When a venture capital or private equity firm invests in a portfolio company (PC) and places a general partner on the PC’s board, they typically require that the PC agree to defend and indemnify the board member in any litigation arising out of their board service, and to purchase directors’ and officers’ liability insurance. However, the D&O insurance requirements are typically quite vague, and down the road the parties may be surprised to learn of key gaps in the PC’s coverage. These gaps are usually discovered when the parties need the coverage most – i.e., after a lawsuit has been filed, naming board members as defendants. Here are two examples I’ve come across in representing venture capital and private equity firms:
Founder Disputes and the “Insured vs. Insured” Exclusion: As the PC becomes more sophisticated and venture or private equity take a larger stake, members of the founding team may be asked to leave and/or have their stock holdings significantly diluted through subsequent investment rounds. A disgruntled founder may then bring a claim against the PC and its board. Directors and officers (D&O) policies invariably contain some form of “insured versus insured” (IvI) exclusion, barring coverage under many circumstances for a claim by an Insured, against an Insured; this includes claims by former officers and directors, as they remain “Insureds” under the policy. However, there are widely-available modifications to the IvI exclusion. One possible modification limits the period of time for which a claim by a former director or officer will trigger the IvI exclusion (e.g., no more than one or two years after the officer or director’s departure will not trigger the exclusion). The best option converts the exclusion to “company versus insured,” effectively barring only claims brought by or in name of right of the company.
Control of the Defense: Some of the most economical D&O policies written for private companies impose upon the insurer a “duty to defend,” rather than an obligation to “pay” or “advance” defense costs. This seemingly minor semantic difference has major implications in the insurance world, because a “duty to defend” policy gives the insurer the right to control the defense. This means the insurer has the right to select defense counsel, to cap the rates at which defense counsel fees will be reimbursed (frequently $250/hour or less), and potentially to dictate whether and to what extent multiple insureds are entitled to their own separate counsel. Even policies that do not impose a duty to defend may require that the insureds use only counsel from certain pre-approved “panel counsel” firms. However, it is certainly possible to purchase policies that allow the Insureds to control the defense, including full control over selection of defense counsel.
Many portfolio companies purchase insurance policies containing these kinds of limitations because they are start-ups and relatively unsophisticated regarding insurance matters. They may see the (relatively minor) pricing difference between the different types of policies and fail to appreciate the greater financial implications down the road, if a claim is made. In that scenario, the VC representative board members will insist on full indemnification of their defense costs, and they are highly unlikely to accept counsel who charges just $250/hour; indeed, they’ll likely insist on counsel who charge three-to-four times that hourly rate. The defense costs will mount rapidly, and the PC will be stuck paying the difference.
Erica Villanueva is with Farella Braun + Martel LLP, San Francisco, CA.
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