If the SEC investigates your microcap company, will you have sufficient directors and officers (D&O) coverage for both your executives and your company? Many D&O policies leave coverage gaps that could expose you to uncovered claims under many common types of regulatory investigations.
Consider how your D&O policy would respond to the following three types of SEC investigations.
Pump-and-Dump Schemes
In a pump-and-dump scheme, fraudsters inflate a stock’s value by spreading false or misleading statements that encourage other investors to buy in. Once the price has increased, the fraudsters sell their shares to make a profit. This is a type of securities fraud, subject to SEC enforcement.
Recently, the SEC has charged three former CEOs of penny stock companies as well as a disbarred California attorney over their roles in an alleged $112 million pump-and-dump scheme. According to the SEC’s complaint, the CEOs signed or allowed their signatures to appear on disclosure statements with materially-false and misleading information.
Stock Manipulation
Closely related to pump-and-dump schemes, stock manipulation occurs when someone artificially affects supply or demand of a stock. As with a pump-and-dump scheme, this could be to inflate stock prices. It could also cause stock prices to fall.
As an example of this, the SEC settled charges against four defendants over accusations that they participated in a microcap scheme that generated more than $27 million in unlawful stock sales.
In another case, the SEC charged four individuals with fraud over claims that they concealed the fact that two lawbreakers ran the company. The two individuals had prior legal violations, but they were presented as consultants rather than the people running the company to avoid disclosing this. The SEC says leaders created the company to receive money and stock.
Unregistered Dealer Lending
Unregistered dealer lending occurs when a company sells convertible notes to raise capital. The debt is converted to stock and then sold. The impact that this may have on the stock’s value is sometimes called toxic or death spiral lending.
According to Corporate Compliance Insights, supporters of this practice argue that it’s an important source of liquidity for companies that need cash and that the lenders should not have to register as dealers because they do not interact directly with investors and engage in other broker activities. The SEC disagrees with this last point. Since 2020, it has taken multiple enforcement actions, including an announcement that the SEC won a summary judgment against company and its CEO.
However, the frequency of these investigations may be declining. The SEC has announced that it has dismissed multiple civil enforcement actions in cases involving unregistered dealers.
Do You Have Adequate D&O Coverage?
When a company is subject to SEC enforcement, the events leading up to that enforcement often follow a similar pattern. First, the corporate scandal is alleged. Then, the plaintiff’s counsel files a securities lawsuit. Lastly, the SEC or another authority investigates the underlying issues.
D&O policies don’t always provide adequate coverage for these processes. With many policies, only the insured persons, not the entity itself, have coverage for regulatory investigations, but SEC enforcements often involve both the individuals and the company. As a result, the company may not have protection for the costs associated with SEC investigations.
NSI provides D&O coverage that’s expanded to include formal investigations of the company by securities regulatory authorities when such investigations are connected to an existing securities claim against the company. In the D&O insurance market, this type of coverage is commonly referred to as “related investigatory coverage.” The policy covers the company’s costs related to such investigations in addition to the securities litigation costs, up to the policy limit.
How does your D&O policy respond to SEC allegations? Contact me for a review of your coverage.
