In recent days, there has been a lot of activity as investors in Second Life corporations attempt to recover assets from failed companies and their owners. The actions, as well as discussions surrounding these actions raise the question of whether Directors’ and Officers’ Liability Insurance might be coming to Second Life.

Many people view Second Life as a three dimensional gaming environment. Others, recognizing the value of the immersive environment look to set up advertising in Second Life or to use it as a fancy new way to hold online conferences. Yet many overlook the importance of the Second Life currency and the evolution of financial markets in Second Life.

In December, 2004, Ginko Financial set up its bank in Second Life. It offered high interest rates and a high level of risk. In July, 2005, this expanded into the first stock market in Second Life, and in March 2006, the World Stock Exchange launched in Second Life. Many companies have been formed and listed on the World Stock Exchange, and many have failed as well, including Ginko Financial.

When SLC went under last week, Samantha Goldflake, the communications director for the Virtual Stock Exchange, where SLC was listed, suggested that Mystik Boucher, co-owner of SLC should consider returning at least a portion of the L$ 333,896, approximately U.S. $ 1,200, that she had withdrawn from the Virtual Stock Exchange to investors in SLC.

Later in the week, Your2ndPlace ran an article entitled, Seizing Ill-Gotten Gains which spoke about efforts to recover assets related to the failed ‘Merlin’s Investment Bank’. The article included a press release from Skip Oceanlane, Vice-President of Merlin’s Investment Bank, who is attempting to recover assets from the head of the bank. Included in the press release was this paragraph:

It has been reported that Investor Merlin purchased stocks on SLCapex and the WSE with Lindens obtained from MIBank depositors. After contacting the owners of each of these stock exchanges, they graciously placed "holds" on Investor Merlin's stocks until this issue can be resolved.

In turns out that Investor Merlin was also one of the largest non-director shareholders of SLC. Digging a little deeper, it appears that 7% of Greyhound Builders, over on the World Stock Exchange (WSE) was held by some investor whose assets have been transferred into the World Trading Fund, aptly abbreviated WTF, where WSE moves shares and assets of failed companies.

A representative of one of the exchanges yesterday asked me about requiring a one-time fee for company owners and directors to pay when their first company gets listed on the exchange. That money would go into a risk fund to pay back investors if the companies fail. To me, that sounded an awful lot like Directors’ and Officers’ insurance.

The liabilities that directors and officers face in Second Life are different than those faced by directors and officers in real life. Yet for directors and officers that have large holdings in the various Second Life exchanges, this could be helpful in protecting these assets. It could also be valuable to investors and build investor confidence in the markets.

To come up with what sort of premiums would be necessary to cover directors and officers in Second Life, I did a little research into the initial press releases on the World Stock Exchange from March of this year.

In looking at over 150 press releases, 53% of the press releases came from companies that have been removed from the World Stock Exchange. It turns out that failing companies on the WSE issue more press releases per company than successful companies, and the percentage of companies that have been removed is only 42%. In addition, at least on of those companies is currently trading successfully on a different exchange. Nonetheless, speaking conservatively 30-40% of the most visible companies that listed on the World Stock Exchange when it started have failed.

Some of this may have been because of legitimate business reasons. Many companies were making their profits from gambling which Linden Labs banned. Others were speculating on land prices which have declined substantially. Still others were investment firms who invested in the failed gambling or land speculation firms or developers whose business depended on these same gambling and land speculation firms.

Some of this may also have been due to pure and simple fraud. Given the lack of verification of identity of the company owners and the near impossibility of recovering assets from failed companies, buying stocks in Second Life remains similar to making an unsecured loan to someone you don’t know.

In order to increase the viability of the markets, Second Life based stock exchanges are implementing new rules to verify the identity of company owners, seeking ways to gain better control of the assets of failing companies and implementing risk funds to cover investments of shareholders in failed companies. Some sort of Directors’ and Officers’ Liability Insurance may be one of the next features from real life to make its way into Second Life.

Those close to trading in Second Life have often compared it to the Wild West. I like to think of it as being similar to the early days of the American financial markets before there were substantial regulations in place. With either comparison, the Wild West and the early financial markets were eventually tamed and those who helped in that taming often made out very well.

It is my belief that same will apply to the financial markets in Second Life and that the rare breed of technically and financially savvy would be wise to step in, lend a hand, and find a lucrative and fun new business adventure.
(Cross posted at Toomre Capital Markets).