The Devil Is in the Details (Part III): The Risky Intersection between Insurance Coverage and Corporate Transactions
Insurance policies do not exist in a vacuum. Rather, they play a critical role in the management of a business’ risks. Also, they are among the many contracts that form a web of obligations and rights for the typical business. Routine corporate contracts and activities, as well as transformative events such as a merger or the sale of a business, may trigger insurance notice obligations or affect a policyholder's rights under its insurance contracts. In Part I and Part II of this series, we outlined some of the consequences that events such as a financial restatement or a change in corporate control may have on insurance coverage and why those impacts are better assessed early rather than later. We also discussed how seemingly minor differences in policy wording can result in gaps in coverage.
Pitfalls for policyholders are not limited to claim disputes with an insurer and policies that lack suitable terms. Routine corporate activities create insurance pitfalls, too. For example, a contract may require a company to provide or receive additional-insured status to or from the other contracting party but, all too often, too little attention is given to the terms under which additional-insured status is granted or obtained or to which of the widely varying forms conferring that status are used. Business activities such as a reduction in force or participation in a joint venture may trigger notice obligations and/or changes in coverage. An acquisition, divestiture or other transformative transaction can have a dramatic impact on the rights of a policyholder. The manner in which a transaction is structured may unexpectedly alter the rights of formerly related companies vis-à-vis their insurance coverage. If the effect of a transaction on a policyholder's rights under its insurance programs are not taken into account, the policyholder runs the risk of squandering a costly corporate asset that might not be available when it is most needed.
In connection with the sale of business units or subsidiaries (whether through a stock purchase agreement or an asset purchase agreement) or corporate mergers, the failure to address the disposition of insurance assets and the respective rights of the affected parties to the relevant insurance coverage may give rise to unintended disputes in the future. The manner in which rights under an insurance program are distributed as a consequence of a transaction is an area that is fraught with hazards for policyholders. Further, the treatment of the disposition of insurance in connection with a single transaction may vary widely across different jurisdictions, depending on the form of the transaction and the construction of standard insurance policy "anti-assignment" clauses within a jurisdiction.
In connection with the sale or acquisition of a business, familiarity with the available insurance products also may provide a means of reducing exposure to indemnification, breach of warranty or other post-transaction contingent liabilities. An agreement for the sale of a business often will contain representations and warranties concerning the business and its financial condition, as well as potential tax and other liabilities. If the representations and warranties prove to be incorrect, the party making the warranties may be subject to penalties or indemnification obligations under the terms of the relevant transaction document. Similarly, an agreement for the sale of a business often will contain disclosures concerning known or expected claims and other reasonably foreseeable sources of potential liability. Often, if the losses associated with identified current or potential claims exceed a certain threshold, or if there are claims that were foreseeable but were not disclosed, the seller may be required to provide indemnification for such liabilities.
Under the classic model of the comprehensive general liability policy, these indemnification and warranty obligations were not covered because they are breach of contract claims and/or they involve known, rather than fortuitous, events. The insurance industry, however, has developed a number of products designed to respond to some of the indemnity and warranty obligations that arise out of corporate transactions. These include representations and warranties coverage, tax liability insurance and environmental cost cap coverage. If properly structured, these types of policies can provide value by bringing certainty as to one's potential exposure, limiting the scope and magnitude of one's contingent liabilities, and converting an uncertain potential liability into a fixed premium payment. These types of insurance contracts, however, are by their nature unique to the transaction or the potential liabilities being covered, and great care must be taken to ensure that the insurance contract is responsive to the specific risks. Complex and costly, these policies tend not to be “form” policies and usually require considerable negotiation to make sure that the policy and the covered risk have a good fit. It is imperative that the terms of the policy properly identify and track the liabilities or warranties being insured against and that the conditions and exclusions to coverage are understood before the insurance contract is finalized.
Attention to the value of a target’s insurance assets and to the potential that a purchaser might be able to access those insurance assets if a transaction is properly structured also may provide opportunities to a properly situated investor. The agreements governing a merger or the sale of a company typically contain disclosures and recitals concerning the insurance policies currently held by the parties to the agreement. Prior to the transaction, those insurance policies typically are made available in the course of due diligence, as is information concerning current and expected claims. As to occurrence-based policies, however, the effective insurance policies may well represent only the tip of the iceberg for insurance policies that potentially are responsive to liability claims. Indeed, for latent bodily injury or property damage claims, historic occurrence-based policies may well contain more favorable coverage terms than current coverage. Attention to the potential value of legacy insurance assets, and to the structuring of a transaction so as to preserve rights to those assets, can create substantial value for diligent investors.
The following hypothetical case studies illustrate some intersections between insurance policies, insurance coverage law and corporate transactions and why insurance should not be taken for granted in the transactional setting. It is important to keep in mind, however, that these case studies actually oversimplify the complexities facing the parties. Successorship rights to insurance policies and the extent to which they survive following a stock transaction or an asset sale vary from state to state and remain in constant flux.
Case Study 1: The Tug of War Over Shared Insurance Assets between
Former Corporate Siblings
Widget Company was spun off by Industrial Gear Company in a stock transaction. Widget was a wholly owned subsidiary of Industrial Gear. Both companies were identified as insureds under a series of occurrence-based general liability insurance policies and both companies retained their respective rights under those policies. Significantly, the agreements governing the spin-off did not require either of the formerly affiliated companies to notify the other if one of them made a claim against the shared occurrence-based policies. Widget Company incurred substantial liabilities as a result of toxic tort bodily-injury claims resulting from its former use of an insulating material that allegedly caused lung disease in third-party workers using its products. The toxic tort plaintiffs alleged that they were exposed to the injury-causing materials during a period that included the shared general liability insurance policies. Widget Company settled with the insurers for policy limits. Several years later, Industrial Gear became embroiled in its own series of toxic tort bodily-injury claims initiated by users of its products due to the company’s former use of a friction-control solvent that allegedly increases the risk of cancer. Once again, the plaintiffs argued that they were exposed to the injury-causing substances during a period that included the shared general liability insurance policies. When Industrial Gear turned to the relevant general liability insurers, it learned that the relevant policies had been exhausted. Litigation between the formerly related companies ensued.
In a slight variation on the story, when Widget Company settled with the general liability insurers, it agreed to indemnify them for claims brought by other insureds under the settled policies. When Industrial Gear sought coverage for its bodily-injury claims, the general liability insurers promptly demanded that Widget Company indemnify them for Industrial Gear's claims for coverage.
In yet another variation, the agreements governing the spin-off required the formerly affiliated companies to notify each other of claims under the shared insurance policies and to obtain the consent of the other party to any proposed settlement that might materially impair the rights of the other party to the policy proceeds. If Widget Company and Industrial Gear could not come to an agreement, they were required to submit their dispute to arbitration. When Widget sought Industrial Gear's consent to the proposed policy limits settlement with their common insurers, Industrial Gear refused to consent and the parties commenced arbitration.
Case Study 2: The Case of the Disappearing Indemnity
Do-Hickey Corporation and Thing-a-ma-jig Corporation were both subsidiaries of Mega Corp. and were named as insureds under the terms of the parent company’s general liability insurance policies. Do-Hickey and Thing-a-ma-jig were both spun off from Mega Corp. in stock transactions and the parent company dissolved. Under the terms of the relevant transaction documents, Thing-a-ma-jig retained the exclusive rights to make claims under the occurrence-based general liability policies under which both companies had been named as insureds but agreed to provide indemnification for a period of six years for claims arising from circumstances that took place during the time that Do-Hickey and Thing-a-ma-jig were jointly owned. During the intervening years, a number of exclusions were added to the general liability insurance policies that barred coverage for latent bodily injury claims resulting from exposure to Substance S. Historically, Substance S was an important component of Do-Hickey's products. After the indemnification period expired, Do-Hickey began seeing claims from third-parties for long-latent bodily injuries resulting from alleged exposure to the Substance S contained in Do-Hickey's products during the period that the company was a subsidiary of Mega Corp. Unfortunately, coverage was excluded under Do-Hickey's current general liability insurance policies, Do-Hickey did not retain any rights under the historic general liability insurance policies and Thing-a-ma-jig's indemnity obligations had expired.
Case Study 3: Where Did Those Old Insurance Policies Go?
Bigger Tool & Die Corporation acquired Smaller Tool & Die Corporation in a stock purchase agreement. The agreement contained comprehensive schedules setting forth the insurance policies issued to Smaller Tool that were currently in effect but contained no disclosures concerning historic occurrence-based policies. The due diligence prior to the transaction did not uncover any current or anticipated environmental property damage claims against Smaller Tool. Moreover, Smaller Tool had a reputation for being extremely responsible in its materials-handling procedures. Shortly after the acquisition, Bigger Tool terminated nearly all of Smaller Tool's former employees and closed its facilities—disposing of many old records in the process. The current general liability insurance policies covering the combined company contain absolute pollution exclusions. Thirty years ago, Smaller Tool used Solvent X in its manufacturing processes and although it followed the prevailing best practices for disposal, some solvent leaked into drain pipes and eventually migrated to the groundwater. When Solvent X was detected in the municipal wells, the various state and federal environmental authorities asserted that Bigger Tool, as the successor to Smaller Tool, was responsible for the costs of remediation. Coverage was excluded under Bigger Tool's current general liability insurance policies, and (at least in the controlling jurisdiction) Bigger Tool's historic general liability policies were not triggered with respect to occurrences that predated the acquisition of Smaller Tool. A mad scramble ensued to track down any evidence of the old general liability policies issued to Smaller Tool decades ago that had been disposed of during the shut down of Smaller Tool. In addition to illustrating the importance of maintaining records of legacy insurance assets, this situation presents an example of why the purchase of, for instance, environmental impairment liability insurance might have been prudent on the part of the purchaser if due diligence had revealed any reason for concern.
Case Study 4: When Opportunity Knocks
Brake Pad Corporation suffered catastrophic mass tort claims because of its manufacture and sale of defective products. The company’s insurers denied coverage for the tort claims, but because management was desperate to reach closure regarding the claims that had damaged its reputation, Brake Pad settled with the underlying claimants. For a variety of reasons, including the damage to its reputation and the depletion of its cash reserves to settle the mass tort claims, Brake Pad’s share price declined precipitously. Sensing an investment opportunity in the heavily devalued company, Buyout Co. purchased 100% of the shares of Brake Pad and maintained it as a portfolio company. Brake Pad then commenced hard-fought litigation against the insurers that had denied coverage and ultimately obtained substantial insurance recoveries that approached what Buyout Co. paid to purchase Brake Pad. Eventually, once market conditions improve, Buyout Co. plans to take Brake Pad Corp. public at a comfortable profit.
Case Study 5: I Thought I Was Insured for That
VentureCo acquired a 15% interest in NewCo and as a consequence gained the right to name a representative to the NewCo board of directors. Mr. Veep, an executive of VentureCo and its selection for the NewCo board, was an insured person under VentureCo's directors and officers (D&O) liability insurance program with respect to wrongful acts committed in connection with his service as an officer of VentureCo. That D&O policy, however, did not extend to acts arising out of the service on a board of a for-profit entity that is not a subsidiary (at least 50% owned) of VentureCo unless there was an express extension of coverage. Mr. Veep was also insured under NewCo's D&O insurance with respect to wrongful acts committed in connection with his service as a director of NewCo. Eventually, the relationship between VentureCo and NewCo became strained and Mr. Veep resigned from the board amidst accusations that he had not acted in NewCo’s best interests. The relationship became so contentious that NewCo sued Mr. Veep, alleging misconduct in his capacity as a NewCo director. When Mr. Veep sought the advancement of defense costs under NewCo's D&O insurance, coverage was denied because of an “insured vs. insured” exclusion. VentureCo agreed to advance Mr. Veep's defense costs, but when VentureCo sought reimbursement from its D&O insurer for the indemnification of Mr. Veep, the insurer denied coverage because the suit had not been brought against Mr. Veep in his capacity as an insured person and the suit concerned acts committed as a director of an outside for-profit entity.
In closing, we return to the observations we made at the start of this series. The purchase of insurance is too often treated as nothing more than an unavoidable expense item. In reality, insurance policies are complex commercial contracts that play a critical role in business strategy and are a pervasive part of the legal environment. They operate within the web of commercial activities and other contracts, where multiple—and sometimes competing—obligations can interact in unexpected ways. Below are but a few of the factors to take into account at the intersection of insurance coverage and corporate transactions:
- The disposition of insurance assets as a consequence of a transaction;
- The effect that a transaction will have on current insurance assets;
- Whether a transaction may result in competing claims to a finite pool of insurance assets;
- The new risks undertaken as a result of a transaction that may be insurable;
- The extent to which there may be untapped value in historic or legacy insurance assets; and
- The extent to which contractual relationships may require providing additional-insured status to contracting partners.
Unless insurance assets are treated as an integral part of the business lifecycle, and are taken into account throughout it, the policyholder risks losing the benefit of a valuable asset and missing strategic opportunities.