Buying and Selling a Business: Insurance During an Acquisition
There’s a roller coaster of emotions when a business owner sells their company. The week before the business is to sell, the business owner’s voice is stressed, nervous, hair-triggered with concern. If you speak with them again 2 weeks after, you can barely recognize them as the same person. They’ve become jovial, and conversation naturally leads to planning vacations and other exotic adventures that previously they could not have considered doing before they exited their business. Alas, ignorance is bliss because many business sellers often overlook a facet of selling their company that could put a damper on that new lifestyle that they’re about to embark upon.
In most instances, the seller of the company will notify their insurance company that they are leaving and request to cancel their policy. Business owners who cancel their policies often feel secure in doing so because they have an indemnification clause in their contract that states that they will be responsible for any claims which occurred before the closing.
On some occasions however, the buyer and seller discuss transition strategy and decide that they can just pass the insurance policy rights from one to the other – but this type of assumption is nearly never acceptable in the eyes of the insurance company.
A new buyer under the supposition that the policy will provide protection for them until the renewal date will be in for an unpleasant surprise when a claim against the company is made as any faulty work claims during this transition time are the responsibility of the buying party, and the insurance company will not cover them.
To this point the line in the sand for responsibility seems pretty clear. However, for some industries, it gets a bit more complicated. Consider this example:
A deck building company installs a deck at a home in the summer of 2011. The owner of the deck company sells the company in February of 2012. The following May, a deck that was installed during the previous owners watch collapses, injuring several people. The deck company customer’s file a claim against the deck company for faulty workmanship. Who is responsible for the damages? The buyer or the seller?
It depends. Sometimes this exact situation is negotiated prior to closing. More likely however, sellers have examined their policies to determine if they carry a “claims-made” or an “occurrence” based policy.
An “occurrence” based policy means a claim can still be made against the policy even though it may have expired, provided it was in force at the time the loss occurred. So in the case of the faulty deck, the seller’s previous policy would cover the claim. Examine the policy closely though – many insurance policies state the claim must arise out of an occurrence that takes place during the policy period. If this is the case the seller’s vacation might be ruined.
However, if the insurance policy is a “claims made” policy, coverage for the period before the sale was terminated, and the seller’s insurance policy will not cover the damages. Buyer obviously will fight against incurring the cost of the accident, and depending on their new policy, they may not be responsible either. That means the seller could be personally at risk for the event.
Alternatively, the seller with a “claims made” insurance policy could have purchased a “tail” policy In order to continue coverage for that prior period. Also known as an Extended Reporting Endorsement, this “tail policy” must be in force before the business seller’s transaction is complete. This tail policy extends the cancelled or expired claims-made policy. Timing is crucial though – sometimes a tail policy is only be available when the policy is purchased and can be more challenging to get when canceling the policy.
For coverage written on an occurrence policy, underwriters will offer either discontinued operations coverage or discontinued products coverage – both of which are a necessity for most contractors, manufacturers, professionals and others with similar exposures. Unfortunately, not every company writes this coverage.
A recent real example of a buyer and seller failing to notify their insurance carrier of a change in ownership when to Federal Court in Texas. In Keller Foundations, Inc. vs. Wausau Underwriters, the purchasing company acquired the assets of the selling company and then changed its name and organizational structure to an LLP. Neither buyer or seller notified the insurance carrier, so the Comprehensive General Liability insurance remained in the corporate entity name, providing no coverage for the LLP that was formed later. It’s important to note that the insurance policy had a non-assignment clause
After the sale took place, several lawsuits were filed in Texas, California and Florida for defects and property damage allegedly arising from the seller’s work prior to the purchase and during the term of the insurance policy. The insurance company declined to defend the buyer or the newly formed limited partnership, so buyer assumed the defense on its own, consistent with its assumption of liabilities in the purchase agreement and sued the insurance company on the coverage issue. The court rejected buyer’s assertion that the insurance company should provide defense and indemnification despite the non-assignment clause and its claim that the insurance company was not prejudiced by the fact that the company wasn't asked to add buyer or the newly formed limited partnership as an insured.
When selling a company or buying a business, it’s vitally important to review the insurance policies during due diligence -- not just to determine coverage amounts and to shop for new policies, but to verify assignability and exposure for both parties.