When private companies are on track toward a planned IPO, much of the focus and attention is on readying the company for the burdens and responsibilities it will face as a public company. Among other things, this also means a focus on the potential liability exposures for the company and its directors and offices once the company goes public. Until the company actually completes its planned offering, however, it is still a private company — albeit one with a heightened set of risk exposures because of the company’s pre-IPO activities. If the planned IPO never happens, the company and its senior officials sometimes face liability claims arising from pre-IPO activities. A recent complaint filed in the Northern District of California against the former directors and officers of a pre-IPO company that ultimately went bankrupt illustrates the kind of claims pre-IPO companies and their executives can face. Pre-IPO companies’ liability exposures have important implications for the companies’ D&O insurance programs, as discussed below.
Background
On March 8, 2017, plaintiff investors filed a lawsuit in the Northern District of California. A copy of the plaintiffs’ complaint can be found here. The plaintiffs are investment funds that purchased securities in a company called Delivery Agent. The defendants are former directors and officers of Delivery Agent. Delivery Agent was engaged in television-commerce; according to the complaint, the company “claimed to have developed proprietary technology to connect television viewers to the products they see on TV and the companies that offer those products.”
The case summary below is based solely on the unproven allegations of the complaint. By summarizing the allegations here, I do not intend to suggest that the allegations do or do not have any basis in actual fact or that the claims asserted do or do not have any merit. My purpose here is simply to show what the complaint alleges.
The complaint alleges that between March 2014 and March 2016, the company issued and sold securities to investors, including the plaintiffs, with the represented goal of covering the company’s short term negative cash flow until it had achieved positive cash flow and completed an IPO. The complaint alleges that the defendants “consistently and repeatedly represented that an IPO was ‘imminent.’” The plaintiffs allege that in reliance on defendants’ representations about the company’s technology and its planned IPO, they ultimately invested about $17 million in Delivery Agent.
The complaint alleges further that the company failed to disclose that its high profile demonstration of its technology in a February 2014 Super Bowl commercial was “a complete failure” because viewers were unable to use Delivery Agent’s technology. The complaint also alleges that the company’s CEO ordered Delivery Agent personnel to purchase the products in the Super Bowl ad once it was clear that the technology had failed. The plaintiffs also allege that the company disseminated false information about the sales following the failure of the Super Bowl commercial.
The complaint further alleges that shortly after the Super Bowl commercial failure, a whistleblower contacted the company’s auditor and provided information about what happened with the commercial, including the product purchases by company officials and the alleged misrepresentations about sales following the commercial. The auditor alerted the company’s board’s audit committee of the report and began investigating.
Meanwhile, following the Super Bowl and following the report to the audit committee, the documents prepared in connection with subsequent private financings described the company as “poised for success” and as planning to go public in April 2014. The company circulated to investors (including the plaintiffs) a draft S-1 that the company had prepared for its “imminent” IPO. The draft S-1 referred to the sale of product in connection with the Super Bowl commercial. In subsequent conversations with plaintiffs’ representatives, company officials allegedly describe the Super Bowl ad as a success and provided reassurances that the company was on track for an IPO. Company officials also provided the plaintiffs with an updated version of the draft S-1.
The complaint alleges that the audit committee’s investigation of the whistleblower reports resulted in findings that consumers had been unwilling or unable to buy products in connection with the Super Bowl commercial; that company personnel had bought products following the commercial; and that, according to the complaint, the company “subsequently misrepresented that the merchandise had been purchased by consumers.” The audit committee allegedly advised the auditor of these findings in March 14, 2014, but the documents in connection with the offering completed on March 18, 2014 allegedly did not reflect and were not updated to show these findings.
According the complaint, a series of actions between the auditor and the company ensued, which culminated in the company’s termination of the auditor on July 29, 2014. According to the complaint, because of the additional disclosures that the auditor termination would require, the auditor termination effectively ended the realistic possibility that the company would complete its IPO.
The complaint further alleges that even while the company was “feuding” with its auditor, it continued to solicit additional investments, while providing reassurances about the company’s past successes, future promise, and even about its planned IPO. The company also prepared and circulated updated drafts of its draft S-1 in June 2014, October 2014, and January 2015, which allegedly referenced among other things the success of the Super Bowl commercial. The complaint further alleges that while the company disclosed that it was changing auditors, it did not disclose the reasons for the termination.
A long series of events ensued in which the company allegedly sought to explain the delays in providing audited financials, and in which further reports regarding the Super Bowl advertisement were produced. Ultimately the company was unable to raise further financing. In September 2016, the company filed for bankruptcy under Section 11 of the bankruptcy code.
The complaint asserts claims for damages against the defendants under Sections 10(b) and 20 of the Exchange Act; as well as claims for fraud and negligent misrepresentation.
Discussion
As I noted above, the case summary above refers only to the unproven allegations of the complaint. There undoubtedly is another side to this story, and the defendants may and likely do have defenses to the allegations that are not apparent from the face of the complaint. Again, my purpose here is simply to show what was alleged, as a way of illustrating the kinds of claims that can arise against pre-IPO companies and their directors and officers when the companies fail to complete their planned IPO.
While this case is only at the very outset, even at its earliest stages it provides an interesting example of the kind of claim that can arise when a pre-IPO company “fails to launch.” When the planned IPO fails to take place as hoped or intended, there are going to be various constituencies that may be disappointed. For example, as was the case here, pre-IPO investors who allegedly relied on the completion of the IPO may feel aggrieved, particularly when the reasons the IPO did not take place is the company’s failure to complete or execute on its business plan.
Regular readers of this blog know that this case is far from the first example of a pre-IPO company’s failure to launch resulting in claims against the company and/or its directors or officers. I have written about prior examples of pre-IPO failure to launch claims (for example, here, here and here As this case and the prior examples show, when these kinds of companies are unable to execute on their IPO plan, disappointed investors may, like the investors here, assert claims for damages based, as was the case here, upon alleged misrepresentations. These claimants might also assert claims based on detrimental reliance and frustrated expectations.
I am reiterating these points about the pre-IPO company’s liability exposures for possible failure to launch claims for a specific reason. That is, when a company is planning an IPO, there is a natural tendency among both company officials and the company’s advisors to focus on what the company will face once it goes public; this is true in numerous respects, but in this context, it is particularly true with respect to the company’s future liability exposures.
As a result of this focus on the company’s possible needs as a public company, a great deal of thought and attention is given to ensuring that the company will have an appropriate D&O insurance program in place when it goes public. This effort is entirely appropriate, because the liability exposures the company will face one it completes its IPO are considerable. However, this post-IPO focus may overlook the fact that the company potentially may face liability exposures if, like the company here, it fails to complete the planned offering.
The possibility of a “failure to launch claim” arising if the company fails to complete the planned IPO has important D&O insurance implications. If the company gets hit with a failure to launch claim, the D&O insurance program that will respond to the claim is not the public company D&O insurance program that was intended to go into effect at the time the planned offering was completed; rather, the D&O insurance program that will be implicated is the private company D&O insurance program that the company had in place and that will remain in place unless and until the company completes its planned IPO.
Because the private company D&O insurance policy is the one that will be implicated by any failure to launch claim, it is important that the private company policy’s terms and conditions take the possibility of these kinds of claims into account.
Among other things, the wording of the Securities Exclusion typically found in most private company D&O insurance policies could be very important. The Securities Exclusion should be reviewed to ensure that it does not exclude liabilities for pre-IPO activities, such as roadshows, or for pre-IPO documents, materials and statements. The best approach to the Securities Exclusion will state that it is will only apply when and if the company’s registration statement is declared effective by the SEC or the securities registration process is complete according to the rules and requirements of any other country’s regulatory body that is the country’s equivalent of the SEC.
To the extent that company management are willing to take time during the lead up to the planned offering to talk about D&O insurance related issues, it is often with a focus on insurance needs the company will have once its shares are publicly traded. However, as this case shows, claims can and sometimes do arise against companies after their IPO plan falls short, based on activities and events that take place in the period that preceded the ultimate failure to launch. For that reason, it is critically important, as companies ready themselves for planned IPOs, that they also consider the demands that could be placed on their existing private company D&O insurance policy.
One final insurance note about this case. The complaint mentions (see paragraph 89) that at least by some point in early 2015, the plaintiff investment funds had a representative on Delivery Agent’s board of directors. Whether or not this fact creates an insurance question depends on the actual circumstances as well as the wording of the insured vs. insured exclusion in the relevant portion of the company’s D&O insurance policy. However, the fact that the plaintiffs’ representative served on the company’s board at least raises the question of whether or not the relevant policy’s insured vs. insured exclusion is implicated.
House Passes Class Action Litigation Fairness Act of 2017: On March 9, 2017, the U.S. House of Representatives passed the Class Action Litigation Fairness Act of 2017, a bill that I discussed in a prior post here. The Class Action Lawsuit Defense blog has a good short summary of the legislation as passed by the House, here.
Readers may recall that one of the objections to the bill as originally proposed was that it prohibited attorneys from serving as class counsel that had previously represented the named plaintiff in any prior matter; in a February 22, 2017 guest post on this site, Columbia Law School Professor John Coffee noted his particular concerns with this provision.
While the draft bill was still in committee, the bill’s sponsor, Rep. Bob Goodlatte, introduced a number of amendments; among other things the amendments struck the prohibition on the use of the same class counsel if the named plaintiff is a present or former client, or has a contractual relationship with, the class counsel. The amendments also carved out private securities litigation class actions from the conflict of interest and stay of discovery sections. These so-called Manager’s amendments can be found here.
Absent further proceedings in the House, the bill will now move to the Senate for further consideration and action. Readers may recall that a predecessor to this bill that Rep. Goodlatte introduced in the prior Congressional term successfully passed the House but did not make it out of the Senate. It remains to be seen how this bill will fare in the Senate, and if it passes, what the form of the legislation ultimately will be.
What Makes Life Worth Living?: On Saturday morning, I was listening to the radio while taking care of some domestic chores. Mozart’s Symphony No. 41 came on the radio; the symphony is often referred to by its nickname, the “Jupiter Symphony.” This piece of music – Mozart’s last symphony – includes the symphony’s famous Second Movement, scored Andante Cantible. You can listen to the Second Movement here.
In Woody Allen’s 1979 film Manhattan, Allen, playing the film’s main character, dictates into a cassette sound recorder his list of the things he thinks make life worth living. The Jupiter Symphony’s Second Movement comes third on Allen’s list, after Groucho Marx and Willie Mays, and before Louis Armstrong playing the Potato Head Blues. The scene ends touchingly when Allen finishes his list in a reverie, after noting the final item on his list, “Tracy’s face.” (Tracy is played in the movie by Mariel Hemingway.) I confess that pretty much on a continuous basis since seeing the movie when it first came out, I have been composing my own comparable list. Buy me a beer sometime and I will be happy to share my list with you.
Here is a short YouTube video of the scene from the movie (sorry for the ad at the beginning of the video, at least it is short):