Why SMEs shouldn’t rely solely on directors' and officers' insurance to cover mergers and acquisitions risks

During the height of the COVID-19 pandemic in 2020 there was naturally a period of disruption. But mergers and acquisitions (M&A) are very much back on the agenda for small and medium-sized enterprises (SMEs). In fact, M&A activity involving UK companies reached a record number of transactions in 2021. Driven by pent-up demand amongst cash-rich investors.¹

Huge, multi-billion-pound deals make the headlines – like Elon Musk’s acquisition of Twitter.² But M&A activity in the SME sector is also sky high. In 2021, SMEs completed 323 M&A deals worth a combined £1.46 billion. Respectively, those figures represent 21% and 27.3% increases compared with 2020.¹

What’s more, SME valuations are 61.7% higher than in 2020. M&A activity is expected to remain robust throughout 2022 and into 2023. As a result, there are likely to be tempting opportunities for SME owners and shareholders to realise significant value through a business sale.¹

Mergers and acquisitions risk for SMEs

For any SME owner considering a merger or acquisition, it is important to remember that M&A transactions can be complicated. The opportunity to realise value from years of hard work building a business carries significant risk. There are a huge range of issues that can derail a deal or leave a seller facing the prospect of having to hand back some, or all, of the sale proceeds.³

What’s more, the risks associated with selling a business don’t end when the deal is complete. For instance, if it emerges that the seller made inaccurate representations about the sold business, the buyer has up to seven years from the deal completion to make a claim. This timeframe depends on the type of warranty breach and the limitation periods stated in the sale agreement. The result, if a court finds in favour of the buyer, can be significant unforeseen costs – from defence costs to compensation.³

So, if you’re an SME owner or shareholder who’s thinking about selling up, it pays to be prepared. That means understanding the risks and taking steps to minimise them throughout the sale process. The right insurance can play a vital role.

Understanding the limitations of directors' and officers' insurance in mergers and acquisitions

Director’s and officers’ (D&O) insurance covers company directors and officers personally. It provides cover for defence costs and awards made against them for ‘wrongful acts'. For example, in the event that trading standards, environmental or other regulatory claims are made against them personally.⁴

It’s easy to understand why some may assume this cover offers protection during a business sale. Directors and officers are more exposed to potential liability claims during the M&A process. For instance, claims could arise from decisions around whether to approve or reject possible sale transactions.

Duration and limitations of D&O run-off cover

Many of these risks may not manifest for years. So D&O run-off cover is often purchased for a period of up to seven years. (This is influenced by the statutory limitation period in the applicable jurisdiction). The premium for run-off cover is fully earned at inception. So the cover can’t be cancelled or amended for the duration of the contract.

Exclusions of D&O run-off cover

D&O run-off cover will not protect against warranty and indemnity liability that the seller may have assumed under the sale agreement. This liability arises from providing the buyer with financial recourse for a breach of warranty. Warranties in this context are statements of fact about the business. They protect the buyer if they suffer financial losses in circumstances covered by a warranty.

Warranty period risks

A seller remains at risk for the duration of the warranty period. This is typically two years from the date on which the business is sold for non-tax warranties and up to seven years for tax-related warranties. Therefore, a successful warranty claim post sale could result in the seller being obliged to pay back some or all the sale proceeds.

The role of warranty & indemnity insurance

Warranty & indemnity (W&I) insurance covers unknown and unforeseen financial losses arising from a breach of a warranty given by the seller to the buyer in the sale agreement. It can help facilitate a clean exit for a seller and enable sale proceeds to be used immediately as the risk has been transferred to a W&I insurance policy.

Here to help

In addition to advising on and placing run-off D&O cover, at Marsh Commercial we have access to a dedicated Private Equity & M&A (PEMA) team. Supporting the investment, M&A community and our clients to de-risk transactions and create value through:

• Pre-transaction risk and insurance advice.
• Advising on and placing M&A insurance solutions for unknown and unforeseen risks (W&I insurance) and known and quantifiable risks (Contingent Specific Risk insurance) to facilitate transactions and transfer transactional liabilities to the insurance market.
• Advice relating to disposal of assets in distress and/or corporate restructurings.

The world of mergers and acquisitions is complex. If you’re considering a business sale, find out more about the potential risks and insurance solutions. Or contact one of our local experts for confidential support and guidance.

Sources

1 cbw.co.uk/ma-activity-in-the-uk-sets-new-records-in-2021
2 bbc.co.uk/technology-63402338
3 cfcunderwriting.com/what-to-know-when-your-sme-client-is-selling-their-business
4 marshcommercial.co.uk/directors-and-officers

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