Liability risks for startups

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2023 December 04

Startup businesses are known for bringing innovative products, services, and solutions to market; however, they often operate in uncharted and uncertain territory which can present considerable risks.

These risks can cause the budding entrepreneurs of these startups to face lengthy and costly litigation when things go wrong. Here are two key areas that result in liability claims for startups.

Insolvency

Insolvency is one of the most common reasons to trigger a Directors & Officers (D&O) Liability claim. If a startup fails and is forced to liquidate, investors will typically lose most, if not all, the capital they invest in the company. This opens the directors to exposure under an array of legislation for perceived “reckless trading” and acting “unreasonably”.

A recent court case this year was a classic example of where things can go wrong:

• The company was pushing for rapid international expansion. Unfortunately, it operated with tight cash flows and was unable to secure enough capital to remain operational, resulting in the company being placed into receivership and being liquidated.
• One investor had provided approximately NZD$3.2M of his family’s inheritance in unsecured loans. He was deemed to be an unsecured creditor and lost his money. He commenced proceedings against the former directors, alleging that they were trading recklessly and not operating the company with due diligence.
• Following an initial trial and subsequent High Court / Court of Appeal hearings, the directors successfully defended their case. This is in large part due to the legal and financial advice they sought during the company’s financial turmoil.

This highlights the need for D&O cover as:

• Even though the directors were successful, the legal proceedings were lengthy and would have been incredibly costly (we estimate the directors’ legal fees over seven years could be in the range of $1M - $3M).
• One director had stepped down but was still charged. If the company had D&O cover, his legal fees would have been covered, as well as any other past, present, or future directors.

Regulatory Issues

Often startups will not have the financial means to employ inhouse legal counsel or engage with costly external legal advice. This can present challenges in compliance with legislation, as startups may not be aware of the acute intricacies of the law.

Another recent case, who this time ended up in front of the Commerce Commission several times as well as the Court of Appeal, was due to the company being unclear about their fees.

This case highlights the importance of obtaining Statutory Liability insurance, as the Commerce Commission commenced proceedings directly against the company for its breach of the Credit Contracts and Consumer Finance Act 2003 (CCCFA). Without proper legal advice, the organisation was unaware that it was breaching the law, especially as its innovative business model proved to operate in a grey area on this matter.

Statutory Liability would have covered the costs of defending and appealing this matter, as the insurance provides cover for an inadvertent or negligent breach of legislation and regulation.

Given that a great number of startups have innovative business operations and ideas, they open themselves up to risk of breaching the law where it is not clearly defined.

The rise of cryptocurrency platforms and AI technology present these risks as well, as the law is yet to catch up.

Need some help understanding what your liability risks are? Please reach out to our liability specialists on insurance@icib.co.nz or phone 09 377 4314.

Disclaimer: D&O policies often exclude claims arising from insolvency for startups but insurers are usually happy to review and remove these after a few years - once companies can prove financial stability and a good pipeline of business and revenue streams. Thus, it is important to be aware of any and all exclusions in your policy and maintain open and continuous dialogue with your broker and insurer over the lifetime of your D&O policy.