Shareholder Suits: More Reason To Secure Insurance

By Daniel K. Winters and Douglas Cameron, Reed Smith LLP

With increasing frequency, private equity deals are spawning a little-known but potentially significant risk: shareholder lawsuits. After spending significant time, effort and money to initiate, develop and close a deal, having the cost of the deal unexpectedly increase by seven figures or more can be devastating. Responding to lawsuits, or even a regulatory agency’s investigations and probes, can cost millions of dollars. There is, however, a way to reduce the downside potential of this risk.

In many cases, a company’s insurance policies, particularly so-called Directors & Officers policies, will provide coverage for these expenses. D&O policies serve three purposes. First, D&O coverage provides insurance to directors and officers for defense costs and indemnity payments that the company is unable or unwilling to cover. Second, it reimburses the corporation for those defense and indemnity costs that it does pay on behalf of the officers and directors. Third, depending upon the policy language, the policy can reimburse the corporation for its own defense and indemnity costs related to securities claims. This is known as Side A, Side B and Side C coverage. (Generalizations between policies can be difficult because every insurance company that sells D&O policies has placed its own imprimatur on its policy form. Because each insurer offers unique coverage programs, the specific language contained in a particular policy will always govern.)

The insurance needs of a private equity firm are unique in that they include concerns for the firm itself in addition to their portfolio companies. Therefore, private equity firms can face two kinds of lawsuits that D&O insurance may cover: investor claims and portfolio company claims. Investor claims typically involve lawsuits by a limited partner against the general partner for unsuccessful investments. Such claims typically allege that the failed investment either (1) violated the firm’s investment guidelines or (2) resulted from inadequate due diligence. However, a limited partner’s desire to participate in future deals or a fear of being shunned by other private equity funds may act as an extra-judicial restraint on the filing of these lawsuits. Claims brought by the shareholders of portfolio companies, however, have no such limiting influences and recently these types of suits have been filed with increasing frequency and speed.

As an example of recent portfolio company lawsuits, late in 2006 a class-action lawsuit was filed against thirteen private equity funds claiming that they had colluded to purchase target companies, which included HCA and Harrah’s Entertainment, for below market value. Early in 2007, a class action was filed on behalf of the shareholders of Biomet, Inc., claiming that four buyout funds purchased Biomet common stock for an inadequate price. And the claims involving Topps Co. Inc., the well-known producer of baseball trading cards, perhaps best illustrates how the claims against private equity funds have picked up speed and frequency. Topps announced an intention to go private on March 6, 2007. On March 7, 2007, the first class-action lawsuit on behalf of an individual investor had been filed. Two days later, the first class action on behalf of a pension fund was filed in the same New York state court. The need to respond to such lawsuits, which are filed sometimes less than 24 hours after a deal is announced, is becoming an all too common occurrence.

Coverage For Securities Claims

D&O policies commonly provide coverage for losses arising from claims related to wrongful acts committed by directors or officers. When dealing with claims related to private equity buyouts, the breadth and scope of the definitions of these terms (claim, wrongful act and who qualifies as an officer and director) will be the determining factors in finding coverage.

1. Defining A Claim

First, the policy will provide a definition for what constitutes a claim. Some policies provide that a claim is made only when the insured receives a demand for monetary relief or an action—either civil, regulatory, administrative or criminal—is commenced. Some policies however, specifically define a claim as encompassing a civil, criminal, administrative or regulatory “investigation.” The inclusion of the word “investigation” can make a significant difference in the scope of coverage.

In the context of shareholder lawsuits, coverage for alleged securities violations can be particularly important. Many, but not all, D&O policies provide coverage for alleged securities claims. A typical definition of a claim is one that provides coverage for “any error, misstatement, misleading statement, act, omission, neglect or breach of duty arising from or in consequence of any securities transaction.” As most of the recent lawsuits filed against private equity firms allege that the shareholders in the target companies have been paid an inadequate price for their securities, this type of coverage will be particularly germane. (While a company that is being acquired by a private equity fund may have its own D&O insurance, that insurance may not be available to the private equity fund or its own officers or directors. This topic is discussed in more detail in Part 3 below.)

2. Wrongful Acts

Next, D&O policies provide coverage for wrongful acts, which they typically define as “any error, misstatement, misleading statement, act, omission, neglect, or breach of duty committed, attempted, or allegedly committed or attempted, by an insured.” Further refining this definition is language related to alleged securities violations.

For securities claims, some D&O policies provide entity coverage as well. Entity coverage insures to the benefit of the corporation itself, as opposed to the individual officers and directors. Therefore, in the context of securities claims against a private equity fund, the private equity fund itself can seek payment of defense costs and indemnification for settlements or judgments.

Taken together, the definitions of claims and wrongful acts commonly found in D&O policies provide coverage for alleged securities violations by private equity funds. First, the lawsuits, regulatory actions and investigations would satisfy the definition of claim. Second, the allegation that the actions of the private equity fund caused the stock to be sold at an artificially low price satisfies the definition of wrongful act. The last question, then, is who qualifies as an officer and director (or covered entity if the policy contains entity coverage) under the applicable policy, and it’s a crucial question.

3. Determining Who Qualifies As Insured

D&O policies generally cover losses for those persons or entities who qualify as named insureds under the policy. This can present a unique challenge for private equity funds that do not carry their own D&O coverage or that carry insurance but do not have outside directorship coverage.

First, the private equity fund may seek to obtain coverage through the acquired company’s D&O coverage. This may pose several challenges. Lawsuits may claim that actions taken by the private equity fund before the target company was acquired resulted in the low valuation of the target company. Under such a scenario, it would be difficult to assert that the private equity fund was a named insured under the target company’s insurance before the acquisition took place. Furthermore, some D&O policies allow additional parties to qualify as insureds only after the insurance company has consented to the addition. Securing that consent prior to the completion of the acquisition could be extremely difficult.

Second, the private equity firm may seek coverage under its own D&O policies. This presupposes, however, that the private equity fund has its own D&O coverage. In addition, depending upon whether the alleged wrongful acts occurred before or after the target company was taken private, it may be necessary that the insurance policy provides coverage for outside directorship liability. Given the sparse disclosure requirements for private equity funds, determining how many funds carry such insurance can be difficult. Some recent estimates, nonetheless, have put the number at less than 50 percent. Because of the increased attention—and increased number of law suits—the number of private equity firms that carry D&O insurance will likely increase dramatically in the near term.

For those funds that do carry D&O insurance, it is important to make sure the coverage extends to outside directorship liability. Outside directorship coverage protects the private equity firm and its employees, officers or delegates from exposure generated from the firm’s portfolio companies. Such coverage typically provides coverage for any losses arising from any claim made against any insured who was, is or may become, at the specific request of the company, a director or officer of any outside entity for any wrongful act in the insured’s capacity as a director or officer of the outside entity.

Through this provision, the private equity fund could access its own D&O policy to provide coverage for claims arising from the operation or management of its portfolio companies.


The past year saw enormous growth in the number and size of private equity deals. The flood of news on these private equity deals has brought with it an increase in the number of claims asserted against private equity firms as well. D&O policies can provide coverage for the defense and settlement of these claims and offer protection against a private equity fund taking a multimillion (or larger) charge for the defense and settlement of these claims. For this reason, private equity funds should be sure they have obtained necessary coverage and that the insurance covers the claims and risks unique to private equity funds.

Daniel K. Winters is a partner in the Insurance Recovery Group at Reed Smith LLP; reach him at Douglas E. Cameron is head of the Insurance Recover Group, and also a partner; reach him at