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 some firms may be surprised to learn of key gaps in the PC’s coverage. These gaps are usually discovered when the VC/PE firm needs the coverage most – i.e., after a lawsuit has been filed, naming their board member as a defendant. 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. 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. 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, 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.

At the same time, venture capital or private equity firms may erroneously assume that, if the PC’s insurance is not strong, they can simply retreat to their own insurance. But venture capital and private equity liability policies usually provide that their coverage for general partners serving as outside directors is excess to both the PC’s insurance and the PC’s indemnity obligations. In other words, the venture capital or private equity liability policy will only respond if both the PC’s insurance denies coverage and the PC refuses to indemnify. This may create a “Catch-22” situation for a portfolio company in a precarious financial situation, and of course any damage to the financial health of the PC ultimately impacts its investors, as well. The best approach may be for the venture capital or private equity firm to work with insurance coverage counsel or their own insurance broker to develop a “checklist” of key provisions that the firm would prefer to see in their portfolio companies’ D&O insurance policies.