Transactional Liability Insurance: Why Management Liability Isn’t Enough in Today’s M&A World

After a slight Covid-19 related dip in 2020, M&A activity has reached unprecedented levels with 2021 being the busiest year on record, resulting in significantly elevated demand for M&A insurance.

At the same time, M&A insurance claims activity has also increased with one leading broker reporting claims to be up 23% in 2020 versus 2019 and market data indicating no difference in the likelihood of a claim on deals with a small versus large enterprise value. There are multiple causes of this trend including a broadening of commercial terms in transactions, a more sophisticated understanding of M&A insurance and claims process by brokers and insureds alike and a wide variability in business performance due to the continuing impact of the COVID-19 pandemic.

However, while M&A (also known as transaction liability) insurance has become a widely adopted risk management and deal facilitation tool for transactions with an enterprise value between $100 million and $5 billion, it is only recently that similar solutions became available for those with an enterprise value less than $50 million.

Small-to-Medium-Sized Enterprises and Risk

The value of this to micro and SME businesses cannot be underestimated. While every seller wants to enjoy the full value of their deal as soon as possible, the buyer will usually require the seller to place a portion of funds into escrow for several years to protect against any future losses in connection with a representation or warranty, or may negotiate to hold back a portion of the proceeds unless and until certain performance hurdles or other post-close conditions are achieved. Transaction liability insurance helps micro and SME sellers to avoid having to provide an escrow or be subject to a holdback.

Up to this point, directors and officers buying micro and SME businesses relied upon a misconception that they and the seller company were protected against transaction liabilities by their management liability policy. The reality is however very different. Management liability policies simply do not offer the same level of protection against the four most common types of representation breaches in sales contracts that we see — financial statements, compliance with laws, tax matters and material contracts because of the breach of contract (or contractual liability) exclusion almost universally included in all management liability policies.

Management liability policies typically address three key D&O insurance clauses for private companies, commonly known as Side A (covering the directors and officers personally), Side B (covering the company for the indemnity given to the directors and officers) and Side C (covering the company for claims against the company).

However, in an M&A transaction, the seller (a company or individual) and sometimes the management of the company will give representations and warranties to the buyer about the company which they are selling. If the buyer found the company they had recently acquired was not compliant with certain laws for example, and such non-compliance constituted a breach of a seller’s representation, then this would constitute a claim under a transaction liability policy (with defense costs also covered) but not under a management liability policy where the breach of contract exclusion would deny coverage.

Without transaction liability insurance, sellers are at risk of financial loss if there is a breach of any of the representations they give to the buyer in an M&A transaction.

To illustrate this point, here’s a real-life example of a claim that we managed.

An independent fast-casual chain of restaurants in Arizona and California were acquired by private equity investors. Following the transaction closing, the chain was investigated for breaching the maximum allowable weekly working hours of its employees resulting in defense costs, fines and penalties. At the time the representations were given in the deal process, the seller had incorrectly thought they were in compliance with relevant employment laws. An investigation concluded otherwise and the resulting loss was $7 million (including damages, defense costs, and rectification costs). Fortunately, the seller had purchased transaction liability cover, fully indemnifying them for losses relating to the breach of representation.

In the above claims scenario, a management liability policy may be triggered for directors’ costs and expenses in the underlying investigation, but the breach of contract exclusion will not cover claims brought by the buyer against the seller for the misrepresentation under the Sale and Purchase Agreement. This example shows that claims can be brought in the usual context of a D&O claim that relates to a pre-acquisition wrongful act.

All management liability policies have a trigger when they are acquired, which generally states that in the event of a corporate takeover during the policy, the cover will continue to apply but only in respect of wrongful acts committed or alleged to have been committed prior to the effective date of the takeover. All companies should consider purchasing tail cover, as any go-forward cover will only be from the date of acquisition and will either fall under the buyer’s own management liability policy or, if it is a private equity purchase, the new go-forward policy will fall under a managed portfolio of business. Either way, it is important that directors and officers of the selling company ring-fence their historic exposure as they will no longer control their company, its insurance or indemnification provisions.

To further demonstrate the benefit of having one fit-for-purpose transaction liability policy versus an entangled web of different policies which may or may not cover a claim, here’s another example.

A customer of a U.S. medical diagnostic company filed a suit against the company, its buyer and four of its directors for allegedly submitting fraudulent insurance charges for non-reimbursable medical services. The initial demand was for $20 million plus damages and attorney fees. The alleged fraud dated from 2014 to 2020.

‘Without transaction liability insurance, sellers are at risk of financial loss if there is a breach of any of the representations they give to the buyer in an M&A transaction.’

The medical diagnostic company had a management liability policy with a retro date of January 1, 2016, which excluded any claim or investigation arising out of any act, error or omission occurring, in whole or in part, before that date. The company was acquired on December 31, 2019, and as its management liability policy went into run-off, it purchased a six-year tail period which only provided cover for claims arising out of wrongful acts prior to December 31, 2019. As well as the alleged wrongful act dating back to 2014 and after 2019, there were numerous other complexities in the claim, including allegations of fraud, as well as multiple policies in play that could respond (each with other insurance exclusions).

Eventually all parties agreed to mediate and settle. The total claim paid was $3.5 million, shared by three different insurers. Had the medical diagnostic company purchased appropriate M&A cover, there would have been just one policy in place which would have addressed this specific exposure for the selling company and its directors.

As M&A activity is increasing, so is the likelihood that brokers and agents will receive notification that their clients are selling their business. They have a duty of care to ensure their client is aware of the risks associated with an M&A deal but, more importantly, to ensure their client understands the limitations of a management liability policy in the context of a transaction and how they can mitigate risk by purchasing a transaction liability insurance which can specifically ring-fence and indemnify against such exposures.

Topics Mergers & Acquisitions