Liability Risks for Directors of Start-ups and D&O Insurance Coverage

As a rule, founders will want to avoid being personally liable for the start-up to the extent of their private assets. For this reason, they will generally use a company as the commercial entity, such as a limited liability company. This means that the shareholders are normally not personally liable beyond any capital contribution. In fact, the risks of personal liability for the directors of the start-up, even where a company is used as legal entity, is often forgotten in the euphoria at the initial stages of a start-up. Directors have a duty to the start-up to manage the business of the start-up with the diligence of a prudent businessperson. Directors, who breach their duties, are liable to the start-up for any damage arising (see § 43 German Limited Liability Companies Act, GmbHG).

In their daily work, managers are therefore constantly exposed to a risk of personal liability. Since the Siemens scandal, this starts with the recognised obligation on directors to ensure compliance with all relevant laws (compliance). Such statutory requirements are constantly increasing, the General Data Protection Regulation (GDPR) is just one example. In addition, directors have a duty to manage the company with care. Apart from that, the directors have a further, but not unlimited discretionary power when taking decisions on behalf of the company. In addition, the directors must act for the good of the company on the basis of appropriate information. If something goes wrong and the company suffers damage, it has become almost a reflex action today to ask whether the directors can be found liable. Even if frustrated shareholders don’t question of the liability of directors for the damage caused, at the latest, ay insolvency administrator appointed in the case of insolvency will examine the previous decisions of the directors.

Against this background, it is almost standard now for companies to take out socalled D&O insurance. This provides insurance cover, in accordance with the applicable insurance conditions, when a claim is made against directors for the breach of one of their mandatory duties in their activities for the company. In the case of start-ups, the liability risks for directors are often significantly higher than they are in the case of established companies. Often, reinforced work processes or instructions have not yet been established. The company is likely to face many issues for the first time, so that there are some uncertainties and little experience. Often, personnel or financial resources are not sufficient to allow all relevant issues to be recognised and sufficient care to be taken. Sufficient insurance cover, in particular D&O insurance, is therefore recommended, particularly for start-ups.

This is why we spoke to one of the leading insurance agents about the extent to which these risks can be insured and what you should keep in mind when taking out insurance. As with so many things, the devil is in the details, which in the case of insurance means in particular the scope of the insurance protection and the specific insurance conditions.

What are the liability risks for managers of start-ups?

Under law, directors will be liable to the extent of his private assets to the start-up company for all financial loss arising due to a breach of a duty of care. Many start-ups go bankrupt. The most common reasons for this are the lack of business plans, insufficient equity base, no followup financing or no "Plan B". A lack of marketing or deficits in accounting or in human resources can also lead to insolvency. Then not only customers, but also official authorities such as tax authorities, data protection authorities, and social security agencies and health insurance funds will proceed against infringements with much more focus than they did a few years ago. At the same time, the claim mentality has changed. In the case of a loss of assets, shareholders and insolvency administrators appointed by the court will not delay for long. They want those responsible to refund any loss suffered by the start-up. The insolvency administrator even has its own liability risk, that he satisfies when preparing the insolvency by assessing whether any claims can be made against board members in order to increase the insolvency assets.
Can you designate typical board duties?

Naturally, as a director, I have to comply with all formal rules, i.e. all laws and the articles of association of the company. In addition, I must avoid breaches of my duty of care which may lead to adverse business or risks for the start-up, such as bad investments or debts. Typical duties of directors include selecting the right personal, properly managing the business operations and continuously monitoring the compliance with all legal, operational and commercial rules. These duties intensify when money is tight. Supervisory or controlling advisory boards also have control duties. Such board members are also liable with their private assets to the start-up if they fail to properly oversee the management and this results in loss of or damage to the assets, or if the board members fail to pursue damages claims against the directors.
Companies take out D&O management liability insurance on company costs for their directors for exactly these types of cases. Should start-ups do the same?

Definitely. The risks are the same. Ultimately, managers can be personally liable for bad decisions for minor negligence, and this liability is unlimited.

In the case of emergency, the D&O insurance will pay the legal costs of the defence against unjustified claims for damages and will pay out any justified claims. Compensation for damages is also in shareholder’s interests, because it guarantees certain "balance sheet protection" for shareholders while later enforcement against private assets may show little chances of success.
How high are the premiums normally and what documents does an insurer need in order to take out the insurance?

This depends on the sum that should be ensured insured and its availability on the market and, in particular, on the business plan. Whether, to what extent and for what amount an insurer decides to offer insurance cover depends crucially on their positive assessment. A detailed presentation covering a number of years and including the planned economic developments and financing is important for the insurer’s assessment of the risks and the offer of a reasonable insurance quote. The curriculum vitae of the directors and their experience in the field of business also play a role in the assessment of risk. If all factors fit, coverage of EUR 2 – 3 million can be obtained for premiums of EUR 2,000 - 4,000. These are normally operating expenses.
What if the company does not want to finance D&O insurance because the shareholders are against it?

A director may always take out their own personal D&O insurance and pay for it from their own pocket. The requirements with respect to the necessary documents are the same. A director who takes out his own personal D&O insurance has a sum that is insured and does not need to share this insured sum with anyone else. However, in practice, there is an increased risk that the director will be held personally liable if the existence of this insurance becomes known. For this reason, if possible, the director should not inform the company that he has taken out private D&O insurance.
What happens when the public prosecutor’s office is suddenly standing on the start-up’s doormat or the start-up has received post from an investigating authority requesting information about alleged infringements (e.g. data protection infringements, tax evasion, etc.)?

We recommend taking out company regulatory insurance or company criminal insurance, which the start-up can also pay. When authorities investigate, you cannot control the investigations. The state is not at all concerned about holding the legal person, i.e. the company, responsible, but instead looks to identify the company directors and/or the employees responsible. Those who have to defend themselves against criminal proceedings need a good defence lawyer. And lawyers can be costly. Good criminal insurance will cover even a good lawyer’s hourly rate. If the company does not want to pay the insurance premiums, we recommend that directors conclude their own personal criminal insurance at their own costs.
What should you bear in mind when concluding such an insurance policy?

The "fine print". The market for director insurance is not consistent and policies can be difficult to understand for directors and even for lawyers. In addition to a good product that provides comprehensive protection for the identified risks, a high degree of expertise in providing advice is fundamental, so that the director will not be left alone "in the rain" in the case of a claim. As a specialist agent, we make our D&O expert teams and our own network of lawyers available, as well as our claims department, which interfaces between customers and the insurer and is there to assist directors in the event of a claim.