Insuring Against Risks in the Purchase & Sale of a Business

Insuring Against Risks in the Purchase Sale of a Business

Seller’s shareholders do not want to make representations and warranties, Buyer is not willing to live with “best of knowledge” representations; and the negotiations continue. The answer to these problems and to other risk issues associated with the purchase and sale of a business may be solved through the use of uniquely designed insurance products that shift the risk to an insurance company. Although the parties will still have to agree on the amount of coverage and who pays the premiums, they have at least found a way to move forward with the transaction.

The following is a summary of the key insurance products that are offered to facilitate the completion of a merger or acquisition. Each of the thirteen products described below can be used to overcome what may appear to be insurmountable problems in the transaction.

  1. Representations and Warranties Insurance – If the seller of a business does not want to set aside a large portion of the proceeds from the sale of the business in an escrow account, there is another alternative – Reps and Warranties coverage. It is possible to reduce or eliminate the escrow, or if there is no escrow requirement, it can reduce the ultimate exposure by transferring the risk. For example, if an escrow of $10 million is required, it would be possible to reduce that amount by paying a premium in the range of 2-7% of the limit (a one time premium of $200-700K, which can be financed off balance sheet). This coverage can be utilized to insure all Reps and Warranties, or merely the ones that appear to be substantive.
  2. Pending Litigation – If you are attempting to sell a company that has a large uninsured loss (or is poised to have a large hit to earnings) it is now possible to transfer the entire liability to an underwriter, thus cleaning up the balance sheet. For example, if your company had reserved $5 million for an uninsured loss you could use litigation insurance to transfer the entire liability to an insurance company. The premiums would be approximately $1 million per year for 3 years thus spreading out the hit to earnings (plus there may be some tax benefit to the company from payment of the premiums). Any disclosure issues for a public company could be dealt with up front by indicating that the loss was substantially covered by insurance.
  3. Environmental Coverage – In nearly every transaction environmental issues are brought up, whether or not they are material to the transaction. When there is a known significant problem, the entire exposure can be transferred to one of several insurance companies – they in essence buy the claim. Coverage can also be provided that would cap the maximum exposure for remediation – called Remediation Cost Cap Coverage, which would provide coverage for any cost that exceeds the original estimate for remediation. This capping of the exposure may be helpful in making a company more palatable for sale. There are a number of other environmental coverages which may have application as well.
  4. Tax Related Issues – There are a number of tax related risks which can be insured against. One example is a Corporate Reorganization Tax Indemnity. One case in which Corporate Restructuring Insurance was used involved a well known U.S. corporation that was owned by a combination of (a) trusts and holding companies for the benefit of various third and fourth generation heirs to the founder, and (b) a profit-sharing plan. To address the desire of the “grandchildren” and “great grandchildren” to liquidate their holdings, the corporation sought to rationalize its structure in a manner that would be tax-free under the Internal Revenue Code. Getting this tax position wrong could have resulted in substantial tax liability to the shareholders ($100 million+). Hence, the profit sharing plan, the largest shareholder, required the corporation to obtain insurance against this reorganization being determined to be taxable. The insurance here was “true” insurance, where no party was obligated to counter-indemnify the insurers for a loss.
  5. Run-off Coverages – Run-off coverage is designed to protect sellers (and buyers) from liabilities arising out of a change in control event that was either a) insured by a claims made policy (which would not cover “claims made” after the change in control) or b) uninsured. Run-off coverage is purchased to cover claims arising from prior acts that are made after the change in control/policy expiration. The coverage can be tailored to fit almost any exposure (most often D&O, EPL, products/environmental liability) and for a period of up to six years. Premiums are usually reasonable as the policies only cover prior acts. All exposures going forward, post closing, will be insured under new policies.
  6. Financial Guarantee – Using sophisticated, structured solutions, the insurance market via credit enhancement insurance, surety bonds and financial guarantees can facilitate and maximize the investment needs of corporations. This is especially true for borrowing, lending and leasing activities such as: 1) increasing the loan to value/cost, 2) reducing the associated rates and costs, 3) increasing cash flow from an investment, 4) enhancing securitization of the assets, and 5) generating liquidity.
  7. Residual Value Insurance – This product is designed to guarantee an agreed upon asset value at the termination date of a lease or financing. This insurance can be used as a credit-enhancing tool for the financing of real estate by increasing loan proceeds, facilitating more favorable borrowing terms (lower loan rates and increasing cash flow by lowering the loan amortization), and enabling favorable leasing terms.
  8. Regulatory Risk – This type of product can insure against failure to obtain various types of regulatory approvals, usually within a defined period of time. It can also facilitate transactions for which the investment cannot be deferred or made contingent upon securing the necessary regulatory approval. It will function as a guarantee of approval from state and federal agencies, thus eliminating the “regulatory risk” factor.
  9. Lost Revenue Coverage – At times there may be one particular risk that the dealmaker is uncomfortable accepting in a transaction. An example of this occurred where the purchaser of a ski resort insured “paid skier days.” The coverage resulted in a substantial payment of a claim in a year that had normal snowfall. Regardless of the reason that kept the skiers away from the resort, the insurance coverage paid the shortfall.
  10. Lease Enhancement – A lease normally will allow tenants to terminate the lease in the event of condemnation by eminent domain and direct physical damage to the premises of a specified amount and or duration. In order to enhance lease back loans, this risk can virtually be eliminated. This coverage insures the unamortized balance of the loan and accrued interest resulting from early lease termination. It may also be used to protect the lessor’s equity against diminution due to early lease termination by a credit tenant.
  11. Aborted Bid – This insurance reimburses the insured for the agreed costs associated with an agreed bid, merger, acquisition, disposal or transaction that has been terminated for identifiable reasons outside the control of the insured entity. Loss may result from a termination or non-completion of the transaction caused by: 1) competing bids, 2) rejection of a bid by shareholders, 3) failure of second party to meet closing conditions, 4) intervention by regulatory body, and 5) second party withdraws from negotiation. The contract will cover expenses charged by accountants, attorneys, consultants, financial institutions, investment bankers and others.
  12. Hostile Takeover – The policy reimburses the insured company for direct costs associated with the successful defense of a hostile takeover bid and/or proxy contest.
  13. Corporate Restructuring – This coverage can provide an innovative means to address various risks attendant to corporate mergers, acquisitions and divestitures. Typically, the structure of a transaction will allocate responsibility for these liabilities to one party or another. Corporate Restructuring Insurance can be used to support this allocation. Although the coverage is usually not intended to assume a known exposure from the seller; rather it can be utilized to put limits on the buying company’s risk by combinations of risk sharing, layering, deductibles, premiums, and other security.

Conclusion

Insurance should only be a consideration after properly addressing the legal and contractual issues dealing with negotiating and drafting the transaction documents.

My experience indicates that many problems encountered in negotiating a transaction arise out of a misunderstanding by the parties as to the actual liability they may be assuming and how to contractually deal with those issues. Misunderstandings in the area of representations and warranties are legion. It is important to understand issues such as “bond” warranties versus “best of knowledge” warranties, how to define “best of knowledge,” whether a warranty is made for purposes of closing and what effect the warranty has after closing, etc., etc., etc. I will address issues pertaining to representations and warranties in a future brochure.

There are agents and insurance companies that specialize in providing this type of insurance. If you would like to get the name of one of these agents or companies or have any other questions about the use of insurance in closing a business acquisition, please do not hesitate to contact me.


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