Advanced Insurance Issues in Corporate M & A April 18, 2012

Advanced Insurance Issues in Corporate M & A

April 18, 2012

PLEASE NOTE THAT THIS DOCUMENT IS FOR DISCUSSION PURPOSES ONLY, DOES NOT CONTAIN OR CONVEY LEGAL, BROKERAGE OR OTHER PROFESSIONAL ADVICE, AND MAY

OR MAY NOT REFLECT THE VIEWS OF THE SPEAKERS’ FIRMS OR OF ANY PARTICULAR CLIENT OR AFFILIATE OF THOSE

FIRMS.THE INFORMATION HEREIN SHOULD NOT BE USED

OR RELIED UPON WITH RESPECT TO ANY PARTICULAR FACTS OR CIRCUMSTANCES.

Presenters

Peter N. Flocos, Esq.PartnerK&L Gates LLP

David B. MattinglyDirector, Risk ManagementAshland Inc.

Randy L. NornesExecutive Vice PresidentAon Risk Solutions

Agenda• Merger & Acquisition Landscape

• Building a Model M & A process

• Understanding the Deal

• Risk Manager’s Perspective

• Role for M & A Insurance products

• Questions

M & A Landscape• Volume of M&A activity is again increasing

– All types of deals – whether large or middle market, public or private, strategic or financial buyers

– More cross border activity

– Greater deal complexity

• Traditional M & A processes focuses on issues between deal and close, leaving significant risks and opportunities unmanaged

• Need for a new view of M & A risk management that includes:– Target evaluation

– Negotiation and “due diligence”

– Transaction structure and documents

– M&A-related insurance products

– Post-close opportunities

What can we learn from reality television?

M&A Transactions –Top 10 Issues List10 - No post-closing access to pre-closing loss and exposure information 9 - Historic M & A activity and treatment of insurance assets and liabilities

not investigated 8 - Target currently pays corporate allocations which always understate the

true cost of risk 7 - Assignment of the right to assert claims against pre-closing insurance not

negotiated 6 - Bifurcation of insurance obligations (e.g., LC’s supporting pre-closing

programs or priority ofrights to insurance limits) when buying divisions

5 - Captives – purchase agreement, tax, collateral, re-insurer quality or integrations considerations – may also provide an opportunity

4 - Accruals for retained losses understated 3 - Lack of understanding as to replacement of guarantees, surety or

collateral 2 - Missing critical information, information, information 1 - Risk management brought in too late to impact the deal

Defining Success for a TypicalM&A Transaction

Deal Valuation

Deal Structure

Integration

Bid Differentiation

Process Management

Target Evaluation Negotiation Close Post-Close

9

Developing a Transaction Lifecycle Checklist

Risk Management Activities

Offer submitted Purchase Sale Agreement Ownership Vests

Integrated Approach to M & ASimplified Timeline of Events

Work streams

Strategy / Due DiligenceStrategy / Due Diligence Set-Up/Transition Set-Up/Transition Implement/Operate Implement/Operate

Strategy Assessment

Strategy Assessment

Liability & SynergyGap Assess.

Liability & SynergyGap Assess.

DealInputDealInput

ProgramOfficeSetup

ProgramOfficeSetup

Create “90-Day”

Plans

Create “90-Day”

Plans

Create Optimization

Plans

Create Optimization

Plans

Execute 90-Day Plan

Execute 90-Day Plan

Execute Optimization

Plans

Execute Optimization

Plans

Monitor Synergy

Realization

Monitor Synergy

Realization

Transaction Process

StrategicPlanning

Price and TermsNegotiations

Identify Implementation Leaders and Team

Program DesignDecisions

DetailedStrategy

PreliminaryProgram Design

Implementation ofIntegration Plans

Announcement ClosingConfirmatory Due Diligence

InitialDue Diligence

A

B

C

D

E

G

F

• Establish governance structure to manage deal planning and execution

• Define key workstreams based on the specific characteristics of the deal

• Commit early to desired results and define work plans to drive execution

• Set targets for each risk management workstream, assign responsibility and track results

• Communicate: plans, progress and decisions needed with project management office; what should be expected with risk management colleagues

Five Keys to M & A Risk Management

M & A Risk management key success elements

11

Vendor Contracts

Managing Complexity

Mobilize Assess Recommend Execute

Team Governance

Communications

Foreign Property Liability

Director and Officers Liability

Accrual Review

Automobile Liability

Property

Claims

Technology

Core workstreams

Marine Cargo

Workers Compensation

Functional workstreams

Copyright © 2011 by the Risk and Insurance Management Society, Inc. All rights reserved. 13

Insurance Related M&A Issues:

Understanding the Deal

Peter N. Flocos, Esq.Partner

K&L Gates LLP


Legal Form and Structure of M&A Transactions

• There are only three legal forms or types of M&A transactions– merger/consolidation– stock purchase– asset purchase


Mergers• Statutory procedure between two companies; all 50 states have some

form of merger statute• Under the typical state merger statute, two companies merge and there is

a “survivor” corporation– The non-survivor legally ceases to exist

• Under the typical merger statute, the “surviving” corporation in a merger by law:– Assumes all of the rights, privileges, powers and immunities of the non-

surviving corporation; and– Is subject to and assumes the prior duties and liabilities of the non-surviving

corporation


Mergers• For example, Section 259(a) of Delaware General Corporation Law states:

– “The rights, privileges, powers and franchises of each said [merging] corporations, and all property, real, personal and mixed…as well...as all other things in action or belonging to each of such corporations shall be vested in the corporation surviving or resulting from such merger…”

– “...all property, rights, privileges, powers and franchises, and all and every other interest shall be thereafter as effectually the property of the surviving corporation...as they were of the...constituent corporations...” [emphasis added]


Mergers – Before & AfterM ERG ERS A N D A C Q U ISITIO N S O V ERV IEW

BA SIC M ERG ER

A C Q U IR O R

C o ns ide ratio n

M E R G E R

SU R V IV O R (H E R EA C Q U IR O R )

TA R G E T

TA R G E TSH A R EH O L D E R S

FO R M ERTA R G E T

SH A R EH O L D E R S

H IS TO R ICA C Q U IR O R

SH A R EH O L D E R S

A C Q U IR O RSH A R EH O L D E R S


Stock Purchase• In a stock purchase, T the target company remains intact as the same legal

entity it was before– Nothing is changing other than the identity of the stockholders– No asset or liability is being transferred to a legally “new” party


Stock Purchase – BeforeMERGERS AND ACQUISITIONS OVERVIEW

STOCK PURCHASE

Parent/Target Shareholders

Target

Buyer

TargetStock

Cash/Other Consideration

100%


Stock Purchase – After

MERGERS AND ACQUISITIONS OVERVIEW

STOCK PURCHASE

Parent/Target Shareholders

Target

Buyer


100%


Asset Purchase• In an asset purchase, the parties will typically specify in their purchase

agreement which assets and liabilities A is buying from T• Agreement will also typically spell out which assets and liabilities are not

being taken by A (often referred to as “excluded” assets or liabilities)• Courts generally respect the parties’ agreed allocation of assets and

liabilities in the asset purchase agreement– e.g., a claimant cannot go after A on a liability that was “excluded” from the

deal– e.g., a claimant cannot go after T on a liability that was transferred in the deal


Asset Purchase – Before


ASSET PURCHASE

Parent and shareholders

Target Buyer

Assets/liabilities


Copyright © 2011 by the Risk and Insurance Management Society, Inc. All rights reserved. 23Copyright © 2010 by the Risk and Insurance Management Society, Inc. All rights reserved. 23

Asset Purchase – After


ASSET PURCHASE

Parent and shareholders

Target Buyer

Assets/liabilitiesCash/Other Consideration


Asset Purchase• Certain exceptions to the parties’ agreed allocation of assets and liabilities in the

asset purchase agreement (sometimes referred to as “successor liability” being imposed in A “by operation of law”)

– “de facto” merger – transaction really had all the attributes of a merger, so A stuck with all the liabilities as if a merger

– purchasing corporation (A) is “mere continuation” if T (similar to “de facto” merger)– some courts recognize a “product line” exception – when A buys a “product line” from

T, and if plaintiffs have no effective remedy against T or its successor, A is stuck with the liabilities associated with that product

– certain statutes may prohibit disclaiming liabilities, e.g., CERCLA environmental statute– T’s transfer of assets/liabilities was to effectuate a fraud against T’s creditors


Potential Impact of M&A Transactions on Legal Rights Under Insurance Policies

• An M&A type transaction may potentially impact the existing insurance coverage rights of the transaction parties in a number of ways– policy language– statutes– judicial case law interpretations and doctrines

• Insurers may claim that the M&A transaction has eliminated or narrowed coverage

• Issues can be raised with any type of policy – D&O, E&O, fidelity, CGL, property-business interruption



• The language of D&O, E&O and fidelity policies seems to address in more detail what happens in the event of an M&A transaction

– versus CGL and property-business interruption policies, which are often much less detailed or even silent

• Where should one look in the policy? Pertinent language can be anywhere but look particularly for:

– “Change of Control” or “Change of Control”– “Termination”– “Consolidation, Merger and Purchase of Assets”– “Organizational Changes”– “Subsidiary” definition– “Assignment”

• CGL and property-business interruption policies may be silent or have a general “Assignment” provision regarding assignment of the policy (discussed below)



• Various ways that a policy may treat an M&A transaction when such a transaction is specifically addressed

• D&O and fidelity policies often state that if the insured merges into or sells substantially all assets to another company (or undergoes some other “change of control” or “take over”), then:

– policy simply terminates– policy continues but only as to pre-transaction acts or losses

• D&O and fidelity policies often state that a newly formed or acquired subsidiary is covered (CGL policies can address this as well)

– policy may state that only post-acquisition acts or losses are covered– there may be certain restrictions as to the size of the subsidiary based on asset tests, or

as to the amount of time that coverage exists



• Most of the litigation occurs when the policy is silent or simply has a general anti-assignment provision– Example: “This policy is not assignable without the written consent of the

insurer.”• Most of the litigation occurs with CGL policies due to absence of language

or specific language coupled with “occurrence” trigger and potential to cover “long tail” claims

• Hypothetical example and case studies


Insurer Consent to the M&A Deal: Should You Seek It?

• Consult with counsel– Each transaction should be approached on a “case by case” basis because the

analysis is fact specific and depends on a number of factors which state’s law applies

– E.g., the pertinent state may have a statute that arguably makes an anti-assignment clause enforceable, notwithstanding the traditional common law approach

• See Del Monte Fresh Produce (Hawaii), Inc. v. Fireman’s Fund Ins. Co., 117 Haw. 357, 183 P.3d 734 (2007) (state insurance statute interpreted to make anti-assignment clauses enforceable; court did not need to decide whether to accept or reject the Henkel approach)

– Little or no case law directly addressing the “strategy” of seeking or not seeking consent



• General framework: balance risk of not obtaining consent versus the risk of seeking it, arguably creating a record that the policyholder believes consent is necessary, then the insurer says “no”– assess which state’s law applies– analyze policy language

• issues generally should not exist if the policy is silent on M&A issues and contains no anti-assignment language, due to the bias of contract law in favor of transferability

– understand the form of the transaction• mergers and stock sales may well not present issues, asset sales may present issues

– assess the number and importance of the policies that contain an anti-assignment clause

Copyright © 2011 by the Risk and Insurance Management Society, Inc. All rights reserved. 31Copyright © 2010 by the Risk and Insurance Management Society, Inc. All rights reserved. 31


– assess historical relationship and course of dealing and future prospects with insurer

– there is case law in some states indicating that in other insurer consent contexts, e.g., insurer consent to settlement, insurer cannot arbitrarily or unreasonably withhold consent

• such case law may factor into the M&A consent analysis– Proposal by past audience member: send insurer request for consent shortly

before closing, then close and claim “waiver” of consent rights by insurer for failure to respond?

• may be unduly risky as a general proposition• courts generally require waivers to be knowing and intentional• would silence really be enough, especially on a short time frame?• creates record suggesting policyholder thought consent was necessary• what if insurer responds quickly with a “no” prior to the closing?



– some policyholders may decide that insurer will take forever to address a consent request and then say “no” anyway

• conclusion may be that there is nothing to be gained by seeking consent• one option may be to send the insurer a communication giving notice of the

transaction and opportunity to say something but stating the insured believes consent not necessary

– complete the assessment before the purchase agreement is signed so that desired language can be included in the agreement (e.g., if consent will be sought, is insurer’s consent a closing condition or not?)

– if consent will be sought, allow for sufficient time prior to closing obtain the consent

Risk Manager’s Perspective

David B. MattinglyDirector, Risk Management

Ashland Inc.

Phase I: Identification of Target

Prior to any particular acquisition or disposition:• Know your company’s business model and growth plan• Insert yourself into strategic planning discussion• Be a consumer of the company’s media

• Press releases• Financial filings• Management presentations• Internal publications

Understand likely targets for dispositions and what types of businesses would be strategic additions

All part of a robust Enterprise Risk Management approach

Phase I: Identification of Target

Be certain M&A evaluators and decision makers understand the value of early input from Risk Management• More precisely modeling and deal valuation• Fewer surprises - identifying issues that could compromise deal

certainty or value • Enhanced negotiating strength

Don’t “wag the dog”• Concerns raised should be significant in relation to the deal• Requests should be demonstrably reasonable, so that if challenged

your credibility is intact

Phase I: Identification of TargetEvaluate target’s risk and exposures in relation to those already

facing your company• Industry • Key markets• Supply chain exposures• Operations• Location and size of facilities• Financing of deal• Financials of target business

Maintain accurate understanding of how these factors are likely to impact insurance markets • Capacity• Rate• Alternatives

Phase II: Negotiation and Bid

Review proposed agreement• Type of transaction – stock, asset, etc.• How are pre-closing liabilities assigned• Any insurance representations or covenants• Indemnification (duration, credit issues, scope)• Any run-off issues• Access to all necessary information before closing• Anything else applicable

Phase II: Negotiation and BidPurchase Agreement Type of Deal Focus of Insurance Due Diligence

StockAssuming preclose liabilities

Stand-alone Buying 100% of the company

• Evaluate current policies and costs.– Change in control provisions?– Estimate costs for run-off– Savings opportunities by adding to existing corporate

program ?• Quantify accrual for historic liabilities, if necessary.

Stock Assuming preclose liabilities

Spin-off Buying a division of a company

• Evaluate current policies and costs/allocation– Is entity or parent the Named Insured?– Estimate cost of rolling into corporate program and ensure

that access to the seller’s policies is granted to cover historic liabilities

– Entity: Change in control provisions?• Quantify accrual for historic liabilities, if necessary.

Stock Assuming preclose liabilities

Roll-up Merging two companies

• Evaluate current policies for both entities– Identify/estimate stand-alone costs– Estimate merged program costs

• Quantify accrual for historic liabilities, if necessary.

Asset Assuming preclose liabilities

• Ensure current and historic policies included in asset schedule or access is granted to these policies

• Estimate costs for post-close roll-in• Quantify accrual for historic liabilities, if necessary.

Asset NOT assuming preclose liabilities

• Identify pre-close costs for insurance policies• Estimate costs for post-close roll-in

Phase II: Negotiation and Bid

Try to get as much information from outside target as possible within negotiating constraints

Make recommendations are certain to significantly decrease risk or add value

Identify any “holes” in the agreement and prepare to fill in next phase• Later negotiated agreements like TSAs, leases, etc.

Phase III: Closing the Deal

Information exchange is vital:• Identify counterpart(s) and establish terms of relationship• Use other sources of information if available:

Data room Target’s broker* Target’s TPA* Target’s website and SEC filings Target’s intranet* Target’s other employees** Normally would require a release obtained through counterpart or deal

team• Develop and use a diligence checklist


AB(TA)C – Always Be (Thinking About) Closing• Prioritize every task and request by whether or not it is required to

close or not• Do not allow a risk management or insurance item delay closing

Items to consider and prioritize:• Contract covenants• Day 1 insurance coverage and documentation (binders, certificates,

auto ID, WC postings) • Budgetary impact• Claims reporting information• Access to archived data


Day 2 and beyond priorities:• Evaluate risk management strategies of acquired company and

incorporate best practices across the organization• Deliver promised synergies as soon as practical • Obtain applicable returned premium and release of collateral and

other forms of financial insurance• Understand the changes to your company

Business and operations New financial constraints (or lack thereof) Strategic direction Important exposures Changes in risk philosophy and tolerance

Fold into your ERM program and prepare for the next change

M & A Insurance Solutions

Randy L. NornesExecutive Vice President

Aon Risk Solutions


Purchase Agreement Review• Purchase Agreement

– Representations & Warranties– Covenants– Closing conditions– Indemnity provisions– Termination provisions

• Reps and Warranties Insurance

Insurance Solutions to Facilitate M & A Transactions

• Reps & Warranties Insurance

– transfer indemnity obligations to third party insurer

– replace / reduce / enhance escrow requirements

• Tax Indemnity Insurance

– transfer risk arising from IRS / other taxing authority challenge

• Litigation Buyout Insurance

– existing claim / related claims capped at a maximum liability

– removes uncertainty of liability

• Contingent Liability Insurance

– known and unknown liabilities are transferred for a fixed premium

– one-off situations not fitting within product definition

• Environmental Insurance

– known and unknown liabilities

Using Reps & Warranties InsuranceTension Points in a Transaction

Sellers makes statements regarding the business being sold

Buyers wants financial recourse against the Sellers if statements aren’t accurate & Buyer sustains a loss

Indemnification

Reps & Warranties

• Limit length of time of responsibility for breaches of R&W

Seller seeks to:Seller seeks to:

• Define the maximum amount of the indemnification

• Ensure the Buyer pays a minimum amount before requesting indemnification

Survival Period

The Cap

The Basket

• Ensure security that there will be financial resources to back up Seller’s indemnification obligations

Buyer seeks to:Buyer seeks to:

• Create a competitive advantage in auction situations or a solution where Buyer & Seller disagree on the contract

Escrow

R&W Policy

Value of Reps & Warranties Insurance• Buyers

– Increase maximum indemnity / extend survival period for breaches of reps & warranties

– Distinguish bid in auction– Protect key relationships– Ease collection concerns– Provide recourse when no seller

indemnity possible (public company sales, bankruptcy)

• Sellers– Reduce contingent liabilities– Distribute sale proceeds– Protect passive sellers– Expedite sale process– Attract best offers by maximizing

indemnification

Examples of Reps & Warranty Insurance• Examples of Transactions

– Seller Coverage (Dissolution) Fully Indemnity - Broad Based• As part of a planned dissolution and liquidation, a leading telecommunication

equipment and services company sold its two largest subsidiaries in separate stock sales totaling $160 million. A single R&W Insurance policy was issued, providing the Seller with $10 million coverage in respect of the bulk of its indemnification obligations for Breaches under the respective Stock Purchase Agreements.

– Buyer Coverage – Full Indemnity – Broad Based• Buyer-based R&W Insurance has been useful as a credit enhancement. One such

instance involved the purchase of a $200 million real estate/service company from a Seller on the verge of bankruptcy. While the Seller was liable to the Buyer under the indemnity, a 4 year, $20 million R&W Insurance policy enhanced the Seller’s obligation.

Examples of Reps & Warranty Insurance• Examples of Transactions

– Buyer Coverage (Negotiated Deal) – No Indemnity – Broad Based. • R&W Insurance has been used to insure a Buyer of a company against a Breach of

the full complement of Seller’s representations. In one case involving the sale of a $145 million manufacturing company to a foreign buyer, a $25 million policy ran to the buyer for a non-cancellable 3-year term. The parties agreed that the Buyer’s sole remedy for a Breach was the R&W Insurance.

– Buyer Coverage (Auction) – Limited Indemnity – Broad Based. • R&W Insurance has proven an effective tool in an auction situation. By using a $10

million R&W Insurance policy covering all representations to limit the indemnity it required of the Sellers, a private equity fund prevailed in a bidding war despite offering a lower purchase price than other bidders.

Addressing Potential Tax Problems• Situation:

– In a portfolio company’s recent tuck-in acquisition, there was a potentially large tax liability that jeopardized the closing of the deal

• Discussion:– During diligence, we discovered a potential tax liability that could exceed $100M in total

exposure

– Not surprisingly, the buyer and seller had very different views on both the size and risk associated with the tax issue

– As buyer, we were unwilling to jeopardize our existing investment by taking on this additional risk and a full cash indemnification did not make sense for the seller for a variety of reasons

• Outcome:– To bridge the gap, we investigated a variety of options and found a cost effective tax

insurance policy that addressed our concerns, relieved seller of having to set aside a significant cash as indemnification for a (hopefully) very unlikely event, and allowed the transaction to close in a timely manner.

Keys to Success• Get involved early

• Maintain a team of experts that can quickly integrate into the deal team

• Use a standard project management approach to coordinate all work streams

• Don’t overlook key issues in the target and negotiation phases

• Don’t rely on generic language to address risk and people issues

• Use transaction solutions to improve deal terms and close more deals

• Geography matters – Make sure you tap into local expertise

• Look past the close to develop a plan to achieve the expected benefits of the deal

Questions

Documents

Advanced Insurance Issues in Corporate M & A April 18, 2012