Mergers and Acquisitions – Insurance & Risk Issues
Risk and Insurance Issues Regarding Mergers and Acquisitions – 2 Myths & 3 Lessons
Over the years our risk, insurance and human capital advisory firm KMRD Partners has supported companies contemplating a merger, acquisition or sale with due diligence and other risk related issues. Here are some things to consider, along with five important lessons we have learned.
Myth 1: Stock sales protect the seller from future liabilities.
This statement is generally not true.
When a company sells its stock, past and future liabilities are not always transferred to the buyer.
Representation and Warranties and Indemnification Obligations
- Warranty Clause – A warranty clause is a provision in a contract generally providing a representation that something is true or will happen. This clause can have more than one meaning. It also tends to be misunderstood. In contract law, a warranty entitles the innocent party to damages only if the warranty is not true or the defaulting party does not perform the contract in accordance with the terms of the warranty. A warranty is not a guarantee. It is a promise. It may be enforced if it is breached by an award for the legal remedy of damages. These promises are backed by an indemnification agreement.
- Indemnification Obligations – Indemnification provisions inside a purchase agreement not only protect the buyer and seller from a breach of warranty but can also transfer future lawsuits/liabilities back to the seller if a suit arises out of a product manufactured or service performed by the seller prior to the acquisition date. From a buyer’s perspective, this obligation of the seller also creates a going forward risk because the seller may not be able or willing to protect the buyer.How can protection be built in?
Non-Insurance Related Strategies:
- Hold back/Escrow requirements – A buyer can protect itself from the seller’s inability/unwillingness to indemnify it by requiring the seller to maintain a portion of the proceeds of the sale in escrow. The escrow will typically be held for a limited period of time. This strategy does not work well when the period of time is shorter than potential statutes of limitation timelines or if products have long shelf lives. For example:
- Construction defects statutes can be as long as 13 years.
- Durable products manufactured by the seller can be usable for many years and cause injuries for many years to come.
- Statutes involving minors may not trigger until the injured child is 18. For example, if a child is injured at 6 years of age a lawsuit can be filed 14 years later.
- Cap the liability – This is another contract language strategy that does not involve insurance. It stipulates indemnification be capped at an affordable amount. This amount can be the proceeds from the sale, but we often see this cap as a fraction of the proceeds from the sale.
- Limit the term of the obligation – The seller can sometimes limit the term of its indemnification obligation.
- Limit the indemnification to liabilities not insured – Another contract language strategy which states the indemnification obligation of either the buyer or seller only applies “to the extent not insured.” This should also be coupled with a clear understanding/requirement each party purchases a responsible amount of insurance.
Insurance Related Strategies:
- Discontinued Products/Operations Coverage – For most companies, products and completed operations liability insurance is purchased on an “occurrence basis.” This basis is often misunderstood. An occurrence policy is not triggered on the date the product was manufactured or the lawsuit is filed. The policy is triggered on the date the bodily injury or property damage occurred.
Therefore, any indemnification provision obligating the seller to protect the buyer from pre-sale work would not be supported by insurance. In an asset sale this is always true because the original entity remains under the ownership of the seller.
Discontinued Products Coverage can be purchased for any work or products manufactured prior to the sale date. This insurance is generally quoted to protect the seller (and in turn the buyer) for the outstanding statute of limitations and/or the usefulness of their products. When work/products have a long life, this insurance can be expensive. However, it is definitely worth exploring.
- Environmental Coverage – The marketplace offers environmental liability insurance programs to support mergers & acquisitions. These programs can be structured to not only protect both parties from known conditions but more importantly unknown conditions overlooked by the due diligence team and unknown by either party. These policies can be negotiated to provide protection for a long period of time. The period of time is generally a significant focus of negotiations with carriers and is impacted by current insurance market conditions and particular factual circumstances of the deal.
- Representations & Warranties Insurance – This insurance, which can be written for the benefit of either the buyer or seller, indemnifies the insured for loss due solely to a breach of representation and warranty. In other words, this includes any untrue, false, or materially inaccurate statement or material fact. Today, many transactions utilize this tool to not only mitigate risk but also to assist in negotiating the elimination or lowering of any hold-back/escrow requirements of the seller.
When applying for coverage, you must include a copy of the purchase and sale agreement, the financials of both buyer and seller, due diligence information, and a summary of the transaction, including its purpose, limits sought, parties, advisers and timing.
There are some limitations to these insurance policies such as loss caused by change of law, circumstances the insured knew about at the time the policy was written, and changes to transaction documents unless approved by the insurer. The policy terms will be further tailored to the individual transaction. The policy may also give the insurer the right to subrogate against any party to the transaction. Note that a misrepresentation may be intentional or unintentional. The insurer’s attorneys do their own due diligence, so it may be difficult for the insurer to subrogate, except if there was an intention to deceive.
- Tail Insurance – The most common mistake we see when talking about Tail Insurance is the need to protect for not only directors and officer’s liability issues but other professional related risks as well. Here are exposures to consider:
- Directors & Officers Liability – This coverage is designed to apply to any alleged misrepresentations, unfair trade practices and negligent management occurring prior to the sale leading to a lawsuit after the sale. The term of coverage varies greatly (3-6 years) based on the price and risk tolerance of the parties involved. Suits can come from vendors, bankers and customers but are more likely to come from the buyer alleging a breach of warranty. Coverage is generally written to benefit the seller but is often required by the buyer. A mistake we sometimes see is sellers allow the buyer’s insurance broker to place the insurance on the seller’s behalf. This can lead to a conflict of interest in the event of a claim.
- Employment Practices Liability –Anytime there is a transaction like this, employees are impacted. Allegations such as wrongful termination, discrimination and breach of implied employment contacts are prevalent after an acquisition and almost always involves the seller and the buyer.
- Fiduciary Liability – This policy, which is often overlooked, protects the personal assets of fiduciaries on any benefit or retirement plans. Changes in these plans after an acquisition can lead to class action lawsuits naming both parties.
- Cyber/Information Risk – Coverage triggers in these policies can be complex. The buyer’s program may not trigger coverage for anything deemed to have occurred prior to the closing date. A seller’s policy may need to be altered/negotiated to provide tail coverage to protect against future liabilities arising out of breaches prior to the closing date.
Myth 2: Asset sales protect the buyer from future liabilities associated with the seller’s work.
This statement is generally not true as well!
When a company sells the assets only, they can also negotiate ways to pass along their future liabilities to the buyer.
As discussed above Warranties, Indemnification, Liability Caps etc. can be negotiated in favor of the seller. It is critical to negotiate these terms carefully!
Lesson 1: Involve your trusted insurance broker in the due diligence process.
A qualified risk management and insurance professional should be able to equip buyers with a due diligence checklist that will include, at a minimum, copies of the seller’s insurance contracts and loss experience. Gaps in policies, loss sensitive structures, and poor loss experience can not only reflect on management but can also lead to higher-than-expected risk and insurance costs going forward. Your broker should be able to benchmark and validate whether pro-forma expenses are accurate and take into consideration the buyer’s risk tolerance.
Lesson 2: Involve your trusted insurance broker long before signing the sales agreement.
Your trusted broker should be involved during the draft stages of the purchase agreement. If you provide the agreement after it is signed, it will be too late for suggestions to limit your risks and/or transfer them to an insurance product. To protect your firm’s confidentiality, require your broker to sign a Non-Disclosure Agreement prior to its involvement and consider providing access to your attorney for efficiency’s sake.
Lesson 3: Choose your advisors carefully.
As with all things, experience and competence vary greatly. Select your advisors carefully. Choose one with the experience to understand the issues