Imagine you sat on the board of a company that was acquired. Now let’s say a year later, you’ve been notified that you are being sued for actions you took on behalf of the company before it was acquired.
Of course, your company stopped paying annual premiums to the D&O insurance program after it was acquired. Now, in the face of litigation, you and the other directors and officers are at serious risk.
Let’s look closer at some of these risks and the solutions to mitigate them, chiefly, the “run-off” or “tail policy,” which is an extension of the D&O insurance policy for a specified period past the normal expiration date.
What Risks Do Directors and Officers Face and How Do You Mitigate Them?
The completion of an M&A deal doesn’t protect directors and officers from the possibility of future litigation for their previous roles at the acquired company. Typical claims in M&A litigation assert directors’ breach of fiduciary duties in connection with the sale.
M&A litigation, unfortunately, is almost as frequent as M&As themselves. Cornerstone Research states that shareholders of public target companies challenge 82% of M&A deals.
This is despite the important 2016 Delaware decision in re Trulia Stockholder Litigation that aimed to squash frivolous M&A suits. While Trulia did seem to lower the average lawsuit per M&A deal, according to Cornerstone, the other unfortunate effect was a shift of M&A litigation from state to federal courts.
So what are some of the things we can do to mitigate director and officer risk in M&A?
I’ve written in the past about ways that directors and officers can mitigate their risk during a sale, including upholding certain fiduciary duties and making appropriate disclosures.
Ideally, the acquiring company will also assume the selling company’s indemnification agreements with its directors and officers. It is especially important to have these in place given the current dynamics of the D&O insurance market where self-insured retentions may be too high for some companies to pay. This matters to directors and officers in litigation so that the company will advance legal fees and pay losses on behalf of an individual should he or she be named in a lawsuit in his or her capacity as a director or officer of the company. However, you cannot rely on these agreements alone. I’ll talk more about this later.
Transactional risk insurance like representations and warranties policies can also help a deal go smoothly. For the seller of a company, these policies offer the benefit of reducing escrow and making it less likely that in the case of a disappointing business outcome, the buyer will try to pursue the directors and officers of the target. For the buyer, reps and warranties insurance sets up a fence around broken promises made by the seller of the company by providing insurance reimbursement for financial loss. This reimbursement makes it less likely that the buyer’s own shareholders will want to sue the buyer’s directors and officers for having purchased a pig in a poke. Read more about reps and warranties insurance in our Guide to Representations and Warranties Insurance.
Well before even a hint of M&A is on the horizon, it is a good idea to make sure that your company’s D&O insurance policy is state of the art. The better the policy, the more likely it will respond as anticipated to suits that arise in the M&A context.
Also, the better the policy, the more likely a tail policy will respond to claims that arise post-acquisition.
What Is a Tail Policy?
In M&A, the D&O insurance policy that responds to a claim is the policy that is in place at the time the claim is made. So, for example, if in 2020 a set of actions took place that is later challenged in 2021, it’s the 2021 policy that would respond, assuming you still have an active insurance policy in place.
This is where a D&O tail policy is crucial. A tail policy covers what would otherwise be a gap in coverage for directors and officers after the sale of a company. The gap exists because the D&O policy of the acquiring company will typically not respond on behalf of the selling company’s directors and officers for claims that arise post-closing that relate to pre-closing activities.
When a tail policy is purchased, the insurance carrier for the selling company agrees to hold open the D&O insurance policy for a specified period past the policy’s normal expiration date. In the United States, six years is the standard.
In other words, if a claim arises within six years after a company is sold, the selling company’s directors and officers will be covered under their original D&O insurance policy.
Another benefit of a tail policy is that it’s generally non-cancelable. This feature guarantees that the seller’s former directors and officers will not run the risk of the acquiring company cancelling the policy in order to get back the cash paid for the policy.
Who Should Purchase the Tail Policy?
Whether a company is public or private, it’s hard to imagine a scenario in which the selling company’s directors and officers would not want a tail policy. This is obviously the case if the acquiring company refuses to assume the selling company’s D&O indemnification agreements.
It is also the case even if the acquiring company assumes all the selling company’s indemnification agreements. Having a tail policy in place ensures that directors and officers will be protected even if, at some future date, the acquiring company declines to protect them. This can be the case due to a dispute with the selling company, or due to the acquiring company’s own future bankruptcy.
But tail policies cost money, and sometimes we see the acquirer attempting to avoid paying for that policy during M&A negotiations. In fact, buyers sometimes put a lot of pressure on the seller not to purchase a tail.
The risk here is that the person negotiating on behalf of the seller may not understand the value of a tail policy. The board should be careful to communicate that the purchase of a six-year tail policy is a non-negotiable point.
Finally, given the personal interest the seller’s directors and officers have in their tail policy, it’s generally a good idea for the selling company to be the one who places the tail policy. This allows the seller to use its own broker to place the tail.
Sometimes the buyer’s broker wants to place the tail policy—after all, there’s usually a healthy commission associated with this placement. It’s important to remember, however, that it’s usually the placing broker who manages all future claims.
Assuming that their broker is an expert, sellers usually feel more comfortable knowing that their future claims will be handled by the broker they know and not some broker whose loyalty lies primarily with the buyer.
When Should the Tail Be Purchased?
Public companies looking to sell themselves will normally have D&O insurance policies in place already, and that policy is the one to which a tail will be attached. The tail is negotiated during the time between the signing and closing of the M&A deal, and it becomes effective at the closing.
Many private companies do not carry D&O insurance, but then decide they want a tail policy when they are acquired. In the current market, this is not a good strategy.
Most carriers are only willing to provide D&O tail policies to companies that already have D&O insurance in place before a company has received an offer to buy it.
There is a question on the D&O policy application that asks whether M&A is on the horizon; if the answer is “yes,” insurance carriers may decline to issue a policy. This is a reaction to the sharp increase in M&A litigation that private companies have experienced in the last few years.
For this reason, private companies are well served by having a D&O insurance policy in place before they embark on a process to sell themselves.
How to Purchase a Tail Policy
You want an expert who understands both M&A litigation and D&O insurance to place the tail policy. Here are some critical items to consider when placing a tail:
- The Expertise. Due to the changing nature of the D&O insurance market, even the most experienced M&A attorney could inadvertently draft terms in the sale agreement that could be problematic when it comes time to place a tail policy. Consider seeking out the expertise of those who deal with M&A insurance issues as a core discipline to ensure the draft agreement contains language that is both accurate and realistic.
- The Premium. Most tail policies are placed with the company’s current carriers and this is the preferred route, particularly if you are also in the middle of litigation, including litigation related to the proposed M&A transaction. Still, you may want your broker to do a market check of the premium to avoid paying an above-market price. This can happen if there is no chance of competition between carriers for the tail policy.
- The Continuity. Continuity of coverage is always important in D&O policies, and especially during M&A. The best way to ensure continuity is to place tail coverage with the current insurance carrier. A skilled insurance broker could place a tail with a new carrier, but first should consider: a) the policy’s prior acts and prior notice language; b) whether a warranty statement is required; and c) whether a specific claim exclusion or prior litigation exclusion is added to the tail policy.
- The Exclusions. The “insured versus insured” (or “entity versus insured”) exclusion is typically part of the D&O policy. As a result, there is no insurance coverage when one insured (an individual, or the corporate entity as the case may be) sues the other. In the context of M&A, it’s important to review this exclusion to ensure the D&O policy will not exclude claims brought by the acquiring company against the selling company’s directors and officers.
- The Litigation. Litigation could negatively impact a tail policy. If there is open litigation at a company pre-close, a new aggregate limit of liability should be placed wherever possible, as opposed to extending the aggregate limit of the pre-close insurance program.
- The Sharing Limits. D&O policies generally include coverage for securities claims, where directors and officers share the collective limit of liability available under the policy. After a merger or acquisition, sharing limits may not be attractive. An experienced insurance broker should work with his or her client to ensure that all parties understand the strategic trade-offs that result from various tail policy structures.
- The Self-Insured Retentions. D&O policies contain certain self-insured retentions (similar to deductibles) that apply depending upon whether or not indemnification for the directors and officers is available. The self-insured retention will typically be set at $0 when indemnification is not available, but that figure can skyrocket if indemnification is available. In some cases, a tail policy can and should be amended to specifically address the retention as it relates to claims brought against the directors and officers post-acquisition.
M&A is an exciting time for both buyers and sellers. However, when the selling corporation has not done its due diligence to protect its directors and officers as much as possible through the proper insurances, M&A can become a nightmare for prior board members long after the sale or merger has been completed.
Taking the steps outlined in this post, however, can help to protect directors and officers against post-closing suits that may arise against them.
Related Blog Posts
At the time of an IPO a question that comes up is: Should we place a tail policy on our private company D&O insurance?
When you’re looking at potential M&A deals in 2018, there’s one more thing to add