Risk Insights: Managing Your Hidden M&A Risks
Mergers and acquisitions today generally have more condensed timelines than in the past, which can lead to less time for performing a due diligence review. A rushed due diligence process increases the number of risks that could go undetected when a buyer reviews a seller’s past and current liabilities.
The reason that hidden liabilities are such an issue is because the buyer’s insurance typically doesn’t cover them. Usually, when a company is acquired, its liability covers are terminated. If these potential liabilities aren’t considered when the purchase price is decided and the contract drawn up, the buyer could find itself questioning the transaction later on—when it’s too late to take any corrective action.
Taking on Liability
During a merger or acquisition, buyers take on the liabilities of the acquired company. The type of sale determines the extent to which liabilities are taken on. If the sale is an asset sale, the seller retains possession of the legal entity and its liabilities. Only the seller’s assets and their accompanying liabilities are transferred to the buyer. Assets could include items like equipment, trade secrets, inventory or licences. Buyers typically prefer these types of purchases, as they reduce the likelihood of future contract disputes, product warranty issues or product liability claims.
In a stock sale, the buyer purchases the selling shareholders’ stock directly, and therefore obtains ownership of the seller’s complete legal entity and all of its accompanying liabilities. Stock sales present more risk for buyers, who need to prepare for the possibility of future legal actions, environmental concerns, employee issues or HSE violations. These liabilities can be reduced to some extent through insurance policies and indemnifications. Still, performing thorough due diligence is crucial. Consider the following examples of hidden liability:
- A selling company purchased several other organisations in the past few years, all of which the buyer must now track down, even if they do not exist, to identify all their associated liabilities.
- A selling company has legacy exposures, which are ongoing legal claims that arose against the acquired company many years ago. The buyer must research the past cases and determine possible financial implications as well as their impact on its reputation and the possibility that similar cases could arise in the future.
Organising and Updating Insurance Policies
Depending on the circumstances, it may be wise for the buyer to combine the seller’s existing insurance policies with its own. For example, the seller might have its fleet insurance structured one way, and the buyer might have its fleet insurance structured differently.
Multiplying policy discrepancies across various lines of insurance and keeping track of policy limits, exclusions and excesses becomes challenging. The buyer might find it more convenient, and more cost effective, to insure all the risks for both companies together. In addition to convenience, consolidation of policies will give the buyer an opportunity to reassess insurance policies to make sure the seller’s limits were set at an appropriate value and excesses are well-suited for the needs of the merged entity.
A knowledgeable insurance broker is an invaluable asset during a merger or acquisition.
Every year, businesses face stricter environmental guidelines, which create more environmental liabilities. Some types of environmental liabilities the acquired company could face in the future are pollution, mould and hazardous materials in air, in water or on land. It is important to pinpoint early any exposures for the company being acquired. Here are some policies to manage environmental risks:
- Environmental impairment liability insurance encompasses a range of policies that cover legal liability stemming from pollution. Some insurers may offer additional cover for any cost overruns that were not expected during pollution clean-up.
- Premises pollution liability insurance offers cover for site-based exposures, usually covering clean-up and remediation costs as well as third-party legal action brought on by hazardous material exposure.
D&O policies are typically structured as ‘claims made’. This means they do not cover the company after the policy expires. If a claim is filed against the seller after the seller’s D&O policy expiry date, the seller may be responsible for paying any charges in full. Depending on contract details, this could mean that the buyer is now response for those costs after the sale.
D&O policies are written with policy durations, but claims may be brought up in the future after the policy has expired. To combat this risk, the seller will often purchase a D&O run-off policy to cover claims that may be brought against them in the future.
Buyers will want to consider that the directors and officers of the company being acquired—who may be slated to become executives of the acquiring company—will need to be added to their D&O policy. The policy of the company that was acquired will provide cover only for actions that transpired when those directors and officers were executives of the acquired company, before the merger or acquisition; new cover is needed for any future actions that occur.
Asking the Right Questions
Asking questions, even when they are complicated or uncomfortable, and clearing up any confusion helps a buyer reduce risks and determine an accurate purchase price. Here are some questions that are not always asked, but should be:
- Are there legal and financial risks attached to this merger/acquisition, and, if so, what are they?
- Do the acquired company’s insurance policies have expiry dates that can sustain future financial liabilities, and any others that might pop up from past activity, before the transaction occurs?
- Does the acquired company face any environmental liabilities at present time, and, if so, what are they?
- Is the acquired company in need of environmental clean-up in the future, and, if so, how often?
- What are the specific terms and conditions in the D&O policy of the acquired company?
- Does the D&O policy have any statute of limitation clauses?
- Does the company’s post-transaction risk summary look different from how it did prior to the purchase?
Managing the hidden risks during a merger or acquisition may seem like a daunting task, but with the right information and support it can be done smoothly and thoroughly. Talk to Business Insurance Service for further insight into your potential risks and the measures that would best protect your company.