For the last few years, the level of mergers and acquisitions activity in both Europe and at a global level can best be described as frenzied, with transactions taking place at a rate never before experienced.
In autumn 1998, KPMG estimated the total global value of mergers and acquisitions at US$2,000 billion. For the first six months of 2000 alone, the figure is already estimated to be around US$1,800 billion with the final figure for the year expected to be close to US$4,000 billion. Currently, Europe accounts for approximately half of all the activity. Admittedly, we are experiencing the longest bull run in our markets for over 100 years and, as we know, strong stock markets make it relatively easy for companies to issue new paper to raise money for acquisitions. It is not unreasonable to question whether these figures really reflect growing value, or are symptomatic of the additional market forces inherent in such frenzied times. It is only when things settle down that shareholders can really determine a truer value of their investments.
In this current climate, there are potentially far-reaching additional risks facing the investor other than from a buoyant market. For all the deals that reach a successful and beneficial conclusion, there are many that fail or turn sour, costing both parties substantial and occasionally catastrophic sums which can consequently impact adversely on cash flow, the balance sheet and ultimately share values.
The current level of activity is fuelled by institutional investors looking for greater margins and also the economies of scale that are believed attainable through merger or acquisition. However, the majority of the money circulating in the market belongs to a growing population investing for its retirement provision. It must surely be paramount for directors involved in deal-making to ensure that all the underlying risks to share value are covered for these erstwhile investors.
The deal that goes wrong can go spectacularly wrong
However, many companies, when pursuing their acquisition strategy, fail to build in a parallel risk strategy to protect shareholder interests. Stock market history is littered with companies who have spent good money making bad acquisitions, which in turn have impacted negatively on share prices.
Possibly the ultimate in calamitous deals must be the acquisition of Atlantic Computers by British & Commonwealth. British & Commonwealth, a company formerly capitalised in excess of £400 million, subsequently collapsed as a result of its acquisition.
Another example is Ferranti, originally valued in the region of £400 million prior to making an acquisition that turned out to be valueless. The consequential effect was that Ferranti became a distressed company with debts of over £l00 million and an underfunded pension scheme. Ferranti's five divisions were sold for a little in excess of £100 million, which was sufficient to discharge the £100 million of debt and pay monies owing to the pension fund. There were no funds left to pay unsecured creditors or to return any cash to shareholders whose investment became worthless.
One can reasonably argue that the percentage of transactions failing is relatively small when compared to the overall number of deals done in any one year but, as these examples show, when problems do occur they tend to be spectacular.
Most of the companies involved in transactions will have comprehensive insurance programmes in place to protect their buildings and assets against fire and other perils, despite the fact that each year there are relatively few catastrophic fires. Yet as few as 5% of vendors take out important warranty and indemnity insurance when entering the high-risk world of mergers and acquisitions - a world where a purchaser will fight long and hard through lawyers to negotiate a sale and purchase agreement, incorporating extensive warranties and indemnities which leave onerous liabilities on the shoulders of the vendors, whether they be individuals or another corporation. With such extensive liability, and exposure to loss for both parties, it is surprising how few finance directors and in-house legal departments are aware of the availability of insurance protection which substantially mitigate this exposure. Such policies have the added advantage of helping to speed up negotiations by giving the purchaser confidence to proceed, knowing that the crucial warranties are insured.
Risks facing both parties
Warranty and indemnity insurance has now been available in the United Kingdom for over 20 years. It specifically insures the liability assumed by vendors under the terms of the warranties and the taxation deed of indemnity incorporated in a sale agreement. Warranty cover is extensive. It covers just about every aspect of normal commercial life, including such things as disputes with employees, outstanding litigation, patent and intellectual property disputes, condition of premises and relationship with suppliers. It will also provide full payment of taxation for years preceding the date of sale and purchase of the company (vendors would normally be liable for breach of the warranties for two to three years, and for taxation liability for six or seven years).
Taxation is often a very problematic area for the parties involved in a transaction. Insurance can normally provide a solution. This is of particular relevance when a group of companies conducts a reconstruction prior to disposal, as purchasers will normally be concerned that if, for any reason, the reconstruction does not work and the tax authorities successfully challenge the reconstruction, then a large tax burden can fall on the target acquired by the purchaser. Insurers are now prepared to offer specific protection against the tax penalties in the case of an unenforceable reconstruction. In the event of an arm's-length transaction, warranties and indemnities would ordinarily always be required whether the transaction involves the sale of share capital or merely the sale of assets, business and goodwill.
The consequences of a claim can be extremely damaging to either party. The purchaser acquiring the company will initially bear any loss attributable to a breach of warranty, but it will, of course, be the liability of the vendor to ultimately make good this loss to the purchaser. But what if the vendor does not actually have the cash to make good the loss? It may be a corporation that is already under financial strain, has used the proceeds of the sale in its own business and no longer has any cash available. Or it may be individuals who were proposing to use the money for their retirement and can ill afford to sustain a loss. Equally, as the purchaser has to bear the loss initially, there may be serious implications for its own cash-flow and it could well have a very difficult fight on its hands to secure monies to which it is rightfully entitled as a result of the breach of warranty.
For those prudent enough to consider insuring their liability, a warranty and indemnity policy benefits both parties. Firstly, it indemnifies the vendor, avoiding the need for it to repay any monies received from the sale. Secondly, the purchasers are assured of receiving their just dues, if they are unfortunate enough to have made an acquisition where a breach of warranty arises.
Some major corporations recognise the value of this type of insurance. One company in the FTSE top 25 has recently taken out warranty and indemnity cover for all of its overseas exits. Insuring this liability has enabled it to return somewhere in the region of £500 million back to shareholders, safe in the knowledge that it will not need to make a call on those funds. Another major French corporation views this type of insurance as essential to its acquisition strategy, making it a condition of sale that vendors have this cover before entering negotiations to ensure that its sizeable capital investments are protected. In fact, insurers understanding the importance of the cover to purchasers will even assign the proceeds of the policy under a deed of assignment to them so that they are assured of having access to the important funds should they be needed.
Misconception of D&O cover
It is surprising how many directors mistakenly consider that their directors and officers (D&O) liability policy affords this essential cover in the event of the sale of a company. This is not the case. A D&O liability policy only protects the directors and officers and the company in circumstances where the company is legally allowed to reimburse the directors for claims brought against them. In the case of a sale of a company, the parent, in its own legal capacity, will be required to give the warranties and indemnities as a contractual liability. Neither the company nor its contractual liability is protected under a D&O liability policy.
Maintaining negotiating momentum
It is most important in any transaction to maintain the momentum of the negotiations. Every deal has its own peculiar problems. If they cause the parties to keep leaving the negotiating table for periods of time, slowly but surely the will to complete the transaction evaporates and eventually the deal craters. This is bad news for everyone involved, as both parties will have normally already committed substantial sums in terms of professional fees. There is also no satisfaction for the professional advisers if they cannot help their clients to achieve a successful outcome. Many of the problems giving rise to such disruption of negotiations arise as a result of due diligence when disclosure is being made against the warrantors.
Special Risk Services Underwriting Agency has dealt with a wide variety of risks identified during the disclosure process. Solutions provided include:
Implementing warranty and indemnity cover
A team of experienced underwriters and corporate lawyers will, in the first instance, offer cover for the full schedule of warranties and the tax indemnity, and then specifically exclude any item involving a known circumstance which arises during the disclosure process. Where the insured wishes to cover that particular circumstance, they will investigate to establish whether the issue is remote. If so, they will assume the risk in return for an additional premium or, alternatively, if it is a guaranteed circumstance, they will investigate with a view to quantifying that element of the problem which involves a certain payment. They are then prepared to offer catastrophe cover to remove the unlimited nature of the problem. This is of particular benefit to the parties in a transaction because the known element can be accommodated within the pricing structure, and then the unlimited nature removed, so the purchaser does not have to worry about exposing itself to the unlimited element of the risk.
All of us who work in this specialist field fully understand time is not a luxury afforded to either party in the transaction. Therefore it is necessary to process enquiries quickly and efficiently. My own company normally reviews a risk within two working days, and provides a solution to any other issues within approximately five working days, offering cover up to £200 million any one transaction, with the ability to insure transactions in every legal jurisdiction in the world. Corporate finance no longer has boundaries and is conducted on a global basis, so underwriters with multinational legal skills and bilingual capabilities are always on hand to assist in negotiations.
In conclusion, I would urge all risk managers to carefully evaluate the potential risks that come with mergers and acquisitions activity and include them within their overall risk assessment programme. Since the Turnbull Report on implementing the Combined Code on Corporate Governance stated that directors should review and report to shareholders on all internal controls including risk management, it would seem wise to ensure that one of the most potentially damaging risks is foreseen and a contingency plan exists.
Eddie Barnes is managing director of Special Risk Services Underwriting Agency Ltd. He has worked within the London insurance market for over 35 years, specialising in liability insurance protection. Working with multinational clients during the 1970s, he identified a need for insurance of sale and purchase transactions and consequently originated and developed warranty and indemnity insurance.