Law Offices of Vance R. Koven | Latest Blog

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Law Offices of Vance R. Koven | Latest Blog

Insure For When the SEC Knocks

Wednesday, April 18, 2018

An article published yesterday caught my eye in that it focused on a previously unremarked aspect of a Securities and Exchange Commission (SEC) enforcement action I have been following. It's worth mentioning here.

A month or so ago the SEC brought a civil lawsuit against the founder of Mozido, a financial technology (fintech) company, alleging that he had fraudulently induced investors into putting money into companies he controlled, giving the investors to believe that they were investing in Mozido itself (Mozido is not a party to the SEC action).

The factual setting of this case is interesting and somewhat unusual for involving several different layers of business entities, some off which the founder controlled and some he didn't. However, the reason for mentioning it here is twofold.

First, it is a cautionary tale for startups and other privately held (that is, not listed on a stock exchange or otherwise subject to SEC registration requirements) businesses, that one area of the US securities laws applies to everybody: fraud in connection with the purchase or sale of any kind of security in a company is a civil and criminal violation of federal law (and state law too). These laws and regulations apply to shares of stock, bonds and other debt instruments, interests in LLCs (where the holders are not active managers of the business) and any other kind of arrangement where the holder stands to profit from the management of the business by someone else. Needless to say, there are many ifs, ands, and buts, but that's the general principle, and you don't have to be "unicorn" startup like Mozido to be enmeshed.

Second, and the specific reason I brought up this article, is that startups and other privately funded businesses can mitigate some of the pain when they or their directors or officers get caught up in SEC (and in some cases private) lawsuits under the anti-fraud rules, by having Directors' and Officers' (D&O) liability insurance. These policies cover defense costs and ultimate liabilities under separate headings for the company's direct liabilities, the directors' and officers' direct liabilities, and the company's liabilities under indemnification provisions of its organizational documents. While SEC policy states that companies may not indemnify a director or officer guilty of fraud, it doesn't prevent that person from having insurance.

As the article points out, even if it turns out that the policy does not cover an aspect of ultimate liability, the insurer's duty to defend usually continues until there is a determination by a court that the potentially insured person was liable. That alone is worth the price of admission in many cases. Some policies take a more generous view of defense costs than others, and may cover a company's costs in persuading the SEC that it should not be charged even if its officer or director is.

For these reasons, any business looking to raise money from other than its principals should make D&O insurance part of its basic setup package. You can read the entire article here.