SEC Action Highlights Importance of Specific Language in Directors and Officers Insurance for Fintech and Other Startup CompaniesThe founder of Mozido, the fintech startup once claimed to be valued at $5.6 billion, has been named as a defendant in a civil lawsuit filed by the Securities and Exchange Commission (SEC). The complaint names Michael Liberty (and others) individually and also names corporate entities related to Mozido as defendants. This action by the SEC highlights the importance of ensuring adequate Directors and Officers (D&O) insurance for startup fintech entities and for their directors and officers. In addition, the fraud allegation illustrates the significance of negotiating specific language in the standard D&O fraud exclusion.

In its civil complaint, the SEC asserts that the defendants engaged in a “long-running fraudulent scheme using multiple fraudulent securities offerings” that “tricked investors into believing they were funding fast-growing startup companies.” The complaint further alleges that this fraudulent scheme “centered on MDO, a financial technology company (then known as Mozido LLC), and later on Mozido, Inc.” and that “Liberty claimed to be the founder of MDO and served as a de facto officer of MDO and Mozido, Inc.” The 66-page complaint asserts a number of securities fraud claims and seeks injunctive relief, disgorgement, and civil monetary penalties.

The typical D&O policy provides insurance coverage under three different insuring agreements, commonly known as Side A, Side B, and Side C coverage. Side A provides “direct” or personal liability coverage for individual directors and officers where the company cannot legally provide a defense or indemnify loss (where such indemnity is prohibited by state law) or where the company is financially unable to do so. Side B indirectly covers the individual directors and officers of the company by reimbursing the company for defense or indemnity payments that the company has made or is required to make on behalf of its directors and officers. Side C, which is also known as “entity coverage,” provides coverage for claims against the company itself. In short, D&O insurance may protect corporations from potentially sizable losses and also protects the individual directors or officers against those losses when corporate indemnification is not available.

The insuring agreement of most D&O policies will provide coverage for “loss” that is incurred as a result of a “claim” made for a “wrongful act.” While the specific language of D&O policies varies, the term “claim” typically refers to an assertion of a legal right or demand for payment by a third party against the insured, and the term “wrongful act” generally is defined as “actual or alleged act, error, misstatement, misleading statement, omission or breach of duty.” Importantly, the term “loss” usually includes defense costs; the value of the D&O policy in providing coverage in response to claims such as the SEC complaint is that the insurer should advance defense costs to an individual, or corporation, accused of offenses.

In addition, most D&O policies will include a “fraud exclusion,” which excludes coverage for claims based on an insured’s fraudulent act. A policyholder may incorrectly assume that a claim alleging a “long-running fraudulent scheme,” such as the SEC complaint, is excluded by a D&O policy. It is important to understand, however, that under the fraud exclusion language found in many D&O policies, allegations of fraud alone are insufficient to trigger the exclusion. For example, the fraud exclusion may apply only when there is an “actual finding of dishonesty or fraud,” a “final adjudication of fraud,” or better yet, fraud that is “established by a final and non-appealable adjudication.” Courts interpreting such narrow fraud exclusions, which are construed against the insurer, have generally found that “actual finding” requires a finding of fraud by a court. When such language is included in the fraud exclusion, the D&O insurer should provide coverage for claims such as the SEC complaint, unless and until a court finds the defendant has committed fraud.

Any fintech startup should work with coverage counsel and an experienced broker to identify risks and consider procurement of insurance to offset those risks. Counsel and the broker can help ensure that policy language, such as a narrow fraud exclusion, will maximize coverage to the insured in the event of a claim.