Posted at the National Law Review last week by Daniel J. Struck and Neil B. Posner of Much Shelist – a review of different type of insurance products that can be helpful in facilitating certain types of financial transactions: 
Insurance coverage as a commercial risk management tool has been around for centuries, but there are a number of newer transactional insurance products that can actually help drive business opportunities and close deals. Developed in the last decade or so and becoming more widely available, these products—including representations and warranties (R&W), tax liability, litigation liability and environmental stop-loss insurance—are decidedly not your father’s insurance coverage. Rather, these less traditional types of coverage can help facilitate the purchase or sale of a business or a significant business asset by reducing the uncertainties associated with potential indemnification obligations and liability exposures.
Traditional Insurance Coverage: Still an Important Corporate Asset
For many businesses, standard commercial insurance is treated as a routine expense in which premiums are the deciding factor in evaluating largely interchangeable form policies. In previous articles, we have discussed why this approach is often short-sighted.
The types of insurance coverage purchased by most businesses are predictable. General liability insurance protecting against liabilities owed to third parties resulting from bodily injury, personal injury and property damage is a given. Some kind of first-party property coverage for loss to owned or rented premises, damage to inventory and equipment, and resulting business interruptions also is generally necessary. Because most businesses have employees, insurance related to workers’ compensation and employee benefits programs is essential. Depending on the particular business, additional lines of insurance—such as management liability, employee dishonesty/fidelity, fiduciary liability, cyber-liability and professional liability—may be necessary as well.
For all their differences, these types of coverage all serve as a means to manage risk and reduce the exposure to potential “fortuitous” first-party losses or third-party liabilities, ranging from slip-and-fall accidents at a retail location to a devastating explosion at a factory or an alleged breach of duty by a company’s directors. Although traditional insurance coverage may help protect the financial health and solvency of a business and its individual partners, officers or directors, it does not often operate as an actual driver of business opportunities.
Transactional Insurance: A Tool for Facilitating Corporate Transactions
Transactional insurance policies, on the other hand, generally insure against risks that fall outside the scope of more traditional coverage and have the potential to drive, or at least facilitate, certain corporate transactions. Examples include:
- R&W insurance, which provides coverage for the contractual indemnification obligations resulting from breaches of the representations and warranties of a specific agreement (often a contract for the purchase/sale of a business or a significant corporate asset);
- Tax liability insurance, which provides coverage for an identified potential tax liability or penalty, or for the liability resulting from an adverse determination in a specified ongoing tax dispute;
- Litigation liability insurance, which may provide coverage if an award of damages in an identified piece of litigation exceeds a threshold specified in the insurance policy; and
- Environmental stop-loss insurance, which may provide coverage for the costs of an ongoing environmental remediation project that exceeds a specific cost threshold.
Although commercial insurance policies of every type should be tailored to the particular needs of the insured, the levels of detail and specific underwriting and negotiation involved in placing transactional insurance are generally even greater. For example, the process tends to be fact specific and often involves extensive manuscripting (i.e., the negotiation of customized coverage terms applicable to the specific risks insured against).
But how can transactional insurance facilitate the completion of corporate transactions? Even in the best of times, potential buyers and sellers may find it difficult to agree on price. In the current economic environment, however, distressed sellers may be reluctant to discount the value of their businesses in hopes of a return to better days, while value-conscious purchasers are determined to buy at a substantial discount. Assuming that agreement can be reached on price, the parties must still negotiate the representations and warranties provided by both the buyer and the seller, and then reach acceptable indemnity terms for breaches of those representations. But the challenges don’t end there. A buyer with concerns about the ability of the seller to satisfy its indemnification obligations naturally will want the indemnification provision to be backstopped by a substantial escrow. A seller, however, likely will not want a substantial portion of his or her personal wealth tied up in an escrow account to pay for liabilities related to a business with which he or she is no longer associated.
In this challenging context, R&W insurance might help bridge differences and facilitate the successful closing of the transaction. For example, a potential buyer can use R&W insurance as a means to avoid relying solely on the seller for indemnification. A potential buyer might be able to make an offer more appealing by incorporating R&W insurance into its bid to reduce the portion of the purchase price that will be held in escrow. Similarly, for a seller that is eager to divest a business and minimize the scope of its continuing obligations relating to that business, a carefully tailored R&W insurance policy may provide a greater level of comfort that the seller will not be forced to pay out of pocket to satisfy potential indemnification obligations.
The following scenarios illustrate some of the ways in which transactional insurance might be used effectively to facilitate a transaction or to make a particular proposal more financially appealing.
Scenario One: Show Me the Money
After spending 25 years building a successful manufacturing business, Jacob Marley has decided to retire and tour the world on a yacht purchased with the proceeds from the sale of his company. He retains an investment banker to put the business up for auction and receives interest from a number of private equity firms, including HavishamCo. Rather than grossly over-bidding its competitors, Havisham distinguishes its offer by including an escrow requirement that is dramatically lower than would normally be expected (subject only to Havisham’s ability to secure R&W coverage). While putting its bid together, Havisham negotiated terms of an R&W insurance policy to insure over the seller’s representations and warranties. The bid prices from the various private equity firms were roughly equivalent, but Havisham’s escrow holdback was several million dollars lower than in any of the competing bids. Thanks to this creative use of R&W insurance, Marley accepts Havisham’s bid and sails off into the sunset.
Scenario Two: Good Intentions and a Token Will Get You on the Subway
CogswellCorp is experiencing financial difficulty because its “visionary” CEO has begun expanding the company beyond its core cog-manufacturing business. In order to finance its ambitious growth strategy, Cogswell decides to sell its cog-manufacturing operations. SpacelyCo seizes the opportunity to purchase the operations of a longtime competitor, and the parties easily agree on price. In an effort to close the deal quickly, Spacely proposes a modest escrow of only $1 million. However, the cap on Cogswell’s indemnification obligations for breaches of its representations and warranties is significantly higher at $30 million. Although Spacely believes it is purchasing the fundamentally sound operations of one of its largest competitors at a bargain price, Spacely’s management team fears that Cogswell’s expansion efforts will fail, leaving the company unable to honor its indemnification obligations if called upon to do so. In order to address this concern, Spacely obtains an R&W policy that provides coverage above a retention amount equal to the escrow of $1 million, and the deal closes successfully.
Scenario Three: The Long Goodbye
Forty years ago, ApexCo was the world’s largest electronics manufacturer. The company also maintained one of the foremost R&D departments in the world and now holds patents for inventions that are widely used in data storage devices, computer chips and consumer electronics. Over time, Apex discovered that the licensing of its patents was far more lucrative than its manufacturing operations. After being acquired by a private equity firm, Apex shut down its manufacturing and marketing operations in order to focus on licensing its patents and vigorously protecting its intellectual property. Today, the company continues to own a number of shuttered manufacturing facilities and distribution centers in populous suburban locations. There is extensive environmental contamination at several of these sites, which makes them difficult to sell without providing broad, open-ended indemnifications to the buyers. In an effort to control the financial obligations associated with these facilities, Apex seeks the placement of stop-loss insurance that will apply to each of the properties. The underwriting process requires significant due diligence, testing and the preparation of estimates for the remediation cost at each property. Ultimately, Apex is able to secure a stop-loss policy that generally covers remediation costs above a threshold specified for each site. As a result, Apex is now able to market the properties knowing that its financial obligations will be fixed but that buyers will enjoy a level of assurance that additional remediation costs will be paid for under the stop-loss policy.
Scenario Four: Death and Taxes
Holding company Jarndyce & Sons consolidated a number of its subsidiaries into a new subsidiary, BleakCo. Based on the tax opinion of its law firm, Kenge & Carboy, Jarndyce believed that the roll-up had been accomplished through a series of tax-free transactions. Eventually, Jarndyce decided to sell Bleak and entered into negotiations with private equity firm PickwickPip. During due diligence, however, PickwickPip’s law firm, Dodson & Fogg, raised concerns about whether the roll-up transactions had indeed been tax free. Despite these concerns, PickwickPip felt strongly that Bleak would be a valuable addition to its portfolio. Because it disagreed with the tax position taken by PickwickPip’s counsel, Jarndyce was unwilling to place the full amount of the potential tax liability in escrow or to provide a full indemnity. Jarndyce, however, was willing to pay a portion of the premium for a tax insurance policy that would cover PickwickPip for any tax liability above an escrow amount agreed to by the parties in the purchase agreement.
A Strategic Solution
As these scenarios illustrate, transactional insurance can be used strategically by both buyers and sellers to overcome obstacles that might otherwise make it difficult to complete an acquisition or divesture. It is not, however, an off-the-shelf product. The underwriting often requires its own due diligence, and the terms under which coverage is provided frequently require intense negotiations. Accordingly, whether transactional insurance products might be useful in bridging obstacles to a transaction should be an early strategic consideration. Given the myriad issues and financial interests at stake, it is important that a potential purchaser of transactional insurance pay close attention to the risks for which coverage is sought, the extent to which the proposed coverage terms respond to those risks and the legal effects of the negotiated coverage terms.
© 2011 Much Shelist Denenberg Ament & Rubenstein, P.C.
