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Small Business | Financing and Insurance

Acquisitions Are Liable to Carry Insurance Risk

June 24, 1998|Juan Hovey | Juan Hovey is a freelance writer

Next time you launch an acquisition campaign, get your advisors into one room and ask them what they know about:

* Sunset clauses.

* Insurer's reservation of rights.

* Contingent business interruption.

If your people understand the impact these things can have on your acquisition plans, you're in good hands. If they don't, you may face some unexpected costs, particularly if your campaign involves complex deals.

As discussed in this space recently, no business owner would launch an acquisition program without assembling a team of solid professional advisors, including top-flight legal help plus input from a competent insurance broker or risk manager.

Any business lawyer knows what sunset clauses are and what it means for an insurer to reserve certain rights when defending you in court. Similarly, any good insurance broker knows what contingent business interruption insurance is.

But it takes special expertise in risk management to understand the impact these three things can have on any acquisition, and if your advisors can't help you here, you may need to seek that help out.

As the name suggests, sunset clauses put an end to something. In the legal documents governing a business acquisition, sunset clauses often detail at what point the seller of a business no longer stands liable for such things as the costs of environmental cleanup work stemming from past operations. Sunset clauses also parcel out responsibility for product liability, directors and officers liability and other risks.

What's the danger to you?

Given the frequency with which investor groups buy and sell businesses these days, you need to know whether the business you want to buy has changed hands in the past and whether the sunset clauses stemming from such transactions threaten you, as the next owner, with unexpected liabilities.

In simpler language, you need to know at what point you become responsible for liabilities stemming from the past operations of the company you want to buy--so that you can prepare for it, say, by insuring the risks.

*

Similar dangers lurk in what insurers call the "reservation of rights" clause found in many insurance policies.

Liability policies commonly obligate the insurer to defend you in any court fight stemming from your coverage, but the obligation is rarely open-ended. For one thing, your insurer may hold the power to settle litigation with or without your approval. For another, even when an insurer engages counsel for your defense, it may reserve the right to refuse to pay any claim for which the insurance coverage turns out not to apply.

In plain English, this means that if your insurer can show that your policy doesn't cover you for a specific claim, it can refuse, at any time, to pay the claim. Worse, it can bill you for the cost of any legal counsel engaged on your behalf, even if your policy requires your insurer to defend you against the claim.

If you think that sounds like a loophole, you may be right. The important point, however, is that when you negotiate an acquisition, you need to know about any insurance claim against your target company being defended by an insurer on a reservation-of-rights basis--because if the coverage turns out not to apply, you go into the insurance business.

"You can't assume, because an insurer is defending your target company against a claim, that the insurance will apply," said Alan Weiss, a risk manager and senior vice president of the mergers and acquisitions group of Aon Risk Services, a unit of the insurance brokerage Aon.

"If an insurer feels there could be aspects of a claim not covered by its policy, it may provide a defense to the policyholder on a reservation-of-rights basis, meaning that if it is later discovered that there is no cover, everything stops," Weiss continued.

"This means that any business owner doing a merger or acquisition needs to know if any claims are being defended on a reservation-of-rights basis--because the buyer could get stuck with the bill for uninsured claims."

*

Contingent business interruption insurance is also important, Weiss said, particularly if your target company outsources significant parts of its operations.

If the target company manufactures its goods in an overseas plant, for example, and the overseas plant burns down, the target company can't sell to its customers, he said. Similarly, if the target company itself supplies components to a manufacturer that gets shut down by an earthquake, it might suddenly find itself with a warehouse full of worthless inventory.

"You can insure both of these risks, and many insurance companies throw some coverage for the exposure into their standard policies," Weiss said. "But if you're buying another company, you've got to know how much of this coverage the target company has, and whether the coverage really reflects the risk--just like you have to know about sunset clauses and reservation-of-rights litigation."

It's important to analyze these risks so you don't take on unwanted liabilities, and even experienced lawyers who do mergers and acquisitions don't always see the dangers.

"We saw one transaction involving the maker of plastic linings for landfills which had changed hands about three years before," Weiss recalled. "The sunset clauses in the original sale and purchase agreements were going to run out a couple of months after the new transaction closed, leaving the new buyer with a substantial liability that nobody had seen.

"As it turned out, the buyer and seller negotiated a way to share the risk--but if the buyer hadn't known about it, he could have been left holding the bag."

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Freelance writer Juan Hovey can be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.

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