Risk minimization through D&O insurance for managing directors

A solid financial basis is a decisive success factor for start-ups and innovative companies. In my many years of legal practice, especially when advising young, up-and-coming companies in IT and media law, the need to ensure a robust financial basis in addition to creativity and innovation is regularly apparent. The legal and economic challenges faced by innovative companies require not only a well thought-out business strategy, but also sufficient financial reserves to cushion unforeseen developments and adequately address legal risks. Particularly in sectors with highly dynamic innovation, such as artificial intelligence, blockchain technology or digital media, regulatory frameworks can change rapidly, requiring flexible adaptation of the business model and, if necessary, additional investment in compliance measures. Case law in recent years has shown that courts are applying increasingly strict standards to the duty of care of managing directors in innovative industries. For example, in a ruling dated 21.09.2017 (case no. 23 U 2093/17), the Munich Higher Regional Court emphasized that managing directors of technology start-ups have a special duty to continuously monitor the legal and regulatory environment. This often requires the use of external expertise, which in turn can entail considerable costs. Against this backdrop, the recommendation to build up and maintain a substantial financial reserve – often referred to as a “war chest” in technical jargon – proves to be an essential component of a sustainable corporate strategy.

The need for a “war chest”

The recommendation to maintain sufficient financial reserves is based on the legal and business experience that innovative companies are often confronted with complex and cost-intensive challenges. These challenges can be diverse in nature and range from the need to apply for and defend patents to the implementation of extensive data protection measures and the defense against competition law attacks by established market participants. Practice shows that disruptive innovations in particular often result in legal disputes, the financial consequences of which can threaten the existence of young companies. In this context, reference should be made to the case law of the Federal Court of Justice (BGH), which has specified the requirements for management when assessing litigation risks in several decisions (see BGH, judgment of 04.11.2002 – II ZR 224/00). Accordingly, managing directors have a duty to carefully examine the prospects of success of legal disputes, whereby expert advice must be obtained in cases of doubt. The costs of such advice and any subsequent legal proceedings can be considerable and must be taken into account in financial planning. In addition, the development and market launch of innovative products or services often requires a longer period of time than originally calculated, which makes additional financial buffers necessary. In this context, a solid “war chest” not only serves to protect against legal risks, but also enables the company to react flexibly to market changes and take advantage of strategic opportunities without running into financial bottlenecks. A detailed discussion of this topic can be found in the blog post “The more innovative a company, the bigger the war chest needs to be”.

Protection for managing directors: D&O insurance

In addition to ensuring that the company itself has sufficient capital resources, the recommendation to managing directors to take out adequate D&O insurance (Directors and Officers Liability Insurance) proves to be just as important in consulting practice. This special form of directors and officers liability insurance aims to protect managing directors from the financial consequences of personal liability claims. The relevance of such insurance arises from the increasing tendency in case law to hold managing directors personally liable for wrong business decisions or breaches of duty. Particularly in the context of innovative start-ups, which often operate in legal gray areas or areas that are not yet fully regulated, D&O insurance can offer decisive protection against liability risks that threaten the existence of the company. In recent years, case law has continuously tightened the requirements for managing directors’ duties of care. For example, in its ruling of October 20, 2009 (case no. II ZR 240/08), the Federal Court of Justice clarified that although managing directors enjoy a broad scope of discretion when making business decisions, this is limited by the duty to obtain appropriate information and carefully weigh up risks. In a further ruling from 18.06.2013 (case no. II ZR 86/11), the BGH also emphasized that managing directors must give due consideration to the interests of creditors when taking risks. This case law highlights the need for comprehensive cover, such as that offered by D&O insurance. A detailed description of the various liability risks for managing directors and the importance of D&O insurance can be found in the article “Misjudged liability risks: What GmbH managing directors need to know”.

Protection against derivative directors’ liability

In the context of directors’ and officers’ liability, the issue of derivative liability deserves particular attention. Here, D&O insurance can make a significant contribution to minimizing risk. Derived directors’ and officers’ liability arises in particular in situations in which directors are held liable for the actions or omissions of their employees. This is based on the legal construction that managing directors have a comprehensive duty of organization and supervision, which obliges them to implement adequate structures and processes to prevent legal violations within the company. Case law has specified and tightened the requirements for this organizational duty in recent years. In its ruling of 10.07.2012 (case no. VI ZR 341/10), the Federal Court of Justice clarified that managing directors are responsible for setting up a functioning compliance system that is suitable for preventing legal violations. In a further ruling from 9 July 2019 (case no. VI ZR 113/18), the BGH also emphasized that this organizational obligation also includes the implementation of appropriate control mechanisms. Particularly relevant in this context is the decision of the Munich Higher Regional Court of 23.01.2020 (case no. 7 U 5795/19), in which the court affirmed the liability of a managing director for competition law infringements committed by employees because an adequate compliance system had not been implemented. This case law highlights the need for careful company organization and at the same time underlines the value of D&O insurance, which can provide financial protection in the event of a claim against the managing director.

Conclusion

As a lawyer with many years of experience in advising start-ups and innovative companies, I can only strongly recommend integrating the aspects of financial security and legal risk management into the corporate strategy from the outset. The combination of a solid financial basis, comprehensive D&O insurance for managing directors and the implementation of robust compliance structures forms a strong foundation for sustainable entrepreneurial success. These measures allow founders and managing directors to focus on the development and growth of their innovative company without taking disproportionate personal risks. Case law in recent years has continuously increased the requirements for the duty of care of managing directors, which underlines the importance of forward-looking planning and protection. In its ruling of 26.04.2022 (case no. II ZR 215/19), the BGH once again emphasized that managing directors must always have the interests of the company in mind when performing their duties and must make appropriate risk provisions. According to the court, this also includes the implementation of an adequate risk management system that takes equal account of financial and legal risks. In this sense, setting up a “war chest” and taking out D&O insurance is not only a business necessity, but also a legal obligation arising from the managing director’s duty of care. Particularly in the dynamic world of start-ups, where agility and a willingness to take risks are often seen as the key to success, such a forward-looking and protective approach may initially seem counterintuitive. However, practice shows that it is precisely this prudent planning that can provide a decisive competitive advantage in the long term.