M&A Acquirers Turning to Insurance to Protect Against Post-Closing Liability

August 18, 2017 – FTC Watch

Companies engaged in mergers and acquisitions are increasingly buying insurance policies to protect themselves from unknown dangers that arise post-closing, lawyers say.

Such issues can come from accounting errors that inflate the purchase price, noncompliance problems that lead to fines and fees, contract disputes that cause financial loss, and tax discrepancies that leave the acquirer with unexpected tax bills.

These mistakes, which lawyers say have cost some companies tens of millions of dollars in losses, can take time to discover, and the money can be difficult to recover through a lawsuit once the deal closes and the money is redistributed to investors.

Post-closing surprises don’t necessarily involve matters of interest to competition regulators, but the possibility of such liability raises a conundrum for the antitrust agencies because they rely on companies to give a fair representation of the firm’s ability to compete in the future.

Federal Trade Commission acting Chairman Maureen Ohlhausen declined to comment on the issue, and FTC Commissioner Terrell McSweeny didn’t respond to requests for comment.

Bill Kovacic, a former FTC chairman and now law professor at George Washington University, said the agencies can guard against inaccurate data by diversifying their sources of information — relying on their own prior knowledge of industries, third-party discovery, and conversations with customers and competitors.

Kovacic said many merging parties and their outside counsel are active in M&A and stand on their reputations. “If you lose that reputation, the level of scrutiny the next time increases dramatically,” he said.

And of course, intentionally misrepresenting data could result in legal penalties.

Attorneys say sellers want to close deals quickly, get paid and have a clean exit, leaving the insurance company to resolve any unanticipated problems.

Mark Schwartz, a partner at Chicago law firm Butler Rubin, says he has seen the number of companies buying what’s known as representations and warranties (R&W) insurance rise sharply in the past five years, driven in part by repeat business from private equity firms that have grown confident that their claims will be paid.

American Insurance Group conducted a study with 1,600 of its M&A policies from 2011 to 2015.  The analysis showed that 18 percent of the policies ended in a customer filing a claim. About half of the claims fell into the $1 million to $10 million category and averaged $3.5 million. But the biggest claims, those exceeding $10 million and representing about seven percent of AIG’s total R&W claims, averaged $22 million.

Twenty-seven percent of the claims filed with AIG came in the first six months after close; 48 percent were filed within the first 18 months.

Attorneys say mergers are increasingly complicated and can involve multiple jurisdictions with thousands of contracts and suppliers; and international companies have to comply with different tax laws.

Errors in the sellers’ financial statements are the most common mistake leading to a claim, according to AIG’s research. Most often, the problem is a misunderstanding of accounting rules (26 percent of the time) or a misstatement of accounts receivable/payable (25 percent), followed by undisclosed liabilities (19 percent), a misstatement of inventory (17 percent) and an overstatement of cash holdings or profit (13 percent).

Evidence that more companies are buying R&W insurance policies is largely anecdotal. The National Association of Insurance Commissioners doesn’t track the sale of R&W policies nationwide.

Insurers are usually willing to offer a policy for 10 percent of the value of the merger — a $100 million policy on a $1 billion deal. The bigger the deal, the cheaper the premium. Large deals might charge three percent in a one-time, up-front payment, whereas smaller deals could charge 4.5 percent to 5 percent, lawyers say.

—Curtis Eichelberger