Mitigating Director Risk as Your Business Grows and Raises Capital

Mitigating Director Risk as Your Business Grows and Raises Capital
April 19, 2023 13 mins

Mitigating Director Risk as Your Business Grows and Raises Capital

Mitigating Director Risk as Your Business Grows and Raises Capital Hero Image

Directors face potential equity transaction liabilities throughout a company’s growth. Learn about mitigating these costly risks.

Key Takeaways
  1. At any stage in a company’s growth cycle, financial liabilities can disrupt the balance sheet, directly impacting valuations and investor appetite.
  2. Different capital transactions create their own unique exposures for directors. Mitigating these potentially costly risks is critical.
  3. D&O insurance helps protect the directors’ and officers’ decisions as well as corporate balance sheet indemnification obligations.

Amid the current global macroeconomic volatility, businesses are looking to raise additional forms of capital, including “go-private” transactions. Each transaction brings new potential for director risk, which often comes at a cost. At any stage in a company’s growth cycle, financial liabilities can disrupt the balance sheet, directly impacting valuations and investor appetite.

Different types of transactions create different exposures and risks for directors. From starting a company and mergers and acquisitions (M&A), to initial public offerings (IPOs) and delisting, directors’ and officers’ (D&O) insurance can be tailored to each stage in a company’s growth. This article shares four capital-raising transactions and how companies can mitigate the associated director risk.

1. Protecting Small Private Company Directors

An initial third-party investment is often the first time a company will consider purchasing D&O insurance, especially if the investor assumes a board seat. D&O cover protects directors from potential liabilities, which frequently emanate from employment practice liability, competitor, regulatory and minority shareholder claims. D&O losses do occur with private firms. One in four private companies experience a D&O loss and 96 percent of those companies were impacted financially. Further, the average reported loss was $387,000.1

Take Action: Secure Cover for Small Private Companies

Purchasing D&O insurance is a critical step to transfer the risks and potential financial liabilities off the balance sheet and into the markets, putting the business in a stronger financial position to attract investment.

As companies continue to grow and consider going public, governance structures should be updated to maintain appropriateness and resolve issues.

2. Mitigating Directors Risk After an M&A Transaction

During company growth, there could be successive rounds of funding, or even a merger or acquisition. The composition of the board may also change.

Take Action: Reassess your Cover After an M&A Transaction

Mitigating evolving exposures through insurance is critical to manage financial risks and safeguard capital.

This process may initiate a change of control clause in the D&O policy, and new cover will need to be purchased. Departing directors may be exposed to claims made after the sale based on their past actions. For this reason, an extended reporting period for claims that arise after the transaction for wrongful acts that occurred prior to the transaction — or run-off (“tail”) coverage — should be purchased. In the UK and the U.S., this can be purchased for up to six years. In Germany, this extends as far as 12 years — aligned to the statute of limitations — which enables finality of liability for the former directors.

Understanding specific country D&O provisions is critical. In other countries, the extended reporting period may be granted automatically. For example, in France, claims made policies must grant a five-year extended reporting period.

3. Publicly Listing Equity Through a Public Transaction

As companies continue to grow, listing equity on a public stock exchange through an IPO or a reverse merger will radically impact both opportunities and risks for the firm. Public transactions bring three core risk factors for directors:

1. The public transition itself is another risk element for directors.
From forward-looking statements and assessments of market conditions to potential investors (through roadshows, analyst presentations, prospectus materials, etc.), any proclaimed statement creates potential liability for directors. It can be used by plaintiffs, who could claim to have relied upon these statements when valuing the company.

2. Securities activities, such as shareholder class action lawsuits, generate the greatest liability exposure for public companies and their directors.
In 2022, the likelihood that an S&P 500 company being sued increased to 3.8 percent.2 These risks can be ruinous, with settlements reaching billions of dollars in the largest cases. Directors of companies with exposure to North American shareholders, which raise capital through American Depository Receipts or are listed on a U.S. exchange, often face the greatest risk.

3. Future exposure to past activities will need to be appropriately covered.
There are two ways to handle this:

  • The most robust way is to purchase run off, which protects new directors joining the board and provides a clean break for directors leaving the firm.
  • The alternative is to modify the existing program, including purchase of Side C coverage, and increasing the coverage limit. However, modifying coverage on an existing policy designed for private companies may create potential ambiguities and shortfalls in public company coverage and may necessitate a change to new wording upon IPO.

Amid the current macroeconomic volatility and other challenges, such as supply chain disruptions and geopolitical pressures, full and accurate disclosures of potential risks will enable investors to have a rounded view to make informed decisions.

Take Action: Make Coverage Adjustments to Manage an Evolving Risk Profile

Going public will change the company’s risk profile.

To navigate changing exposures, companies should reassess their D&O coverage. This may include purchasing greater limits as a public company and exploring additional solutions to manage an evolving risk profile.

More common in the EU markets, Public Offerings of Securities Insurance (POSI) creates an additional limit of coverage that protects the “business-as-usual” D&O limit from being eroded by IPO-related claims. Offered as either standalone or a combined D&O/IPO cover depending on the market, POSI can reduce the cost of D&O, which would otherwise include the risk factors of the IPO within the annual premium.

In going public, the cost of the necessary additional coverage can increase significantly. Early preparation and due diligence are essential and will help leaders make better decisions.

4. Delisting and Management Buyouts

As global stock market valuations have declined, more organizations are considering delisting and “go-private” transactions.

Driven by the perceived information asymmetry between management and the elimination of any minority shareholders, the risks of delisting can be significant. For example, a major computer manufacturer recently agreed to a $1 billion settlement related to the forced conversion of minority shareholder stock by controlling shareholders.

Delisting creates a requirement for directors to protect themselves with an extended reporting period. Transparency is another area of risk for directors. This could include issues such as any share incentives for retained management or documenting the intentions for the newly private business — including employees and pension arrangements.

Take Action: Get Ahead of Delisting Risks by Establishing Consistent Disclosure

The key to mitigating these risks is to establish fair and consistent disclosure to protect against allegations of wrongdoing. Directors should also consider a separate insurance policy to further mitigate the acute heightened risk of a delisting transaction, similar to a POSI.

Grow Smartly and Make the Right Risk Decisions to Protect Your Exposures and Balance Sheet

Potential equity transaction liabilities exist for directors throughout a company’s growth journey.

Wherever you are on this journey, raising additional forms of capital must be done smartly. Make risk mitigation of potential director liabilities a key element of your equity growth plans. Consult with your risk broker throughout any transaction process to ensure the right director risk strategies are in place for your firm.

3.8%

Increase in the likelihood an S&P 500 company being sued in 2022.

Source: Cornerstone Research | Securities Class Action Filings – 2022 Year in Review

Read the Report

1  Private Company Risk Survey: D&O Risks and Risk Management | Chubb
2  Cornerstone Research | Securities Class Action Filings – 2022 Year in Review

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The information contained herein and the statements expressed are of a general nature and are not intended to address the circumstances of any particular individual or entity. Although we endeavor to provide accurate and timely information and use sources we consider reliable, there can be no guarantee that such information is accurate as of the date it is received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation.

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