In mergers and acquisitions (M&A), risk mitigation is a critical consideration for both buyers and sellers. One key element in this process is tail coverage, which is often included in the negotiations to address potential liabilities that may arise after the transaction closes. This article will explore what tail coverage is, why it is essential, and what it typically includes in an M&A transaction.
What Is Tail Coverage?
Tail coverage, also known as an extended reporting period (ERP) endorsement, is an insurance provision that extends the reporting period for claims made under certain policies, such as Directors and Officers (D&O) liability insurance or Errors and Omissions (E&O) insurance. It provides protection for claims that arise from actions or events that occurred before the transaction’s closing date but are reported after the policy has expired or been terminated.
Why Is Tail Coverage Important?
When a business changes ownership, there is often a gap in liability coverage if the new owners choose not to renew the existing insurance policies or switch providers. Tail coverage ensures that the selling party is protected from claims related to their tenure, safeguarding them against post-closing legal actions tied to their decisions or actions while operating the business.
For example, if a claim arises due to a misrepresentation in financial statements made before the sale, tail coverage ensures that the former owners and executives are not left personally liable for the defense costs or settlements.
What Does Tail Coverage Include?
Tail coverage in an M&A transaction typically includes the following:
Directors and Officers (D&O) Liability Protects former directors and officers from claims alleging wrongful acts, such as breach of fiduciary duty or mismanagement, that occurred before the transaction closed.
Errors and Omissions (E&O) Insurance Covers claims related to professional services provided by the company prior to the sale. This is particularly important for service-oriented businesses.
Employment Practices Liability Insurance (EPLI) Protects against claims related to employment practices, such as wrongful termination or discrimination, that took place before the closing date.
General Liability Insurance Ensures coverage for claims stemming from incidents like bodily injury or property damage that occurred before the sale but are reported after closing.
Environmental Liability Insurance For industries where environmental issues are a concern, tail coverage can address liabilities arising from pre-closing activities that might lead to environmental claims.
Cyber Insurance With the increasing prevalence of cyber threats, tail coverage can include protection against claims arising from data breaches, cyberattacks, or other cybersecurity incidents that occurred prior to the sale but are discovered or reported afterward. This is especially critical for businesses that handle sensitive customer data or operate in technology-dependent industries.
Structuring Tail Coverage in M&A Transactions
Tail coverage is usually addressed during the negotiation phase of the transaction. Key considerations include:
Duration of Coverage Most tail policies provide coverage for a specified period, typically 3 to 6 years post-closing. The duration should align with the statute of limitations for relevant claims.
Cost Allocation The cost of tail coverage can be significant and is often a point of negotiation. Sellers frequently bear the expense as part of the transaction’s closing costs, but buyers may contribute in certain situations.
Policy Limits Ensuring the limits of the tail coverage policy are adequate to cover potential claims is crucial. This includes evaluating the aggregate limits and ensuring they are not depleted by prior claims.
Carve-Outs and Exclusions Buyers and sellers should carefully review the policy terms to identify any exclusions or carve-outs that could impact the effectiveness of the coverage.
Best Practices for Implementing Tail Coverage
Engage Insurance Experts Collaborate with experienced insurance brokers or advisors who can tailor the coverage to the transaction’s specific risks.
Perform Thorough Due Diligence Both parties should conduct due diligence on existing insurance policies to understand their scope, limitations, and claims history.
Negotiate Early Addressing tail coverage early in the transaction process ensures there is ample time to evaluate options and secure appropriate coverage.
Document Agreements Clearly outline tail coverage obligations in the purchase agreement, including cost-sharing arrangements, coverage terms, and duration.
Conclusion
Tail coverage is a vital risk management tool in M&A transactions, offering peace of mind to sellers by protecting them against post-closing liabilities. By understanding its importance and structuring it thoughtfully, both buyers and sellers can minimize disputes and focus on achieving a smooth transition. Whether you are preparing to sell or acquire a business, consulting with experts to address tail coverage is an essential step in protecting your interests.
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