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How to Cover Unknown Exposures When You Buy a Business

January 2011 | New York RIMS Chapter Monthly Breakfast Meeting

Douglas H. Hartman, ARM

The RIMS program said "With M&A volumes rising, are we prepared to execute successfully? The Critical role of a Risk Manager in an active M&A environment."

Instead, what I heard was more of a sales pitch for Representations & Warranties insurance. Yet the presentation appeared to be welcomed by this audience made up of sophisticated insurance buyers, brokers and insurance underwriters. Representations & Warranties insurance, after all, is a relatively new form of coverage -- and something good to know about.

Howard T. Spilko, Esq. of Kramer Levin Nathalis Frankel presented a case study. He took us through the due diligence steps in the purchase of the division of a foreign corporation. He highlighted many of the close to 40 risk exposures he would look for. Nice job!

Craig A. Schioppo, Managing Director of Marsh'sTransactional Risk Group spoke about collateral, indemnity baskets and other aspects of the financial due diligence process. Brief but useful.

The sales pitch was delivered by David G. Pellegrino, Managing Director of of Marsh's Private Equity and Mergers and Acquisitions. He did a good job of illustrating the unknown exposures -- which ones are insured by D&O, commercial general liability and other conventional forms of insurance -- and which exposures can be insured by a Representations & Warranties policy.

Three Observations

  • I did not hear any mention of the difference between a purchase of stock and a purchase of assets transaction. In an purchase of assets, the uncertainties are less accute than in a purchase of stock deal in which the purchaser buys liabilities as well as assets.
  • Regards process, the speakers did not talk about the large number of documents that are usually available to the risk manager and/or the purchaser's consultant. The datasite libraries usually have loss runs, insurance policies, Phase I environmental surveys, lists of matters in litigation, tax returns, financial and operating statements, legal compliance filings and thousands of pages of other documents.
  • I didn't think the speakers said enough about the role of the risk manager in analyzing the purchase agreement and recommending what representations, warranties and indemnities the sellers should make.

     

    Synopsis of A Representations & Warranties Coverage Form

    1. The form I reviewed was expressly written to insure specific representations & warranties made in the actual purchase agreement.
    2. It had some definitions I had not run into before in other forms:
    3. "Net provable damages" means, among other things, expenses arising out of a "direct claim." Also it means the present value of lost earnings as a result of a "breach."
    4. A "direct claim" means a demand for money made by the insured.
    5. A "third party claim" means damages arising out of a "breach" and asserted by persons not party to the purchase agreement.
    6. "Breach" means misstatements, inaccuracies and breach (I guess as defined in a dictionary) of any representations or warranties in the purchase agreement.
    7. Attached to the policy was a schedule listing the titles of specific documents acquired from the seller's datasite and stating that the insured warranted they were complete and correct copies of actual documents supplied by the seller.
    8. This attachment also listed a number of additional representations made by the insured, followed by the names of five senior executives who were the only ones with "actual knowledge" of those statements and other representatons.
    9. The policy period was six years and, excepting non-payment of the premium, it could not be cancelled.
    10. There was a $10 million retention that dropped down to $1 million after the first year.
    11. This particular policy included recognized environmental conditions but carved out one in particular.
    12. Naturally, anything to do with asbestos was excluded.

    In other words, the Reps & Warranties policy form I reviewed pretty much insured the risks of loss talked about by the RIMS panel.

    Our Sales Pitch

    At Montclair Risk Advisors we perform a large number of Insurance Due Diligence Reviews, mostly for sophisticated private equity firms. In our experience, these private equity firms do not purchase Representations & Warranties coverage. We have done some work for strategic buyers and can see why an industrial company -- especially the foreign buyer of a U.S. business -- might want to add a pair of suspenders to the belt of their due diligence.

    For information about our transactional services visit our Services Menu. Also, visit our Free Tools Menu for other useful M&A Due Diligence ideas. Or give us a call at the telephone number on the banner below.