Recently, I’ve discovered some of my crypto clients are having trouble obtaining an important business planning tool: directors and officers (D&O) liability insurance. In my opinion, as I’ll explain, a combination of COVID-19 “event-driven” litigation, crypto regulatory uncertainty, and a misunderstanding of crypto on the part of some in the insurance industry, is making it difficult for crypto entrepreneurs to secure an important service.
Many countries, including the U.S., impose a fiduciary duty on directors and/or executive officers that they owe either to the shareholders or to the corporation. Depending on the jurisdiction, the law may impose a “duty of care,” a “duty of loyalty” or a “duty to promote the success of the company.”
However you define it, it means these individuals are held to the highest legal standard of care, where a breach of the fiduciary duty on the part of directors or officers may expose them to steep penalties, which often include jail sentences.
There are important policy reasons why directors and officers should be protected from liability. Arguably, directors should be free to run the business, operations, and affairs of a corporation in a decisive manner without the fear that any action they take could lead to personal liability. Limitation of liability promotes healthy risk taking by management, which, one hopes, leads to economic benefits for a corporation. This is supported by the reality that in the laws of many jurisdictions corporations, legal entities are separate and apart from their stakeholders.
In an effort to protect directors and officers from liability, corporate bylaws often mandate that, provided directors and officers fulfill certain duties, the corporation will indemnify them against costs if they are sued.
“Cryptocurrency companies are suffering from a perfect storm of sorts, which is making it difficult to obtain D & O insurance."
In other words, the corporation will pay to defend and pay the damages awarded against directors and officers who are sued simply for doing their jobs.
A corporation may also enter into an indemnification agreement with a director or officer, providing a similar type of broad indemnification as can be contained in the corporate bylaws. A major difference between indemnification under the by-laws versus an in-house indemnification agreement is the latter can’t be unilaterally terminated without the consent of the other party. By-laws, on the other hand, may be changed by a corporation at any point in time, provided the appropriate director and/or shareholder approvals are obtained.
Why is D&O insurance necessary in light of the above protections? Insurance is critical because it can be used to mitigate risk as well as cost. When directors and officers are being sued, chances are the corporation is being sued as well, and the corporation may not have enough funds to defend itself as well as pay the legal costs of the directors and officers. Finally, the interests of the director or officer may not be completely aligned with that of the corporation, and in order to prevent a conflict of interest it may be necessary for the director or officer to obtain his or her own independent counsel.
Crypto company management may want to pay special attention to D&O Insurance, especially in light of the cybersecurity risks facing platforms such as crypto exchanges, and considering the immature state of crypto law.
Based on conversations I’ve had with insurance brokers and feedback I’ve received from clients in different parts of the cryptocurrency industry, I believe cryptocurrency companies are suffering from a perfect storm of sorts, which is making it difficult to obtain D&O Insurance.
First, due to COVID-19, insurance companies are reluctant to provide D&O insurance in general due to a concern about COVID-19 “event-driven” litigation. Many companies, particularly in the travel, entertainment, and restaurant industries, are barely staying afloat amid continued lockdowns and social distancing. Stakeholders are looking to hold corporations and their management liable for losses and damages resulting from employee terminations, reduced dividends, and corporate insolvencies.
Secondly, there is the current murky state of the law governing cryptocurrency. Regulators continue to review regulations to address issues and provide greater certainty. Because of the uncertainty surrounding law in the context of securities, there is an increase in litigation and people looking to the courts to decide the matters.
In the last eight months, there has been a flurry of lawsuits targeting corporations active in the cryptocurrency space. As Kevin M. LaCroix writes in The D&O Diary, April 3, 2020, was a pretty big day for securities class action lawsuits in the U.S. On April 3, 2020, 11 total cryptocurrency-related securities lawsuits were filed in a single day, which is likely unprecedented. The lawsuits were all filed in the Southern District of New York, and they targeted four crypto exchanges and seven token issuers.
Significantly, LaCroix says, in addition to the defendant corporations, each of the complaints targets certain directors and officers of each of the defendant corporations.
Third, I’ve been told that some members of the insurance industry do not understand cryptocurrency and tend to dismiss it as being a scam or too risky to insure. A colleague recently related a story where he spent almost an hour debating with an insurance broker about why Bitcoin is not a Ponzi scheme.
My hope is that as crypto enters the mainstream we will see critical industries, such as insurance, better understand and warm up to the technology. Ideally, as a crypto corporation commences operations, it will have an adequate D&O insurance policy in place. But in the absence of a proper D&O insurance policy, crypto entrepreneurs can still mitigate their risks via a properly drafted set of corporate bylaws or an indemnification agreement.
Matthew Burgoyne is a corporate and securities law partner at McLeod Law LLP in Calgary, Alberta. He has advised clients in the cryptocurrency space since 2013 and is chair of McLeod Law’s cryptocurrency and blockchain group.