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Disgruntled Investors Are a Big Crowdfunding Risk

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When the Securities and Exchange Commission adopted Regulation A+ in March, the new rules exposed companies that raise capital through crowdfunding to new risks.

Regulation A exempts small issuers of securities from registration. As part of the Jumpstart Our Business Startups (JOBS) Act, Regulation A+ expands on that exemption by allowing two tiers of securities offerings. Tier 1 allows up to $20 million in offerings in a 12-month period, but less than $6 million can be from sellers affiliated with the issuer. Tier 2 allows for up to $50 million in securities offerings, and less than $15 million can be from sellers affiliated with the issuer.

Monica Minkel is senior vice president and executive protection practice leader at Poms & Associates Insurance Brokers. She says firm leaders need to make sure they’re protected by directors and officers liability insurance, especially when they introduce multiple new investors through crowdfunding.

“What Reg A+ does is it allows private firms to raise money similarly to how a large company would raise money through an IPO,” she told ThinkAdvisor on Tuesday. “It opens up the opportunity for additional investors to contribute capital to a private firm.”

When companies bring in new investors to raise money, “we see an exposure there from a liability perspective where a D&O insurance product or some of the other products that we have could help protect the leadership team of the company as well as the balance sheet itself.”

Minkel said raising capital is one of the top three triggers that make D&O insurance an important aspect of protecting executives at private firms.

“When you look at companies that have a need for directors and officers liability, almost every publicly traded company out there buys D&O because they recognize the exposure that they have from securities claims from the various investors that they have in the company who may find fault with the leadership or the management of the organization,” she said.

She said that when current and future investors “find fault with the valuation of the company, you can have a situation where the funding fails and the company doesn’t succeed. You can have a situation where you bring in new investors to the company who perhaps don’t have that personal relationship with the leadership team; you go from a small family-owned company to a company with 100 investors and they’re more disconnected from it. They might not be patient about helping the company through their challenges or waiting until they find success.”

D&O coverage helps a firm’s leaders fight claims from those disgruntled investors of “allegations of mismanagement, misrepresentation and other negligence in the management of the company itself,” Minkel said.

Premiums for that type of coverage vary wildly, Minkel said, “and by that, I mean I’ve seen premiums as low as $750 and I’ve seen premiums in excess of $1 million.” Factors that affect pricing include the assets held by the company, the state of domicile, the industry class, overall financial health, merger and acquisition activity and the firm’s growth rate, Minkel said.

“Not only does premium vary widely depending on the company, but coverage varies widely depending on the carrier,” Minkel said. “Last week I had a carrier in my office for an hour and a half. He said, ‘I want to exclude crowdfunding from my policies. How do I do it?’”

She said many policies have exclusions for crowdfunding, “or if they don’t have an exclusion, they’re not actually providing the broad coverage you need if you’re going to do a Reg A+ offering.”

Regulation A+ doesn’t affect the data security needs of firms that use crowdfunding to raise capital, but Minkel stressed that such coverage is something all firms need.

“Although Reg A+ doesn’t directly impact the need for data security and privacy liability and cyber liability, all companies, I don’t care how big or small you are, have exposure to a data breach or a hacking attempt,” she said. To illustrate, she referred to the Italian firm Hacking Team, which provides hacking software and surveillance tools to governments and law enforcement agencies and which was itself hacked earlier this week.

“Here are the guys who are basically writing the software to hack into other companies and they themselves were vulnerable,” Minkel said. “All companies have vulnerability. No matter how good your internal policies and procedures are, all of us have users who occasionally click on an email we shouldn’t, or click on a link or an ad on Facebook that perhaps is problematic, and then we end up with malware or keystroke trackers on our computer. Frankly, us as users, we’re the biggest liability.”

— Check out SEC: Intrastate Crowdfunding Rules Predate Internet, Need an Update on ThinkAdvisor.