limits to protect execs when the company is insolvent and can’t provide indemnification. These additional limits can be vital since companies that are in financial trouble are much more likely to be named in a D&O suit. It can be a vicious cycle. The coverage enhancement ensures that, even if the coffers are dry and the policy has been used up, there will be a safety net available to catch individuals who are still the target of a suit but can’t be protected by the company.
Other enhancements include coverage for the costs of investigating a derivative demand claim (when your shareholders act on behalf of the company and sue you) or the legal defense costs of a dilution suit from a former exec.
Fraud is a frequent allegation made as part of commercial lawsuits. Problematically, fraudulent acts are not covered by insurance. But here’s the key: get the right D&O policy and the carrier will pay to defend you against that allegation until it’s proven true. Assuming the fraud claim is unfounded, a well-written D&O policy will pay to get that part of the suit knocked out.
D&O Insurance Structure: Side A, B & C
You will have to consult your policy documents to confirm exactly what coverage your insurance provides but here are a few scenarios of what is covered by directors and officers insurance :
Protects solely the individual directors by paying the defense costs and settlements levied on the directors as a result of a lawsuit. Side A will only pay the individual directors when the entity is unable (i.e. insolvent) or legally not permitted to do so. Typically, individual directors will ensure that the company purchases additional Side A coverage on top of the traditional ABC coverage.
Indemnifies the entity after the entity has paid the individuals named in the lawsuit.
This is entity coverage. Should the entity be named along with the individual directors in a lawsuit, this coverage protects the balance sheet of the company and will reimburse and costs/settlements incurred.
The below graphic illustrates how sides A, B and C work with regards to claims against directors and a securities claims against the company itself:
What D&O limits do you need?
Choosing the right D&O limits for your business depends on a number of factors including:
There is no rule of thumb and appropriate limits will vary on a case by case basis that depend on the combination of factors we’ve outline (and more). Some companies require only $5m and others need up to $50m or even $500m.
Below is an example of how a potential D&O tower could be structured:
How it Works
Who needs Directors & Officers insurance?
D&O insurance is typically the best fit for businesses with high liabilities, those that need to attract quality executive leadership, and businesses with a board of directors. Executives, especially high-quality ones, may expect D&O insurance as a prerequisite before they’ll even consider joining your company.
- Public and Private Businesses with a Board of Directors: Since general liability insurance and umbrella insurance don’t cover liability of a company’s board of directors, D&O insurance is needed to fill this gap. This includes small businesses.
- Nonprofit Organizations: Since they are managed by a board of directors, all nonprofits should have D&O insurance coverage, especially if they want to attract quality board members who would demand the coverage.
- Businesses with Large Liabilities: If a business owes more than $1 million to creditors, then it’s important to have this coverage to protect the business, the directors, and the officers in the event the business goes under. Creditors might point to the company leadership as to the reason they weren’t paid in full.
Here are some industries where D&O claims are most prevalent:
Wholesale and Retail Trade
Agriculture, Forestry, and Fishing
Transportation, Communication, Electric, Gas, and Sanitary Services
Mining and Construction
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