D&O insurers breathed a short sigh of relief when the U.S. government pledged to protect depositors of failed Silicon Valley Bank last week.
But it wasn’t necessarily business as usual for watchful underwriters in the days following the March 12 announcement—whether they were focused on providing directors and officer insurance and other management liability coverages for financial institutions or for tech startups.
“I agree that the move by the Treasury, and the Fed, and the FDIC on Sunday night [March 12] made a huge difference. Had they not done that, we would’ve had a very different scenario on Monday. We could well have seen companies fail, employees being terminated, all kinds of bad stuff,” said Kevin LaCroix, an attorney and executive vice president of RT ProExec, a management-liability-focused division of wholesaler RT Specialty.
“That immediate trauma was averted,” LaCroix told Carrier Management last Friday, a week after the bank was seized by U.S. regulators. “But it’s way too early to give the all-clear,” he said during a phone interview just four days after the first shareholder class action was filed against SVB and two of its executives.
Related: Silicon Valley Bank Parent SVB Financial Group Faces First Securities Class Action
Earlier in the week, AM Best published a report stating that “underwriters of directors and officers insurance for startups and venture capitalists, as well as the financial institution insureds supporting such entities, could have faced financial distress given that they are operating on very thin capital” if the U.S. government had not stepped in to make all of SVB’s depositors whole. “The potential for D&O claims for startups would have been high in the case government had decided not to help the depositors,” stated David Blades, AM Best associate director, industry research and analytics.
“Just the subsequent events this week show that there’s still a lot of turmoil in the marketplace,” LaCroix said, pointing to the fact that European banking giant Credit Suisse needed a lifeline from the Swiss Central bank to stay afloat. “Credit Suisse had nothing to do with what went wrong at SVB or Signature,” a second bank that collapsed recently. “It had a whole different set of issues. But because it was a troubled bank, investors turned. And had the Swiss Bank not stepped in and extended the short-term lending line, Credit Suisse might have tumbled, too,” said LaCroix, also known to insurers as the author of the D&O Diary blog. (On Sunday, UBS agreed to buy Credit Suisse for more than $3 billion.)
LaCroix also noted that even though 11 large U.S. banks put an “extraordinary facility,” together depositing $30 billion into a troubled U.S. regional bank, First Republic, the move on Thursday did little to calm down the bank’s investors on Friday. (Shares fell 33 percent on Friday, and Moody’s downgraded the bank’s credit ratings.)
In addition, the Wall Street Journal and other financial publications reported that the Securities and Exchange Commission and the Department of Justice had launched separate probes of the SVB collapse.
“In 2008, the Bear Stearns [collapse] was in March. The FDIC negotiated a buyout by JPMorgan, and everybody kind of went back to sleep. But then Lehman Brothers failed in September 2008. That in and of itself makes me very wary of saying that we can sound the all-clear.”
“I just don’t think we can say that we dodged a bullet. We dodged the immediate problem that would’ve emerged on Monday, had the federal government not taken those steps, but that didn’t end the crisis. It’s still too early to say how it’s going to unfold. For starters, there is going to be a significant [D&O] loss on SVB, possibly on Signature Bank, possibly on Credit Suisse. Even for what’s already on the table, we know there’s going to be consequences. The problem is, how bad do the consequences get?”
Reasoned LaCroix: “We dodged the first salvo, but the battle isn’t over. We could escape with relatively little damage, just the claims that are on the table so far. But in 2008, the Bear Stearns [collapse] was in March. The FDIC negotiated a buyout by JPMorgan, and everybody kind of went back to sleep. But then Lehman Brothers failed in September 2008.”
“That in and of itself makes me very wary of saying that we can sound the all-clear—that we can be sure that we’ve dodged the worst of it,” LaCroix said.
More Startup Troubles Ahead: CB Insights
Beyond financial institutions themselves, startups that held deposits with SVB were spared some of the worst consequences of not being able to access their funds, such as not being able to make payroll last week. But financial stresses may be looming over the longer term for venture-backed tech companies, according to a research report published by CB Insights last week. The report’s title, “SVB’s challenges will accelerate valuation down rounds, startup mortality, and layoffs” envisions the types of financial consequences—failures and layoffs—that could turn into D&O and employment practices liability claims, although it doesn’t specifically mention any management liability insurance ramifications.
The main focus of the CB Insights analysis is the idea that “the tenuous state of Silicon Valley Bank will change the accessibility of venture debt.” In short, the research firm highlights the removal of a huge provider of these loans, SVB, as the next domino to fall, setting a string of future startup failures and job cuts in motion.
SVB defines venture debt on its website as “a loan designed for fast-growing investor-backed startups,…most often…secured at the same time or soon after an equity round—and is typically used to extend runway to the next round.”
“Venture debt reduces the average cost of the capital to fund operations when a company is scaling quickly or burning cash. It also provides flexibility, since venture debt can be used as a cash cushion against operational glitches, hiccups in fundraising and unforeseen capital needs,” the website says. Elsewhere on the SVB website, an article titled “Venture Debt: How it Works” refers to venture debt as ” performance insurance” that can be used as a short-term bridge to the next round of equity.
The CB Insights report, citing an SVB presentation published on March 8, highlighted venture debt as a preferred fund raising tool over the past year. “Clients continue to opt for debt over raising equity at pressured valuations,” the SVB presentation says (page 17).
This activity, CB Insights says, helps explain why private market valuations haven’t shown the same sharp declines as public market valuations. According to CB Insights research data, while private tech valuations in fourth-quarter 2022 fell modestly from heights recorded in 2021, they were actually up compared to 2020 across all financing stages. In fact, for just late stages, such as Series C and Series D, valuations climbed 20 and 30 percent.
“It’s feasible that companies with momentum and metrics were the ones raising in the more challenging climate of the past year, and so they might still have been able to command premium valuations. But companies that didn’t have the metrics were availing themselves of debt to avoid ‘pressured valuations,’ as SVB noted,” the CB Insights report says. “Debt helped companies delay taking the medicine of a lower valuation, dilution, and tough conversations with the team. In some cases, it also helped companies avoid (or perhaps delay) layoffs or even failure because of an inability to raise equity capital.”
Without venture debt available from SVB, the CB Insights report suggests that instead of the 20-30 percent increases in late-stage valuations, private market valuations will fall as far, or farther, than public market valuations. The research firm’s data reveals the combined market cap of the 50 largest tech IPOs since 2020 is down 59 percent, and that 90 percent of the top 20 tech IPOs currently trade lower than their IPO valuations.
Bolstering its overall forecast of a financial debacle on the horizon in startup land, CB Insights also notes that:
- Overall dealmaking has been slowing even with venture debt available capital.
- The time between funding rounds has been lengthening as investors become more discerning.
- Startups have been burning cash. One piece of evidence—86 percent of unicorns increased employee headcount since first-quarter 2022.
Travis Hedge, a co-founder of Vouch, an InsurTech that specializes in commercial insurance, including D&O, as an MGU and a reinsurer, believes that venture debt has become less popular in recent years because of the availability of equity financing in the market. Before co-founding Vouch in 2018, Hedge worked as investor for SVB Capital, and before that, he helped to build out the Nationwide Ventures team where SVB Capital was the first investment the insurer’s venture arm made.
“Venture debt has been around for the last 40 years or so. As a matter of fact, if you go back to the 90s and early 2000s, there were dedicated leasing functions for things like office equipment. There were debts specifically for the capital needs of these startups,” Hedge reported.
“The industry has actually evolved quite a bit. Venture debt is important, but it’s actually one of many tools available to companies now. As all kinds of options have matured, you’ve seen more and more providers come into the market. There’s a lot more options out there for companies today in terms of financing than there were 10, 15, 20 years ago,” Hedge said.
While Hedge agreed that venture debt is “absolutely an important part” of the overall funding ecosystem, “the point that I take away there from CB Insights is that it’s not just about the venture debt. It’s about the role that SVB plays in the entire ecosystem,” he said, reacting to Carrier Management’s summary of the report highlights, having not actually seen the report. “We’ve already seen over the last 12 months, it’s been a more challenging funding environment as equity capital in general has become less available, and capital, just across the board, has become more constrained.”
“It has been a more challenging fundraising environment for startups for the last 12 months,” he affirmed. “Who knows how the markets [would] respond had we not seen the Fed action last week?”
Beyond impacts on funding availability to the startup market, SVB’s collapse, absent government intervention, could have had broader impacts “within the startup ecosystem that might have implications on the health of companies overall. It’s arguably not very different from what we’ve seen in other points of the cycle. That is just normal kind of economic volatility,” Hedge said.
Vouch Co-Founder Sam Hodges added his view that over the last year there has been “a renormalization of venture capital activity back to more of what it looked like in 2017, 2018.”
“You have to remember, 2020 and 2021 were outlier years. There was a tremendous amount of capital that had flooded into the space, and that capital really started to recede 12 or 13 months ago,” Hodges said. “I think we’ve already seen a lot of these effects show up in the market.”
From a D&O underwriting perspective, Vouch is “very plugged in with the ecosystem and can stay ahead of these trends,” he added. “In terms of how we thought about underwriting and rating, we made sure we were making adjustments as of a year ago.”
Bottom line, “I don’t think that those shifts are new,” he said, referring to changes in levels of funding activity. “They’ve been in the works for some time.”
Added Hedge: “Given the moves that the Fed made last week, we wouldn’t see the knock-on implications from a D&O perspective. But I think our team was very prepared to respond if and when that became an issue.”
While neither of the Vouch executives could be coaxed to imagine the potential lawsuits and liability insurance loss scenarios that might have played out in the event the federal government hadn’t acted to secure SVB deposits last week, LaCroix did entertain Carrier Management’s questions. In particular, we wondered about reports from entrepreneurs suggesting there they were contractually bound to deposit money in the bank as a condition of funding. (See, for example, “How I Kept My Company Afloat During the Silicon Valley Bank Meltdown” on Inc.com and “Silicon Valley Bank signed exclusive banking deals with some clients” on cnbc.com) Could those contractual provisions have put the bank or venture capital firms recommending SVB in the crosshairs of plaintiffs lawyers?
“As I understood it, those kind of arrangements, where the SVB would extend credit in exchange for an agreement by the borrower to put all of its banking with SVB, permitted SVB to make the loan on a non-collateralized basis,” LaCroix said. In other words, “it was attractive to the borrower. They were going to get the credit they needed, and they needed to bank with somebody. If they just agreed to bank with SVB, they didn’t have to post collateral…It’s not as nefarious as it seems, and a lot of banks do that,” he said.
Taking the question in a slightly different direction, LaCroix said that “SVB had the advantage, because frequently they were willing to lend to startups where perhaps others might not. Would those borrowers, because they couldn’t get access to their deposits, have a cause of action against SVB?”
Without knowing more about the contractual relationship, LaCroix said, “it would depend a lot on the total circumstances around the loan. It was advantageous both ways. It wasn’t just a unilaterally-advantageous arrangement.”
LaCroix continued: “The question I have is, had the Fed not stepped in, [then for] startups that had deposits in excess of the maximum insurance amount, if they had adverse business developments because they couldn’t get access to their funds, would shareholders have had a claim against the executives of those institutions for their poor treasury practices and [for] doing their banking in such a way that they exceeded the limit?”
Admitting that he doesn’t know the answer to the question, he offered, “There would’ve been a lot of reasons that people would’ve been mad, and there certainly would’ve been a lot of claims, perhaps some of them on a novel theory…”
“In a crisis, all theories are on the table. That doesn’t mean necessarily that it would’ve gotten anywhere. But I think if it got bad enough, there could well have been claims like that.”
D&O Market Reaction
With one shareholder suit against SVB already filed and the potential of more suits on the horizon, the D&O insurance market did hit the pause button temporarily, LaCroix reported.
“Earlier this week, everybody was just a little bit on hold,” he said, referring mainly to the reactions of D&O underwriters involved in the FI space. “I think they were just trying to get their bearings, trying to catch their breath,” he said.
While he reported hearing that at least one carrier had pulled open quotes and was temporarily not issuing any terms, even on their own renewals, LaCroix himself didn’t experience this. “I met with the head of one of the leading D&O markets for financial institutions [who] said as far as they were concerned, they were still open for business. They were still quoting business, particularly on their own renewals.”
“They certainly were going to review their underwriting guidelines and be wary of banks that had certain characteristics,” he said, referring to factors like size or narrow concentrations, like SVB or like Signature Bank, “which rather publicly was going after crypto accounts.”
“Wary is probably a good description” of the D&O market reaction, he said.
“As the week has unfolded, I think the reactions have evolved as well.” Pointing to the Signature Bank, Credit Suisse and First Republic situation, he said that “there’s a clear indication that this could continue to unfold. And that could continue to alter the dynamic and alter the marketplace.”
Still, LaCroix doesn’t see recent events changing the overall market for commercial D&O beyond FI. “At least for now, I think that will continue on as it was, which was reasonably competitive, with a lot of capacity.”
In the FI space, “there’s no doubt the underwriting process is going to be lengthened, [and carriers] may be hesitant to extend as much capacity as they have. They may take action on pricing. It’s all going to unfold” as the world gets answers to the question of whether there will be more bank failures. “If that’s the case, you could see a more pronounced reaction by the carriers in the FI space.”
What about reactions by insurers providing private company management liability?
“For now, it’s going to operate as it was…A lot of banking institutions are privately held, [and they] will have to deal with a more cautious marketplace. But outside of that space, I think the private company space for commercial D&O remains as it was, which is competitive, with ample capacity, on terms that are more attractive than they were 12 months ago.”
“I don’t think that’s going to change unless we start to see consequences from the banking turmoil that spills outside the banking industry and starts to affect depositors, customers, and so on,” LaCroix concluded. “Things would have to get worse and broader. The turmoil would have to spread.”
LaCroix went on to distinguish the causes of the current turmoil for banks to the causes fueling the global financial crisis and the S&L crisis. In the earlier events it was bank lending operations that caused the problems. “It was bad loans. Here, what got SVB [in trouble] was really its treasury operations, managing its bond portfolios—really fundamental banking.”
“Do we have an industrywide vulnerability? I think we all have to just wait and see.”
He agreed that financial underwriting questions for non-bank insureds may expand to include questions about banking practices, and also just credit generally: “‘What are your sources of credit? Have you checked in on it? What are your alternatives if that dries up or if you exhaust that?’ There will be questions like that. There’s no doubt.”
LaCroix, who ran a D&O underwriting facility earlier in his career, said that from an underwriting standpoint he would be worried about any interest-rate-sensitive businesses, pointing to the fact that SVB’s downfall was structuring its bond portfolio with unhedged interest rate risk, and also about companies that loaded up on debt when borrowing costs were low.
“Now, some deficiencies in your operations and performance, which you might have been able to mask with easy borrowing, you might not be able to paper over anymore,” he said, suggesting that he would change his underwriting guidelines for debt-sensitive and debt-heavy businesses. Asked what sectors fall in these categories, LaCroix offered retail and transportation businesses among those where operational costs are high.
At Vouch, where the focus is the same high-growth entrepreneurial companies that banked at SVB, Hodges said, “This past week has been a bit of a tabletop exercise in risk management for everyone who’s been in the space,” when asked about lessons for insureds beyond keeping bank deposits below the $250,000 FDIC insurance limit.
“Counterparty risk and business continuity risk always should be on the list of things you are thinking about when you build and run a company,” he said.
“Part of our role at Vouch is to help entrepreneurs manage their most important risks. We historically have offered risk reports and thoughts on market trends that we’re aware of. We certainly think that there’s some really interesting lessons here, particularly for companies in the treasury management and counterparty management space. The conversations I’ve been having with entrepreneurs and investors over the past week, to me, indicate that a lot of folks are really taking those to heart.”
Asked about the tenor of the D&O market generally, Hedge said it was hard to comment on how carriers across the broad market are reacting. “It has been a volatile market in the D&O world for the last few years. I think we, as well as many others, are actually just very closely monitoring this situation right now.”
Added Hodges, “D&O, like many other liability lines, is a dynamic space. If you are providing coverage or underwriting in that space, you need to be responsive to risk trend and risk development, make sure you’re getting coverage underwriting and rating done properly. I think everyone takes that to heart. Certainly, when there are risk events in the market at a high level, you always take a step back and think about what might you want to do a little bit differently as you adjust your go-forward plan.”