Why insurance is important in the sale of a Business
When an owner/shareholder sells some or all of its shares in a company (in this article, referred to as the “Target”), then the Target’s liabilities and assets are largely unaffected by the process.
Two of the most obvious exceptions to that rule are:
- some of the Target’s contracts (including, potentially, its insurance contracts) might prohibit a change in the ownership of more than 50% of the shares in the Target (a “Change of Control”) without the counterparty’s written approval; and
- if the Target has tax assets (losses carried forward from earlier periods) then these may be lost if the sale will transfer ownership of more than 51% of the shares in the Target.
Accordingly, an evaluation of the Target’s insurance assets will form part of the purchaser’s assessment of whether to proceed with the transaction (its “due diligence”). Amongst other enquiries, the insurance due diligence might address:
- whether the insurance policies prohibit a Change of Control (note: if the insurer’s consent is not obtained prior to the sale, then the insurer might claim that the omission is a material breach leading to the termination of the policy on the completion of the sale);
- the adequacy of the types and amounts of insurance held by the Target;
- the excesses/deductibles relevant to any future claims against such policies;
- the Target’s claims record; and
- any current or potential litigation to which the Target’s insurances might respond.
However, when a company (“vendor”) sells a business and the assets relevant to that business, the purchaser typically does not assume any of the vendor’s liabilities, even if they are relevant to the business. The vendor and purchaser might agree that certain liabilities will be assumed – for example, those to the business’ trade creditors (its suppliers). In some instances, such a transfer of liability will not be effective without the counter-party’s approval.
Therefore, an initial reaction might be to conclude that insurance is only relevant prior to a business sale completing. Indeed, that is the only context in which insurance is specifically addressed in ADLS’s standard form Agreement for Sale and Purchase of a Business, 2008(3) (see clause 4.2(1)).
That agreement reminds the vendor that the business remains at the sole risk of the vendor until possession (ownership) transfers to the purchaser (also commonly referred to as “settlement” or “completion” of the transaction).
“Business” is defined in clause 1.1(4) as: “… the business described on the front page of this agreement, including the assets”. “Assets” are defined in clause 1.1(3) as: “… collectively, the tangible assets and the intangible assets” and “tangible assets” (in clause 1.1(16)) as “… all of the plant, machinery, equipment, furniture, fittings, motor vehicles and other chattels owned by the vendor at the settlement date and used in connection with the business” [our emphasis].
The agreement also provides that if any such asset is lost, destroyed or damaged (“loss”) prior to the possession (settlement) date, then the purchaser has some rights, including the right to validly cancel the agreement and retrieve its deposit and any other monies paid, if:
- such loss has not been made good by the repair or replacement of such asset by the possession date; and
- such loss is “… sufficient to affect the purchaser materially in the carrying on of the business …”.
Whilst a number of New Zealand judgments have cited clause 4.2(1) of the agreement, the authors could find no judicial guidance for determining whether a loss is “sufficient to affect the purchaser materially in the carrying on of the business” such that the purchaser could invoke the remedies in clause 4.2(1).
Insurance is relevant to a purchaser
However, the vendor’s insurance is also important to a purchaser, even if there is not a significant “loss” (as defined above) prior to the possession date or a legal obligation to assume the vendor’s liabilities arising prior to such date.
Most liability insurance policies (including those for: product liability; professional indemnity; and directors and officers insurance) are “claims made” policies. Such policies cover claims made against the insured during the period of insurance, regardless of when the event that gave rise to the claim (including negligent manufacture, design or advice) occurred. By contrast, an “occurrence based” policy provides cover if the event (e.g. flood) that gave rise to the claim occurred during the period of cover. Most property and business interruption insurance is “occurrence based”.
Therefore, if the purchaser of a business has such cover and receives claims from a business’ customers in respect of, say, faulty goods or negligent advice, then it will work with its insurer in respect of those issues. However, if the relevant events which created the liability occurred while the business was owned by the vendor, then the purchaser’s insurer will reject liability for such claims (on the basis that the vendor is the proper defendant).
While this might be a satisfactory legal result, it is unlikely to endear the business and its new owner to its customers, especially if the vendor of the business:
- has not effected run-off cover (see below) in respect of any post-possession/settlement claims; and/or
- is unmotivated to protect the goodwill/ brand of the business by doing “the right thing” for rightly aggrieved customers; and/or
- has distributed all of its assets by the time the claims are notified.
(Note: liability claims can arise long after the event(s) that gave rise to them. This means that a vendor, and potentially even its principals, can or will be exposed to claims after it has sold its business. For these reasons, it may be important to consider purchasing run-off cover to protect against the risk. This will be especially important for vendors providing professional services.)
If properly aggrieved customers do not receive appropriate compensation for their losses, they are unlikely to remain customers and bad publicity might destroy the business’ brand.
So, the purchaser may prefer to take control of such claims itself and have recourse to insurance where any of the claims are significant. This will normally only be possible if, whilst undertaking its due diligence investigations prior to purchasing the business, it had investigated:
- if the benefit of the vendor’s insurance policies could be assigned to it; or
- if its own insurers would agree to treat the business as having been covered for a certain period of time prior to the completion of the purchase (so that cover would be provided for claims received after settlement which related to unknown liabilities of the business incurred in the, say, 12 months prior to settlement); and
- any costs associated with those actions.
Insurance is also relevant to a vendor post-settlement
As suggested above, liabilities may exist in respect of a business at completion of which the vendor and its principals/owners are unaware. Run-off cover will assist to mitigate the losses to which a vendor might otherwise be exposed in respect of a claim received after the business is sold.
If there is inadequate (or no) insurance cover in place when things go wrong, it could have significant consequences for the vendor and/or the purchaser. Insurance should form part of both parties’ considerations when involved in these types of transactions.
Readers wishing to learn more about these issues may be interested in the upcoming ADLS webinar “Business Sales – Insurance Risks Refresher” being presented by the authors on Wednesday 15 February 2017. For more information or to register, please visit www.adls.org.nz/cpd.