Venture Capital Insurance and the SEC

In our first post on venture capital insurance, we took a high level view of four scenarios where this management liability, professional liability, and employment practices liability insurance policy could protect you, your firm, and your investors. We also spoke about the potential costs of having — as well as not having — this liability coverage in place once you begin accepting external capital or making investments.

The primary emphasis in that post revolved around legal defense expenses, yet it’s essential to consider another aspect when accepting risk through these venture capital insurance policies: Regulators.

Situation #5: A regulator targets you for an investigation of your fee structure and disclosures. (See the recent Wells Notice issued to Fenway Partners)

The worst nightmare of every Partner: a letter from the SEC indicating you are the subject of an investigation. More often than not, it will be unclear at this point what they are looking for. What will be clear is that the regulator would prefer that you spend the next few months to a year (or more) engaging in a costly dialogue with the federal government. By the SEC’s own calculation, the average time between opening an inquiry and commencing enforcement was a staggering 21 months in 2014¹. It was an off-year: they blew right past their goal of only 20 months…

Important notes:

1. Routine examinations and industry-wide sweeps most likely will not be considered coverable events in your policy. This is something to review with your broker.
2. If someone makes a deliberate omission, commits fraud or otherwise willfully breaks the law, Venture Capital Insurance will not pay for their investigation-related expenses or defense costs. Most policies also explicitly state that the insurer will not pay fines and penalties imposed on you, your firm, or your employees.
3. Venture Capital Insurance will pay for your legal expenses and defense costs up until it is determined — usually by a court or arbiter decision — that you committed one of the above offenses. At this point the insurer will look to recover whatever portion of the defense was allocated to the bad actor.
4. An investigation by a regulator can happen to literally any venture capital firm, big or small, right or wrong. No one is immune, no matter what level of precautions taken.

Sympathy for the Devil Insurance Company

The rationale behind what they will and won’t pay for is actually understandable: the insurance company can’t encourage, or be a party to, a crime. If they promised to defend you after a deliberate fraud or offered to pay your fines, they would essentially be writing you a pass to be a bad guy or gal and promising that they will cover for you if you get caught. (Google “burglary lookout for hire” and you will find the same disappointing results as if you asked your broker for an insurance policy that will pay to defend you after you defraud your investors.)

What the insurance company can do is pay defense and investigative expenses on your behalf if you are actually in the right, or until it is established through due process that you are in the wrong…at which point, you should be prepared to break out the checkbook.

An Example

You launch your brand new firm and start making your presence known to your contacts and business partners. It’s a crowded space that you have entered, but your approach and experience are enough to set you apart from the pack, guaranteeing you reach your fundraising target and deliver returns to your investors. At this point you haven’t made any investments, you’ve only talked to and taken capital from people you know, and you have the presence of mind to have all of your risk management and compliance controls in place before you start rolling. You’re doing things the right way and making sure you don’t make any mistakes this early on — you even contract a law firm to review your offering documents before they get sent out. You take every precaution.

Then one of your competitors sends the SEC an anonymous tip that you made material misrepresentations in your offering documents.

That’s all it takes. In this situation, the investigation could be resolved in as little time as a couple months. It doesn’t take much work by the SEC to sniff out a frivolous tip; they have certainly seen enough of them to know the drill. But during those one or two months, you are racking up bills in ways that you did not plan for and may not be prepared to handle.

A More Expensive Example

Let’s now assume that, again, you are wrongfully accused. This time though, maybe it’s not an anonymous tip. Perhaps the investigation isn’t as simple as a couple interviews, a quick dig into the email history, and a review of your offering documents. All that is guaranteed here is that, in the end, there will be no fines or penalties assessed by the SEC. Don’t get too excited. From the point you receive the letter to that final moment of vindication, you are racking up expenses left and right.

The first portion of this process is known to insurers as an “Informal Investigation”: they are not accusing you of anything yet, but they want some answers. First you retain counsel to review the demand letter and guide you through the next steps. So you begin the process of document production — financial statements, letters, emails, memos, reports, records, logs, transcripts, written procedures — all of them prepared, packaged, and organized in a way that is carefully detailed in order to ensure successful submission to the examiner. The regulator may also want to conduct on-site interviews with you or your employees at this point as well.

Hopefully it doesn’t get to this point, but the second portion is when the trouble really starts: The “Formal Investigation,” accompanied by the service of a subpoena or Wells Notice. The SEC may reach out to your investors to let them know what is going on and possibly take statements from them. The next step might be an on-site visit where a full team from the SEC shows up at your offices, interviews your employees during work hours, and uses your computers to dig around on their own (bear in mind that these steps can also happen in the Informal Investigation stage). A couple of months and several back-and-forths later, you receive the SEC’s first opinion letter.

As expected, they mention nothing about the serious offense your firm was suspected of committing, but to your surprise they also found a half-dozen minor infractions that you never saw coming; things like minor errors in your investor presentation or parts your compliance controls that the regulator would like to see changed. Now you bring outside counsel back around to help with the response letter while simultaneously enacting the changes demanded by the regulator.

Closing the Investigation

By the end of this step, you have a few things:

1. an exhausted staff (especially you and your compliance officer);
2. an increasingly skittish investor base; and
3. the draft of a friendly letter to the SEC outlining your thoughts on each item and how you plan to fix the noted problems (regardless of whether you agree with the regulator or not).

You respectfully thank the examiner for their time and insight, and later, once everyone has gone home, quietly weep over your keyboard as you look at your exploding inbox and legal expenses for the year. Ideally, this will be the end of it.

Summing Up

Venture Capital Insurance (again, also known as “D&O, E&O, and EPL coverage”) can assist by paying the legal fees on the firm’s behalf and retaining qualified counsel to guide you through the life of the investigation. Some policies will only start paying once the investigation becomes “Formal” (i.e. through the service of a Wells Notice) but other policies account for the evolving regulatory environment by providing coverage through the Informal Investigation stage as well — this is something you should ask your broker to pursue.

Between providing defense costs from lawsuits and expenses related to investigations, your venture capital insurance policy has the ability to save you in the hundreds of thousands — even millions. It can mean the difference between you having to simply put up with a nuisance investigation and you having to make some really tough financial and organizational decisions just to keep up with lawyers’ bills.

Next week we’ll take a closer look at lawsuits from your investors: where they come from, how Venture Capital Insurance can protect you, and which factors will determine the price and scope of your insurance coverage.

¹US Securities and Exchange Commission, Agency Financial Report, Fiscal Year 2014. Table 1.10, p.54. http://www.sec.gov/about/secpar/secafr2014.pdf

Insurance Rebuilt, End-to-End

We've supported startups from stealth mode to huge funding rounds.

Get a Custom Quote