Handling your D&O policy in an M&A Transaction
Executive Summary: In this article, we explore the insurance issues a company’s decision makers face when it comes to mergers and acquisitions with specific conversation around the D&O policy’s change in control provision. What it is, how to handle it, and how to maximize protection.
Merger and acquisition activity continues at a record pace, even through 2020, probably the roughest year most businesses have experienced.
One important issue that should be addressed during a transaction is, what do you do with your D&O policy? And, what must happen to ensure proper coverage continuity?
While all the insurance policies in your coverage portfolio need to be addressed during a transaction, the D&O or Directors & Officers Liability policy is probably the most critical. There are several issues why, but this is all about protecting your firm’s decision-makers.
During a time of transition or sale, there is probably no other time that more critical decisions will be made during the lifecycle of a company. Therefore, structuring the coverage which protects those decision-makers and owners is crucial.
The key feature that puts the D&O policy in the spotlight during a sale or merger is the Change in Control provision found in not only the D&O policy, but all claims-made coverage forms such as a firm’s Employment Practice Liability, Fiduciary Liability, Errors & Omissions (Professional) Liability, Cyber Insurance, and others.
The Change in Control provision terminates coverage when there is a change in majority interest in the insured company. At the point of a transaction, the policy terminates and is known to be “put into run-off”.
The premium for the now terminated policy is fully earned, whether it’s been fully paid or not. Meaning there is no refund for the “unused” portion of the policy. And, if the policy was paid on an installment or finance plan, all the remaining installments are now due.
Premiums are an important consideration, but more important is what are the sellers going to do with their policy? Meaning how do they preserve protection for acts which may give rise to a claim after the transaction?
The basics of Claims-Made.
It might be a good idea to take a step back and explain the basics of a claims-made policy form from the basis of a claim.
A claims-made policy form which is used on most management and professional lines of insurance (D&O, E&O, Cyber, etc.) says that the policy which will pay the claim, is the one in effect at the time the claim was made; or presented to the insurer.
Coverage on a claims-made form hinges on two factors in the policy. The first is continuity and the second is prior acts. Continuity means that coverage has been maintained without any gaps in coverage from the date coverage was first obtained. And “full prior acts” is achieved at the inception of the first policy by either endorsing it as such or by not having a retroactive date.
Now, back to the transaction.
The D&O policy (as well as the company’s Employment Practices, Fiduciary, E&O, and Cyber liability policies) is now terminated. What is going to happen to acts that occurred prior to the transaction date, which may give rise to a claim presented after the transaction date?
If the insured does not elect to purchase an extended reporting period commonly called a “Tail” or “ERP” than any claims presented to the insured or their successor company will not be covered.
As a footnote, in some policies and amended by some states there may be short automatic extensions of coverage already built into the policy for 30, 60 or 90 days. Unfortunately, there are insufficient time frames to protect the insured (s) from long-tailed claims.
As mentioned earlier this is a potential liability for both the seller and the buyer. So, it is common to structure the purchase and sale agreement to address this issue. Taking the next step to extend coverage appropriately is required.
Commonly the P&S will require the seller to purchase an extended reporting period of at least three years. Some deals push that out to six years, but most ERPs are limited to three. If six is required, ask your underwriter if they can accommodate. In today’s marketplace, we are not seeing that accommodation provided at all unfortunately. The cost of the extension can run anywhere from 75% to 300% of the annual premium based on the duration of the tail and the insurer. You can typically find those charges in your D&O policy, but if you’re not sure, contact your broker who should be involved in your M&A discussions early on to advise you properly.
Who bears the cost of the ERP?
Often, it’s wrapped into the deal terms with the buyer assuming the cost as part of the transaction.
Now, we have seen some smaller private deals have their D&O underwriters acknowledge the Change in Control policy provision but continue coverage without terminating or forcing run-off. This is a win-win for buyer and seller. It doesn’t happen often, but it never hurts to ask. If the management team on the seller’s side will continue post-close and the business isn’t changing much there may be a good case for continuing coverage.
What happens if the seller has not maintained D&O coverage previous to a deal?
Good question. As mentioned earlier an M&A deal presents significant risk to sellers. There are a lot of statements, documents, and assurances made during a transaction which may be later misconstrued, or misinterpreted and give rise to a claim. There may also be hidden liabilities in a firm which could become claims once a deal is completed. So, how to you manage that risk?
In some cases, the underwriter who will be providing moving forward coverage for the “new” entity may be interested in providing protection for the prior entity with prior acts. It’s typically a one-day policy but priced more like a full-term policy since it’s picking up all prior acts.
While the conversation here focused on D&O, it still applies to all claims-made policies; Employment Practice, Fiduciary, E&O, and Cyber Liability policies all need to be addressed.
For most firms actively involved in the M&A space such as private equity, venture capital and investment banking, the change in control provision issue is well known, planned, and worked into deal terms.
Where this becomes a bit problematic is outside of the M&A environment or a smaller firm doing a deal or two a year and their advisors are not familiar with these issues. This is where getting your insurance broker involved in discussions early on in negotiations is important. If necessary, have non-disclosure agreements at the ready to protect the confidentially of your deal terms. Getting professional guidance to make sure you’re not left with uninsured exposures following the close of your transaction is critical.
For more information on how to handle your D&O policy during M&A, or other insurance issues that arise during the merger and acquisition process, please contact me for a conversation.