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Making the M&A transition with D&O run-off coverage.

Litigation from friendly mergers, hostile takeovers or leveraged buyouts often targets the surviving entity and the outgoing board. Therefore, virtually all merger and acquisition documents between two parties contain provisions for corporate indemnification and/or directors' and officers' liability insurance. Typically, the acquiring company agrees to maintain or purchase D&O insurance for three to six years to cover the directors and officers of the acquired company for acts prior to the consummation date, and in most cases, from the incorporation date.

Merger and acquisition agreements stipulate that coverage must be as broad as coverage afforded by the carrier at the time of acquisition. The designation of this responsibility between the parties is significant, and most companies will not enter into a merger or acquisition unless they are comfortable with the indemnity and insurance arrangement. Some insurers provide run-off or extended discovery coverage that specifically addresses this situation.

How It Works

Usually, the insurance broker or agent for the acquiring company approaches the current D&O carrier to determine whether it can offer the required coverage. If the carrier fails to provide adequate coverage, the broker or agent must consider other insurers. To save on premiums, the broker or agent may advise the acquirer to consider rolling this coverage for the acquired company into its own D&O insurance.

However, in this instance, the directors and officers of the acquired company are dependent on the acquiring company's protection. After the acquisition the surviving company may emerge in a highly leveraged position, which can limit its ability to provide equivalent D&O coverage. A run-off policy purchased separately frees the previous company's directors and officers from worrying about the surviving company's ability to maintain coverage in an unstable period. It also allows them to make unencumbered decisions in a new job.

Even if directors and officers of the acquired company are not affiliated with the new company, they are still liable for past activities. Albert Salvatico, a principal with ARC Excess & Surplus in Mineola, NY, points to a gap in prior acts coverage as an important reason for purchasing a run-off policy. "Often the new underwriter is unwilling to provide prior acts coverage for the acquired company," he says, "yet the period prior to acquisition is one of vulnerability for the outgoing board. The run-off policy specifically meets that need."

Mr. Salvatico points to a discrepancy between the coverage held by the acquired and acquiring companies. In a recent case board members of the acquired company felt comfortable with the $20 million limit of their policy, but the acquiring company carried only a $10 million limit. When the old company was folded into the new one, coverage was folded in as well.

Wendy Johnston, assistant vice president with Swett & Crawford in Dallas, advises purchasing separate run-off coverage in merger, acquisition or leveraged buyout situations. "If we roll prior acts coverage into the company's existing D&O insurance, only one limit is available for the acts of both boards," she says. This limit could easily be used up for an unrelated situation, leaving the directors out in the cold."

In some instances, the new entity fails because of its debts, and the dependent directors and officers are left without indemnification or insurance. Peter Taffae, assistant vice president of Marsh & McLennan's D&O department in Los Angeles, cites a case in which an acquiring company purchased a run-off policy for one year. The new company went bankrupt, the D&O insurance expired and the directors were left bare. "When the claims started coming in, the old directors were caught off guard," Mr. Taffae says. "The situation was unnecessary, because the new entity was financially strong enough at the time of acquisition to have purchased six years of extended coverage at once."

From the surviving company's viewpoint, purchasing separate insurance to protect former directors and officers safeguards corporate assets. The company may respond to the threat of litigation by directly indemnifying the former board. However, if it has run-off coverage in place, the insurer reimburses the company for its indemnification. In addition, the run-off policy provides cost-effective protection and should be non-cancellable for any reason except non-payment of premium. The policy applies one aggregate limit and locks in coverage and premiums for the entire three- to six-year period.

The capability of a D&O carrier to provide six years of coverage in a single aggregate non-cancellable policy is a critical issue for brokers or agents. Not all insurers are willing to provide such coverage because of their risk assessment and the long-term commitment involved. A few insurers offer new excess coverage, which provides increased limits to cover expected claims situations. However, do not believe that a company saves money by not purchasing a separate run-off policy. In fact, such an omission may put the assets of directors and officers and those of the new entity severely at risk.

Underwriting criteria may be specifically tailored to companies involved in merger or acquisition activity. For instance, merger and acquisition documents, articles of incorporation and bylaws of acquiring companies indicate whether the proper level of indemnity is provided to directors and officers of the acquired company. The run-off policy reimburses a corporation for indemnification of its directors and officers. With the possible exception of when the corporation cannot provide indemnity, such as during insolvency, an insurer may reimburse the affected directors and officers directly. Because not all indemnity arrangements are identical, underwriting research determines the indemnification level and the acceptability of risk.

What to Expect

What can a company applying for a run-off policy expect during the underwriting process? First, full financial analysis must be initiated to determine the financial strength of both companies. Public companies have a greater obligation to disclose detailed financial information than private companies, which can make it difficult to obtain such data.

The quality of independent directors' oversight is a weighty underwriting factor. In merger and acquisition activity, the underwriter evaluates the level of expertise shown by the entire board and by the independent directors to determine the acceptability of an offer. An excellent sign, for instance, would be the formation of a committee of independent directors to determine the suitability of the offer at the time it was made.

The type of industry, its environment, claims activity and history of litigation are also important underwriting concerns. The breadth of allegations against a company require particularly close scrutiny. Most lawsuits stem from shareholder allegations of management's failure to exercise due diligence in entertaining additional offers for the company. In Edelman v. Fruehauf Corp. a hostile bidder attempted to prohibit management from using corporate funds to pay investment bankers' fees and other costs related to its attempted leveraged buyout, unless management made similar accommodations to other bidders. The court determined that management's buyout proposal was unfair to shareholders because the board of directors tried to strike a deal with management, regardless of what other bidders might offer.

In this area an insurer may distinguish between continuing and new policies. An existing carrier presumably has a better understanding of the company's situation, while those who entertain new run-off coverages do not have the incumbent carrier's immediate benefit of full knowledge. In addition, it is possible that the existing insurance limit may be depleted by claims. A new insurer entertaining a client for excess coverage must assess the likelihood of impairment, as well as the breadth of allegations in notices to the carrier, because they will probably help determine the type of coverage. Since the lack of full knowledge hampers a new insurer, communication with the broker or agent and potential client is essential.

The fairness opinion regarding the adequacy of the offer given by two or more independent investment facilities is valuable information to underwriters. These documents indicate whether the acquiring company exercised due diligence in the best interest of shareholders. Finally, documents sent to regulatory agencies are important because regulatory issues affect underwriting decisions. Some industries, such as transportation, utilities and insurance, have more regulatory issues than others, and regulatory procedures usually lengthen the time required to complete mergers and acquisitions by up to a year. This prolonged period of instability increases the possibility that directors' and officers' behavior will be challenged. The runoff policy covers lawsuits brought for alleged wrongful acts occurring before control shifted.

Although economic indicators suggest that merger and acquisition activity is declining, the collapse of the junk bond market will probably not deter companies from considering profitable opportunities through mergers and acquisitions. While the vehicle to support them may change, consolidations will continue to play a significant business role. The run-off policy is tailor-made to address the very problems arising from mergers and acquisitions.

A knowledgeable underwriter with this type of expertise should be considered the risk manager's integral partner during the company changeover. Likewise, an insurer that chooses this role can view the situation as an opportunity to enter into a long-term commitment and can provide a valuable solution to the problem of critical and volatile risks. Bruce Hayes is commercial accounts manager at Aetna/Executive Risk, Aetna's underwriting manager for directors' and officers' liability insurance in Simsbury, CT.
COPYRIGHT 1991 Risk Management Society Publishing, Inc.
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1991 Gale, Cengage Learning. All rights reserved.

Article Details
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Title Annotation:mergers and acquisitions; directors and officers insurance
Author:Hayes, Bruce
Publication:Risk Management
Date:Feb 1, 1991
Previous Article:Emerging RM concerns for directors and officers.
Next Article:Private and non-profit firms need D&O coverage, too.

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