Despite the reduction in merger, acquisition (M&A) and initial public offering (IPO) activity in the UK this year, they remain important tools in corporate strategy. However, individual directors and officers taking part in such deals have a greatly increased exposure to claims from a multitude of parties.
In recent years, the normal day-to-day duties of care and skill needed when managing a business have increased significantly, and have been augmented by additional statutory responsibilities. Many directors already struggle to cope with these requirements, let alone take on the added burden of participating in or driving forward a corporate transaction. Furthermore, they may well not be fully aware of the extent of their personal liability until it is too late.
The increased risk to directors from their participation in corporate transactions arises as the direct result of a number of factors.
D&O insurance
Risks such as non-disclosure, misleading statements and mismanagement resulting from corporate transactions can be covered by directors and officers liability (D&O) insurance. Mergers, acquisitions and IPOs are all material facts that you usually need to inform your insurers about prior to the event. The way D&O policies deal with these events differs between insurers.
If your company acquires an entire company during the period of insurance, it will either be automatically included in your D&O policy (within certain total assets/turnover parameters), or else you will need to inform your insurers so that they can recalculate the extent of their exposure. Wrongful acts committed by the vendor’s directors prior to the transaction will only be covered if the vendor buys ‘run-off’ insurance or if your company buys ‘prior acts’ cover. This is usually determined by the sale and purchase agreement.
If your company acquires a subsidiary of another company, cover for its directors for wrongful acts committed prior to the transaction will be included under the vendor’s D&O policy. Cover for wrongful acts post-transaction should be protected under your own policy.
Cover in respect of IPOs can be included in the D&O insurance for an additional premium. Traditionally, the cover will be limited to claims brought as a result of the IPO in question against individual directors and officers. Cover under a D&O policy, especially in relation to IPOs, is therefore by no means exhaustive.
If your company has purchased D&O cover for a some years prior to the IPO, insurers may look upon you more favourably. Premiums will be affected if you only buy D&O insurance in the run up to the transaction. If your company is contemplating any corporate transactions in the future, you should purchase D&O cover now to ensure an easier and more price effective risk transfer mechanism when the transaction takes place.
However, claims for mismanagement need not be limited to the financial element of the transaction itself.
Human element
The importance of human and cultural issues in the M&A process is sometimes considered secondary to the financial implications of the deal. However, the employees of both parties are inextricably entwined in the transaction and should not be ignored by senior managers. Problems can occur at both pre-completion and integration stages.
For instance, pre-completion, the vendor’s disgruntled key employees may decide to leave, taking with them crucial know-how or future revenue potential that could seriously affect the profitability of the post-completion organisation. Shareholders may then initiate an action against senior management if projected profits are indeed affected.
Post-completion, reduction in staff numbers (or even the rumour of redundancy), together with new recruitment drives to capitalise on market share, can lead to an increase in litigation. As a result, individual directors and officers, or more likely the company itself, may face potentially damaging costs arising from employment litigation.
In the USA, post M&A employment actions often result in multi-million dollar awards. In the UK, the situation is not as severe. However, both the frequency and severity of these types of claim in the UK are increasing, mainly due to the growing legislation in this area in recent years.
In the 1980s, there were 11 Acts of Parliament that affected employment. In the 1990s, there were 50, with 40 employment law changes in the last two years. The cap on unfair dismissal awards now stands at £51,700; the qualifying period for bringing unfair dismissal claims has been reduced from two years to one, and there is no cap on discrimination awards. A company and its senior managers without appropriate resources and procedures in place for these types of events could find themselves hit by a ‘double-whammy - litigation from disgruntled employees and subsequent actions from shareholders for mismanagement.
Throughout the M&A process, employees are put under extra pressure through uncertainty, disruption and rumours. It is essential for senior managers to have a clear strategy to reduce the potential for loss, and to have adequate insurance in place to protect their balance sheet.
At all stages of the process, it is critical that senior managers concentrate on reducing their employees’ general level of uncertainty. Pre-completion, they should identify key employees and put in place proven people strategies centred around the individuals’ motivations (ie financial, promotion) to minimise the chance of their leaving. Clear communication of the new business’s direction and vision is necessary and must be followed up.
The business world is littered with companies that have failed to integrate satisfactorily, especially when the two organisations concerned have contrasting cultures. Senior managers must be seen to lead by example. They should also be aware of the risks that may arise from their employees, even at the expense of forgetting the figures for a second!
However well the M&A process is carried out, it is impossible to put a complete stop to actions, or the threat of actions, by employees and third parties. Protection against claims brought against individual directors and officers for misleading statements and the like is an area where D&O coverage will be of use. However, the same cannot necessarily be said for employment litigation.
If a claim is brought against a senior manager for an employment practice violation such as unfair dismissal or discrimination, a D&O policy should respond. But most of these types of claims are brought against the employer, not the individual responsible for the violation. It is possible to increase cover under a D&O policy by buying an entity extension to insure claims brought against the company itself. However, changing underwriting trends, and the fact that this option is rarely available for a new organisation, mean that you should not rely upon being able to add it.
The best way of protecting against the likely effects of employee litigation from the M&A process is to buy employment practices liability insurance (EPLI). Not only does it protect the company as well as the individual directors and officers, but coverage is generally superior to a D&O policy. In some cases, if EPLI is bought before the transaction, automatic cover for subsequent acquisitions will be in place up to pre-determined parameters.
The Redundancy procedures and the Transfer of Undertakings (Protection of Employees) Regulations 1981 can create particular difficulties for employers. EPLI policies will not cover claims arising from the insured’s obligations to consult representatives and employees in relation to collective redundancies. Most do cover breach of obligations transferred to the insured by virtue of the TUPE regulations. But you must check. One major insurer now excludes it entirely.
One off covers
The protection available to directors from D&O coverage alone during corporate transactions may be inadequate. ‘One off’ products such as IPO and warranties and indemnities (W&I) cover can increase protection for individual directors and officers and their companies for any warranties and indemnities given as part of a corporate transaction. The need for IPO insurance arose in the US as a result of the Securities Exchange Committee’s decision that companies could not indemnify their directors or officers for mis-statements or omissions contained in IPO documents.
The purchase of an IPO specific policy can cover events such as debt or bond offerings, rights issues or secondary offerings, a listing or de-listing and private placements. Ideally, you should buy it from the same insurer that provides your D&O cover. The policies should be constructed so that the D&O cover does not respond to claims arising from the IPO and the IPO policy responds to cover the D&O liabilities arising from specific IPOs only.
This type of arrangement has several advantages.
The importance of adequate risk appraisal going into the transaction process, including due diligence, should not be underestimated. The risks to individual directors will be directly proportional to the level of care taken in the risk appraisal process, and should be backed by an ongoing underlying D&O and EPLI programme with one off policies in place for the specific transaction.
Email: charles_boorman@ars.aon.co.uk
AREAS OF LIABILITY
The main duties of directors arise under or in respect of: fiduciary duties; duties of care and skill; articles of association, and statutory duties. The main areas of potential liability for directors involved in corporate transactions fall under statute and common law.
Under statute, the basic rule is that the company, its directors and anyone else accepting the responsibility of the transaction may be liable for mis-statements where investors suffer loss. The rules are variously set out in the Financial Services Act 1986, Public Offers of Securities Regulations 1995, Companies Act 1985 and 1989, Misrepresentation Act 1967, Financial Services and Markets Act 2000, and Criminal Justice Act (Part V) 1993.
In common law, Hedley Byrne v Heller (1964) established that liability exists for financial loss caused by negligent mis-statements outside of a contractual relationship. Therefore, the directors and the company owe a duty to shareholders, if the latter rely on negligent mis-statements contained in the prospectus or the sale and purchase agreement.
Al Nakib Investments (Jersey) Ltd v Longcroft (1990) showed that the directors of a company do not owe a duty of care to existing shareholders who purchase shares in the open market after placing reliance upon a prospectus. However, this was tightened in Possfund Custodian v Diamond (1996) so that a duty of care may be owed to post IPO purchasers in certain situations.
In the M&A process, directors owe shareholders the fiduciary duties of due care, loyalty and full and fair disclosure. Unfortunately, directors often fail to fulfil these duties as a result of material conflicts of interest. To minimise their exposure to claims, directors must ensure that proper due diligence is being undertaken, that other risk appraisal factors have been taken into account and that their existing insurance coverage is set up to respond to corporate transactions as they happen.
