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By Ivan J. Dolowich, Rosa Hong and John E. Iannotti

On April 5, the directors' and officers' insurance landscape was altered by the passage of the Jumpstart Our Business Startups -- or JOBS -- Act, one of the most far-reaching securities laws of recent years.

Even though the Act will not fully take shape until implementing regulations are adopted by the U.S. Securities and Exchange Commission, it is already clear the new law will pose challenges for directors' and officers' underwriters as they balance market demands and changing risk exposures.

With its sweeping changes to the current securities regulatory environment, the JOBS Act presents varied challenges to both public and private D&O underwriters. But the key provisions of the Act that are perhaps most important to underwriters relate to the regulation of initial public offerings and private capital-raising.

In order to reduce the barriers to going public, the JOBS Act creates a new class of issuers for so-called "emerging growth companies," which are subject to reduced disclosure, compliance and governance requirements during -- and for up to five years after -- the IPO process.

Emerging growth companies, broadly defined as companies with less than $1 billion in annual revenue and $700 million in market capitalization, can, among other things, file registration statements with the SEC on a confidential basis, provided such statements are made public at least 21 days before the IPO "road show." Emerging growth companies also have substantially reduced disclosure obligations and, notably, they are not subject to the required Sarbanes-Oxley auditor attestation report on internal controls.

The IPO provisions of the Act are designed to lower barriers to going public and, if they operate as intended, there should be an uptick in the number of IPOs that are conducted.

Previously, companies contemplating an IPO were often deterred by the complex and costly process of going public, which included disclosure of sensitive information, strict limitations on the company's conduct, and onerous disclosure and reporting obligations following the IPO.

With the newly relaxed IPO rules, companies should find it less burdensome and costly to go public, which means that demand for public D&O insurance could potentially increase.

At the same time, the ultimate cost of lowering regulatory hurdles remains unclear.

On the one hand, reduced regulatory requirements may lessen the liability exposure for emerging growth companies and their directors and officers, since such companies will not have the same duties and obligations forming the basis of many claims pre-dating the Act.

On the other hand, the risks of those relaxed requirements may cancel out potential decreases in liability.

One such risk is that emerging growth companies may go public before they have proper internal controls and compliance systems in place. In that case, growth companies seeking coverage may not have the mature control systems that would lower the risk of potential claims. This risk is compounded by the Act's elimination of the requirement of auditor attestation reports.

Ultimately, the decreased scrutiny on internal controls, combined with the likely higher incidences of weaknesses at smaller and younger emerging growth companies, could lead to problems down the road if weaknesses go undetected and uncorrected until a lawsuit is filed or other troubles surface.

Another risk is tied to an emerging growth company's ability to file its registration statement on a confidential basis with the SEC.

This provision makes the prospect of going public more attractive, since, if the IPO is cancelled or delayed, a growth company can withdraw its registration statement without having to attract negative publicity or publicly disclose confidential information.

However, the decrease in transparency and delay in investors learning of any issues with the offering is an important consideration for D&O underwriters.

In view of the uncertainty of insuring emerging growth companies, underwriters may want to consider incorporating some safeguards into the policy forms to take the potentially increased risk into account. For example, rather than rely on a request for all filing statements, the policy application could include a more detailed questionnaire that requests more of the company's financials, possibly with independent verification, as a countermeasure to the relaxed disclosure requirements under the Act.

In addition, if an emerging growth company files its IPO documents on a confidential basis, the insured should provide ample advance notice to insurers to make sure the appropriate public company insurance is in place when it becomes public.

Since the company's registration statement may not be publicly available until 21 days before the road show, the timeframe for procuring the appropriate insurance is significantly shortened.

Another provision of the JOBS Act that is very important for underwriters is the "crowd-funding" exemption, which represents a major change in private capital-raising. Under this exemption, private companies can sell up to $1 million of securities to a large number of investors via online platforms without being subject to registration requirements.

While the creation of the crowd-funding exemption means that private companies will have greater access to capital, investors may be at a higher risk of making poor investments due to the reduced disclosure requirements. The Act's crowd-funding provisions open the door to potential civil actions that may not be covered under a typical private directors' and officers' policy. Under the Act, a purchaser in a crowd-funding offering may bring suit against a company and its directors and officers for rescission or recessionary damages in the event of material misstatements or omissions in connection with the offering.

In this regard, the line differentiating a private company from a public company in the context of D&O insurance is blurred, because a federal securities law is, in effect, regulating a non-public company.

From an underwriting perspective, this requires a close look at any securities law exclusions in a private D&O policy to make sure they are not so broad as to exclude crowd-funding claims. As suggested by other commentators, the wording may indicate the exclusion applies only where an IPO is actually conducted -- since crowd funding would then not fall within the exclusion -- or, if there is a carveback for specified transactions, such a carveback should include crowd-funding offerings.

Another possible consideration for underwriters is how loss is defined in the standard directors' and officers' policy form, which may be an issue in light of the remedy provided for investors in crowd-funding offerings.

Since this remedy is restitutionary in nature, and given that the Act's crowd-funding liability provisions mirror Section 12 of the Securities Act -- and Section 12 claims are not precluded from coverage under most public D&O policies -- private directors' and officers' insurers may want to follow suit and make sure that settlements and judgments arising from a crowd-funding claim count as covered loss under the policy.

If the JOBS Act is successful in meeting its goals, reduced regulatory burdens will lead to privately held companies having better access to capital through public markets, exempt securities offerings and the Internet; and more companies will go public through the IPO process.

However, although the ultimate impact of the JOBS Act on directors' and officers' underwriters will not be known until the SEC adopts regulations implementing the Act, liability exposures for public and private D&O insurers will need to be carefully assessed as the new law gains its footing. This will certainly demand an equally close inspection by underwriters.

IVAN J DOLOWICH is a partner in Kaufman Dolowich Voluck & Gonzo LLP's Woodbury, N.Y., office. ROSA HONG is an attorney in the firm's New York office. JOHN E IANNOTTI is senior vice president of Everest National Insurance Co.

July 24, 2012

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