The “merger mania” that has struck corporate America in recent years reached new heights in 1999 as the number of publicly announced mergers
and acquisitions (M&A) increased to a record 9,192 with a record value of over $1.4 trillion.1 In addition, billions of dollars are transferred annually in the US through the sale of privately owned companies. Unprecedented M&A activity has created new opportunities for businesses in almost every sector. Yet, there are substantial challenges that companies face with every transaction.
Corporations involved in M&A engage in significant “due diligence” to uncover risks and liabilities that can impact the viability of each deal. A few major insurance companies and insurance brokers have developed specialized expertise in identifying, analyzing and evaluating exposures for their clients as part of the due diligence process. They structure highly customized solutions that help companies mitigate the risks associated with M&A .
As corporations have begun looking at risk on an enterprise-wide basis, insurers have expanded their coverage capabilities to encompass a broader spectrum of exposures. In addition to providing insurance for traditional property/casualty hazards, some carriers are now offering a new generation of insurance products that address financial exposures and even operational business risks.
As M&A activity has gained momentum, savvy insurers and brokers have also been helping companies manage transactional risks. Because of the sheer number of deals being done in recent years, this is considered a fertile niche market with enormous potential. A few insurers, such as Reliance National, have taken the lead in developing transactional risk insurance products.
These products, which include representations and warranties insurance, contingent tax liability insurance and loss mitigation underwriting arrangements, can help facilitate M&A .
A variety of corporations are benefiting from the new-found ability to transfer certain M&A-related risks to insurers. This article provides an overview of transactional risk insurance coverages, how they work and when they are generally utilized.
In hammering out a purchase agreement, one of the major areas of discussion is often the representations and warranties section. In every acquisition agreement, the seller is required to make certain representations about the business being sold. The representations and warranties portion of the contract contains statements that attest to the corporate status of the company being acquired, the accuracy of its financial statements, the absence of any undisclosed liabilities, the ownership of property and assets, compliance with various government regulations and tax codes, and a whole host of other relevant items.
The seller's representations generally serve three purposes for the buyer. First, the representations elicit disclosures about the company to be acquired. Second, if the representations are materially inaccurate, they provide a basis for the buyer to walk away from the deal before closing. Third, they provide a basis for indemnification of the buyer in the event of seller misrepresentation.
The negotiation of indemnification provisions is often a protracted and contentious process due to the inherent conflict of interest between buyer and seller. In general, the buyer wants substantial indemnification protection in the event of misrepresentation by the seller, while the seller desires to receive full proceeds after the deal has closed.
In transactions involving privately owned companies, a portion of the proceeds from the transaction are typically held back or placed in an escrow account for a specified period of time to cover any losses the buyer may sustain post-closing due to a breach of representation by the seller. Disagreements over indemnification terms, escrow amounts, “walk away” rights and other related matters can be often be deal-breakers unless consensus can be reached.
Representations and warranties (R&W) insurance, on the other hand, can be an attractive alternative to traditional escrow arrangements. The R&W policy can stand in lieu of escrow (or serve as a supplement to escrow), replacing (or augmenting) the seller's duty to indemnify the buyer for a breach of representation.
R&W insurance helps eliminate conflict and uncertainties about indemnification and escrow concerns. For the policy premium, the insurer assumes the transactional risk and guarantees payment for covered representations and warranties losses. It's a win-win situation, providing security for the buyer and greater liquidity for the seller.
Buyer-based R&W insurance
R&W insurance covers financial loss arising from a seller's misrepresentation. The types of representations underwritten generally include:
R&W insurance can also be expanded to cover loss arising from the breach of a pre-closing covenant (e.g., failure to file a tax return or maintain business operations).
A key feature of buyer-based R&W insurance is that it provides “first-party” coverage for the buyer. A buyer who suffers a loss from a seller's breach need only present its claim to its insurance carrier for payment. In this sense, the policy offers something better than escrow because it obviates the need for the buyer to locate, serve and successfully sue the seller in order to collect damages.
A buyer may purchase R&W coverage to gain greater leverage in negotiating with the seller. The buyer could use the policy as a bargaining tool to obtain a reduced purchase price from the seller since R&W insurance substantially reduces (and possibly eliminates) the need for escrow. In many cases, the buyer who has R&W insurance will lower escrow requirements for the seller in exchange for a discount in the purchase price. This can result in a dramatic benefit for the buyer since the cost of R&W insurance is typically far less than the purchase price reduction.
Buyer-based R&W insurance can also cover losses arising from misrepresentations made in the acquisition (or merger) of publicly traded stock. In acquisitions of public companies without controlling stockholders, the seller's representations typically do not survive closing and thus function principally to guide information gathering, to set forth closing conditions and to serve as a basis for liability if the closing does not occur. Since acquisition agreements involving publicly traded stock most often do not contain post-closing indemnification and escrow provisions, the insurance is an attractive option for an acquirer who would otherwise be left “holding the bag” and possibly subject to securities class action litigation and/or derivative lawsuits in addition to the direct loss resulting from the breach of a representation.
Seller-based R&W insurance
Seller-based R&W insurance provides third party liability coverage. The policy responds to lawsuits filed by the buyer against the seller of a business. R&W insurance indemnifies the seller for losses payable to the buyer as a result of misrepresentation.
At times, a seller may prefer that the buyer obtain buyer-based R&W insurance with the seller agreeing to pay the policy premium in exchange for a reduction or elimination in escrow.
More importantly, though, seller-based R&W insurance offers “sleep” insurance for the seller. It is particularly appropriate in the case of a family owned business that wants to divest itself and be done with the deal.
The coverage is also desirable when the seller is an investment company seeking to distribute the sale proceeds to its investors quickly and doesn't want continued financial responsibility for potential liabilities following the transaction.
In the case of a parent company selling a subsidiary, seller-based R&W insurance can enable the parent to transfer its potential exposure under the sale agreement so that it will be in a better position to be acquired or to engage in other major financial transactions post-closing.
Contingent tax liability insurance
Coverage for contingent tax liability is often included in an R&W insurance policy, but it can also be purchased as a stand-alone policy. Contingent tax liability insurance applies to losses due to breach of representation and warranty made by a seller regarding taxes, as well as loss resulting from the successful challenge of the intended tax consequences of acquisitions and other transactions.
A separate contingent tax liability insurance policy might be appropriate when the seller is the parent of an affiliated group that files consolidated returns and is now being broken up where multiple co-insureds would need to be indemnified for the same tax risk.
Contingent tax liability insurance can also be structured to cover losses that may arise if a tax-free spin-off is successfully challenged. A tax free spin-off may be challenged based upon the facts at the time of the spin-off or based upon events following the spin-off, such as a transfer of control of either the parent company or subsidiary. Coverage can be underwritten either at the time of the spin-off or at the time of a subsequent transfer of control.
It is appropriate to consider obtaining a Contingent tax liability insurance policy wherever the risk of not achieving the intended tax consequences associated with any particular transaction (or series of transactions) is significant and material, and the taxpayer finds it impractical to seek a private letter ruling from the Internal Revenue Service (IRS) and desires insurance coverage to supplement any available opinion from tax counsel.
Loss mitigation underwriting arrangements
Another M&A risk management strategy that is gaining acceptance is loss mitigation underwriting arrangements, or LMUs. LMUs can be used to transfer the risks of pending litigation to an insurance company for a premium. Corporations may opt for this approach when they want to clean up their balance sheets to make themselves more attractive to potential buyers or investors, or to raise capital. LMUs may also be used if a company has inadequate insurance to cover the cost of pending
litigation. In this case, the LMU can serve as excess coverage.
LMUs are often structured for securities class action litigation, where the damages are potentially very large, as well as for employment-related lawsuits, anti-trust actions, product liability, intellectual property, and legal and medical malpractice suits.
LMU coverage may be provided any number of ways - as stop-loss protection with a premium paid to the insurer to cap the company's liabilities at a specified amount; as a buyout of the entire claim for a one-time premium; or as a finite risk program where the litigation/settlement is fully funded.
Transactional risk insurance coverages provide an additional method of addressing the risks of seller misrepresentation, adverse determinations in pending litigation and/or adverse tax consequences, and can also smooth over otherwise difficult negotiations and even add value to a deal.
Representations and warranties insurance, contingent tax liability insurance and loss mitigation underwriting arrangements offer advantages for all parties, including the “due diligence” professionals as well as the individuals and entities who are directly engaged in M&A. As ceos, cfos, treasurers, risk managers and various financial and legal advisors become more aware of transactional risk coverages, insurers expect steady growth in this specialty area.
Companies interested in these new products should look for insurance partners with expertise in M&A risk management. The major brokerage firms and a few insurance companies have professionals on staff with in-depth M&A experience and backgrounds in investment banking, accounting, contract law, tax law and other fields, as well as insurance.
In selecting an insurer, it is important to make sure underwriters are responsive, service-oriented and are adept at customizing transactional risk insurance coverage for the unique requirements of each client. It is also essential to consider the carrier's M&A claims management skills, their track record for paying claims, and their ability to resolve claims promptly and fairly.
By bringing together the best resources and strategies for addressing transactional risks, sophisticated insurance solutions can be developed that benefit companies on both sides of the buy-sell equation.
1. Source: Houlihan Lokey Howard & Zukin's Mergerstat, which tracks mergers and acquisitions involving US companies.