Due Diligence: Insurance Archaeology Prior to Mergers & Acquisitions

In the global economy of the late 1990s, mergers and acquisitions have reached flood tide. Companies fishing the corporate waters for potential acquisitions need to recognize that these waters are festooned with icebergs -- in the form of environmental liabilities and product liabilities that may be unknown to the seller or potential partner. These latent liabilities may emerge years and even decades after damage occurs -- or after a sale or merger becomes fact.

Legal developments of the past few thirty years have heightened all corporate exposure to liability. Under the provisions of the federal government's Comprehensive Environmental Response, Compensation, and Liability Act of 1980, (CERCLA, commonly known as Superfund), a broad range of parties can be held jointly and severally liable for extraordinarily expensive environmental cleanup, often for pollution that occurred decades ago. Under the standards of strict product liability developed by American courts, a plaintiff need not prove that a manufacturer was negligent or at "fault," but only that a product was defectively designed or manufactured or that the manufacturer did not warn against foreseeable dangers. Under the laws of successor liability, moreover, a purchasing corporation is generally held liable for the seller's liabilities.

Fortunately for prospective purchasers, U.S. law also provides some protection against potential and unforeseen liabilities, in the transferability of insurance assets from sellers to purchasers. U.S. courts have generally held that a corporation deemed liable for a predecessor's products or pollution is entitled to coverage under the predecessor's applicable insurance policies. While it is advisable that the acquired corporation expressly assign its insurance coverage to the purchaser, insurance coverage can be assigned without the insurance company's consent after a loss has occurred. Even when the insurance policy contains a "no assignment" clause, courts have granted successor corporations coverage under policies sold to the acquired corporation.

Why worry about old insurance? The fact is, most old CGL policies have as long a shelf life as the liabilities they were purchased to defend against. Under a standard CGL policy, if a claim is filed against a policyholder thirty, forty or even fifty years after property damage or bodily injury occurs -- as often happens in cases of environmental pollution -- a policy that was in effect during the time of continuing exposure or damage is still effective decades later. For this reason, a prospective buyer's due diligence insurance audit of a prospective seller must include a comprehensive historic reconstruction of the seller's insurance history as well as its present coverage.

Indeed, digging deep into a prospective purchase or partner's insurance history, as well as that of one's own company, can often uncover pure gold, in the form of old insurance policies that are far more comprehensive than more recent ones. In many cases, the brunt of the pollution -- and liability -- occurred during the time the company was covered by extremely broad comprehensive general liability policies of the type offered in the 1940s, '50s, and '60s. These policies, no longer available, tend to:

• provide broad coverage terms with no restrictions or exclusions that relate to pollution or contamination;
• contain no aggregate limits, allowing coverage for an unlimited number of occurrences;
• be prepaid and rarely involve claims-handling service charges or additional premiums under old retrospective rating plans;
• provide unlimited coverage for defense costs in addition to policy limits.

Given the value of old insurance policies, and the broad transferability of insurance policies to corporate successors, a comprehensive audit of a potential acquisition's insurance coverage can spell the difference between acquiring a dynamic asset and acquiring a perpetual asset drain. Assessing a target company's insurance coverage, therefore, is an essential part of due diligence for any prospective purchase or merger.

If a company has merged or acquired other companies in its past, the likelihood increases that insurance documents have been misplaced or forgotten -- since changes of ownership generally entail changes in personnel, closing and merging of offices and warehouses, and sometimes even wholesale relocation.

The historic audit needs to be particularly comprehensive when a company is purchasing a division or subsidiary, which may share insurance policies with its parent and which may have gone through several ownership changes in the decades prior to the current purchase. In such a case, if the division or company has substantial liabilities, many entities may be competing for coverage up to the limits of each relevant insurance policy. Thus the insurance audit needs to include as complete a record as possible of claims settled, claims pending, and remaining coverage available under the limits of each policy.

Ideally, a company considering a merger or acquisition should perform a complete historic coverage audit as soon as possible once negotiations begin. A demand for such an audit need not seem a distraction or intrusion, if it is made clear to the prospective partner or seller that the audit may well uncover assets that enhance the seller's value. Indeed, the seller may be induced to perform the audit, since doing so potentially augments its saleable assets. Selling a company with a complete and well-documented insurance history is like selling a house with a new roof and solid foundation.

Conducting the insurance audit prior to purchase is important not only because it provides the purchaser with data potentially crucial to assessing the seller's true value, but because the conditions for such an audit are much more favorable before the purchase than after. A merger or acquisition inevitably creates some disruption -- and sometimes considerable resentment, particularly when major personnel changes result.

The merger and acquisition process has a momentum of its own, and circumstances often do not allow adequate time to reconstruct the past coverage in detail. In this case, the buyer can still prepare to do a complete audit following the purchase and thus prevent a worst case scenario in the years ahead. A partial audit can provide an outline of existing coverage and at least freeze the evidence, ensuring that critical documentation will not be misplaced, lost or destroyed.

At a minimum, then, a prospective purchaser ought to obtain copies of all existing liability policies and identify what gaps exist in the coverage history while negotiations are in progress. In order to complete the audit after the acquisition, the purchasing company should develop a checklist of company insurance records and relevant non-insurance documents. Records in storage should be investigated, with arrangements made to have records retained. Finally, insurance personnel should be interviewed before the transition occurs to determine what they recall about past coverage and records retention.

Whether you rely on the seller or retain experienced insurance archaeologists as part of your due diligence team, take advantage of the leverage that exists before the purchase to locate records and to obtain cooperation from employees and insurance brokers. A comprehensive effort will uncover more assets, preserve evidence and ensure greater protection for unanticipated liabilities for decades to come.

For a step-by-step account of the insurance audit process, please see the article, The Historic Insurance Audit: A New Best Practice.