The Hidden Dangers in No or Low Indemnity M&A Deals

Many M&A transactions now use R&W Insurance as a substitute for seller indemnity. This article briefly discusses considerations for M&A practitioners when confronted with R&W insurance exclusions.

The following are some of the most common exclusions:

  • Environmental (if Phase I’s or diligence evidences contamination);
  • Employee matters such as wage & hour claims (typically limited to California), independent contractor status;
  • Pending litigation, investigations and/or audits;
  • Certain tax matters such as the validity and amount of NOLs, and historical liability if acquired company was previously part of a consolidated group or is now being acquired from a consolidated group;
  • Underfunded pensions plans and multi-employer withdrawal liability;
  • Product or professional liability; and,
  • Matters “red flagged” as problems or otherwise ignored in due diligence.

Although buyers and sellers may intend to use the R&W insurance to reduce and transfer the risk of a breach to the R&W insurance policy, the existence of exclusions requires the parties to behave and negotiate for protection as if the R&W insurance may not apply to disclosed matters that are perceived to have heightened risk.

What to do:

  • Consider whether alternative insurance solutions are available to address the issue (such as tax liability, litigation insurance and tail policies);
  • Consider whether the seller’s indemnity/escrow (particularly for general reps) is sufficient to cover the exposure should there be a claim for an excluded matter or whether a special indemnity is required; and,
  • Ensure that the PSA addresses how the parties will allocate and handle the claim process in the event of an excluded matter.

There is an increasing concern by R&W insurers that buyers are not conducting (or not disclosing) the level of diligence they normally would because of the existence of the R&W insurance.  If due diligence reports address risks related to foreign operations, employee matters, quality of earnings, and taxes in a cursory (high level) manner (or not at all), carriers may exclude such matters until they receive a more fulsome report.

Often, buyers may justify the lack of diligence because they view the risk as “insignificant”. However, given the low retentions in R&W policies (1.5% of the transaction value, which includes the buyer’s basket), the level of materiality for purposes of insurance can be far lower than what the parties deem “material” in light of the overall transaction value and costs to diligence every issue. This thought process can become particularly problematic if the retention can only be eroded by covered matters, which is a common policy feature. Robust diligence can help by providing sufficient support for an R&W carrier to cover the risk, or, alternatively, to insure the risk under a separate policy. At the very least, robust diligence helps the parties negotiate allocation of the risk or adjustments to the purchase price in a fair and reasonable manner.

Of course, there are numerous issues that may arise during the M&A process and often, transferring risks to a third party insurer may be the most desirable resolution.  Practitioners should familiarize themselves with the alternative types of policies that R&W carriers may be able to offer in addition to R&W insurance.

Among the risks that can be addressed by separate policies are tax matters, litigation and/or pending audits, product liability reserves and, disputes arising from conflicting interpretations of law (although factual disputes are difficult to insure).  While tax can generally be underwritten in tight time frames, litigation and contingent liability policies often require significantly more time and expense, so the process should be started as early as possible. In fact, a seller may wish to obtain the insurance as part of preparation for sale.

If the target has heavy product liability or errors and omissions exposure, the existence of tail or run-off policies should be sufficient to cover the exposure.

Where insurance is not a viable solution and the parties are retaining the exposure, the PSA should be clear as to how the liability will be handled should an exclusion apply. Oftentimes, agreements do not address this issue with specificity relying instead on the general seller’s indemnity, which may be insufficient.

For example, should there be an uncovered claim that exceeds both the buyer’s basket and the seller’s escrow (i.e., the retention), no coverage is afforded under the R&W policy even for a subsequent claim that is covered unless and until the buyer suffers loss equal to the retention again. This is because the policy only recognizes erosion of the retention by covered matters. In a subsequent claim, since there is no seller escrow left, the buyer must suffer again an amount equal to another 1.5% of the transaction value in order to trigger the policy. Further, since most policies contemplate that the seller will bear half of the retention, what happens if the seller’s escrow was depleted by a prior uncovered claim? The parties may well be at a standstill at the time of the claim unless the agreement sets forth a process for dealing with such matters.

While the scenarios discussed may seem largely hypothetical, increasing claims frequency coupled with the current retention levels makes them more probable. Unless parties are specifically addressing these matters in the PSA, the resolution of uncovered claims may result in an additional costs and increased complexity in resolving the breach – – both of which the insurance was designed to avoid.