Co-authored with Tim Burns of Burns Bowen Bair LLP.
Well in advance of the lead-up to an IPO, late stage start-ups 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 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 SEC enforcement division recently announced, “[T]here is no exemption from the anti-fraud provisions of the federal securities laws simply because a company is non-public, 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 upon 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 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 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 start-up Jumio 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 start-ups, 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.
