Insurance is a complex industry, full of history, market customs and legal precedent. It is an ever changing and evolving industry reacting to worldwide conditions. Without a full understanding of which institutions are involved, what legislation, rules or codes of conduct are in place and what outside influences are impacting the industry, it is impossible to understand how the matrix of what constitutes today's insurance industry works and operates. This practical guide answers many of the questions you may have.
- Which method of transaction or transfer is best?
- Documentation relating to Company or Business Acquisitions
- Basic Principles of Insurance Broking and MGA Acquisitions
- Company or Business Acquisition - which?
- Pre-acquisition caution: due diligence
- Recurring Issues in Insurance Broking and MGA Transactions
- Warranties and Indemnities
- Bringing in insurance broking and underwriting teams
It has been said that insurance is an industry unto itself. It is also recognised that, insurance is not one industry: but many industries based around the common theme of providing an indemnity against loss. As a result, corporate and commercial transactions in the insurance industry are as similar to the usual transactions involving non-insurance related matters, as chalk is to cheese!!
Why should this be so? Insurance is a complex industry, full of history, market customs and legal precedent. It is an ever changing and evolving industry reacting to worldwide conditions. Without a full understanding of which institutions are involved, what legislation, rules or codes of conduct are in place and what outside influences are impacting the industry, it is impossible to understand how the matrix of what constitutes today's insurance industry works and operates. It also has its own language and acronyms, which can be impenetrable to the uninitiated. However, most importantly it is the plain nature of the industry. Insurance is the buying and selling of a risk management contract today for a premium, which can have a lasting effect or "tail" for many years to come.
In recent years, the industry has reflected upon the different component parts, and there has been a good deal of consolidation, realignment, entry into the market, and development of new products. This has occurred across the industry, be it in UK/EU regulated insurance companies, Lloyd's syndicates, underwriting agencies or brokers. Each has sought to review its portfolio of business, and to develop more profitable business to its best advantage. However, a new dynamic was forced upon the broking and MGA markets in 2005, being the EU Directive regarding the regulation of insurance intermediaries, and FCA Regulation. The cost and complexity of regulation has impacted heavily on the broking and MGA market. Potential buyers are recommended that they should consider these before embarking upon an acquisition, so that they can assess the potential effect that it may have upon the target company.
As at the date of this Memorandum, consideration of the effect of the proposed EU Directive in this area, particularly relating to commission disclosure should be considered. The Directive is likely to have more impact in Continental Europe and if the target has European operations, then this needs full pre-contract assessment.
This Memorandum is addressed mainly at the general insurance broking and MGA sector: the life, pensions and financial services side of the industry are not addressed here in detail. These services have a whole raft of legislation, regulation and traps for the unwary, upon which detailed advice must always be sought.
For the purposes of this Memorandum, "insurance" includes assurance, reinsurance and co-insurance, although each has its own idiosyncrasies.
2. Which method of transaction or transfer is best?
There are many badges that are put onto transfers of business, including moving of broking teams, acquisitions, disposals, mergers, joint ventures, management buy-outs, leverage buy-outs and others. Each of these can be applicable, but in essence, each of them is a transaction to move an insurance business or an insurance entity from one party to another.
Which is best will always be down to the parties involved in the transactions. Regulation and tax will often be main drivers, but also matters such as employee retention and transfer of risk regarding business liabilities will play an important part.
Acquisitions, Sales and Mergers
- Acquisitions/sales can be of shares in corporate entities, of businesses or undertakings forming part of a larger entity, or of teams of business producers or brokers. The term "merger" has no specific meaning within English law - it is simply one company acquiring another company or business, and thereafter in effect merging or joining the business units.
- Joint ventures have become more popular between producing/placing brokers and MGA’s, or between brokers and underwriters. A joint venture can either be by way of a contract or co-operation arrangement, or by way of a formal joint venture company. There are no pre-determined structures to these arrangements other than as may be required to deal with liability or tax issues. The typical corporate arrangement involves setting up a joint venture company in which each party participates, which is governed by a joint venture agreement between the parties setting out their rights, obligations and liabilities in relation to that venture. Alternatively, a contractual joint venture can be entered into, where no separate company is created, and effectively the parties agree to co-operate as to the broking/underwriting arrangement that is to be created.
Management/Leveraged Buy-Outs (MBO/LBO's)
- MBO/LBO’s have become popular whereby the management or team effectively buy themselves out from their employing insurer/broker/MGA, sometimes with the support of financial backers.
3. Documentation relating to Company or Business Acquisitions
The basic documents are:
- Confidentiality Undertaking and "Lock Out" Agreement - to allow the parties to negotiate with each other in confidence.
- Heads of Agreement - these set out the basic non-binding terms and conditions of the agreement (particularly price) between the parties. Care should be taken to ensure that these are a route map and do not become a diversion! Often Heads become so negotiated beforehand, they roll into the main sale contract - they should only set out the basic principal terms.
- Due diligence questionnaire - a buyer would usually issue one of these in order to obtain specific information about the target business or company. This also allows both parties to seek comfort in respect of specific points which arise in the Agreement.
- Accountant's questionnaire and report - buyers usually employ their own accountant to undertake financial and tax due diligence of the entity.
- Acquisition or Transfer Agreement - either of shares or the business. With a share acquisition, this is usually accompanied by a deed of tax indemnity which deals with taxation arising other than in the ordinary course of business. (Tax liabilities remain in the company sold (cf. Transfer of "cherry-picked" assets)).
- A Joint Venture or Shareholders Agreement - setting out the rights, duties and obligations of joint venture/shareholding parties.
- Service contracts - it is paramount that the main executives/employees of the target broking business are tied into a company since they will often be the main insurance business producers/servicers. Equally, it is important to provide appropriate incentive, bonus and share option schemes for them. Transactions in this area often have an “earn-out” feature over a number of years after the deal is completed. This aspect is equally important in such deals to both the buyer and seller.
- Property deals - with assets on business transfers there often needs to be a transfer of lease or freehold title.
- Transitional Services Agreement - if the target is being bought out of a larger group, then it may be that the seller needs to provide temporary support to the target.
4. Basic Principles of Insurance Broking and MGA Acquisitions
Both the seller and the buyer need to understand the principle of "caveat emptor" - i.e. "buyer beware". To anyone contemplating the acquisition of an insurance broking business or MGA in the UK, the best advice is "be especially beware". This is simply a combined effect of the unhelpful attitude of English law to an unprotected buyer, and in particular, the difficulties of evaluating the risks associated with any insurance entity, be it a broker, MGA or otherwise. Further, with the complicated legislation comprised in the Financial Services and Markets Act 2000, the need for care is even greater - the buyer will not want to inherit misselling or legacy regulatory issues!!
In the absence of specific protections negotiated and recorded in the contract with the seller, a buyer is legally almost completely unprotected by the law. Therefore often the buyer drives the transaction, produces the documentation, and the role of the seller is reactive to these. There are ways in which a seller can retain some control over the process. An auction sale can cause buyers to compete in respect of the terms being offered by the seller as well as the price; often terms of the auction can require the deal to be on the basis of the seller's draft sale agreement. The seller may also be tempted to maintain and control a data room, giving the buyer controlled exposure to information relating to the target company or business.
The principal difficulty with buying an insurance broker or MGA is the nature of the industry, being the placing of a risk today, with the claims handling and associated costs, payments and associated problems arising later. This is particularly the case with brokers and MGA’s who are involved in the placing or underwriting of longer tail classes of business where it is almost impossible to calculate the costs and difficulties that may arise in the future. This issue is being addressed at present by the UK Regulators who are insisting that a run-off management provision needs to be created.
There is considerable contention in this area though at present.
Further, liability issues for the target broker or MGA itself arising from past activities, such as errors and omissions can be equally difficult to quantify.
5. Company or Business Acquisition - which?
The Company alternative
The advantages of acquiring an established company, as opposed to building a business from scratch, include the acquisition of:
- an infrastructure, including systems and premises;
- a trained group of employees;
- a ready-made distribution system;
- a book of business or client list;
- know-how; a company with relevant registrations/authorisations; and
- terms of business agreements (TOBA's) with clients and coverholder/binding authority arrangements in place with insurers.
The traditional view is that it is cheaper and comparably quicker to achieve these advantages by the acquisition of an existing company, than by building a new business. However, most of the above benefits are likely to be felt more in the personal lines area, where the benefits of a large infrastructure and distribution system are more acute, given the emphasis on customer service and "added value" in a soft market.
The single most undesirable burden acquired with an insurance broking entity is its responsibility and possible liability for the run-off of its old business. Many buyers of insurance brokers and MGA’s overlook this difficulty and the costs involved - they can be considerable. Sometimes, this problem can be side stepped by the acquisition of the on-going business, with its attendant goodwill and assets. The buyer needs to consider the acquisition of a combination of the following:
- The fixed assets, the systems, employees, the right to use the seller's name, the exclusive right to make contact with existing producers, clients and insurers, and the right to seek them to persuade them to renew their policies with the new company (inertia selling here is often successful).
- The seller retains responsibility for the run-off of its old broking/MGA business, the assets required to manage that run-off, and the employees to look after the run-off.
- As a matter of convenience, the buyer (or probably an associated service company) may undertake the run-off obligation on behalf of the seller, probably on a sub-contracted basis. However, the ultimate risk and cost of the run-off is left with the seller.
A note of caution is advised here for those wishing to follow this route. If the seller is left to conduct the risks placed by him in relation to the business:
- it may not handle the claims as the buyer would wish - unless properly set out in the Agreement, it has no interest in protecting the goodwill going forward, and again it is often overlooked that much of the goodwill in insurance broking and MGA’s relates to ensuring claims are properly dealt with and payment of valid claims occur quickly. If this doesn't happen, the buyer should reserve the right to take over the claims handling at the cost of the seller.
- The buyer should ensure that the seller maintains errors and omissions insurance for the risks previously placed by the seller as well as regarding the claims handling and that the seller holds the buyer harmless against these.
- Premium and claims monies will often become mixed by clients and insurers alike after completion between those for risks placed before and those placed after. Arrangements must be carefully put in place to sort this out perhaps by weekly bordereau. Set-off issues also arise, and can be difficult practically and legally to resolve.
- The seller needs to provide the buyer with full access to its files, both placing and claims files, since the buyer will need the information from these for future placement of the risks. If this is not done, the buyer will have to obtain the individual consent of clients to do so. It should be noted that some sellers will try to exercise their lien over files where premiums remain due from clients, and these should be waived as part of the deal.
- On personal lines business, the seller should ensure that the buyer has the appropriate Data Protection registrations and notifications before transferring any personal data to the buyer, and should take protections from the buyer against any post completion use of such data which was not specifically authorised by the data user. The importance of this is stressed by the FSA's heavy fine upon HSBC in July 2009.
6. Pre-acquisition caution: due diligence
Whatever the buyer purchases, certain steps must be considered before the acquisition. Firstly, a properly undertaken and thorough "due diligence" exercise will need to be conducted. Our view is that prevention is better than cure here, and it is better to know matters before the deal rather than sue for breach of warranty afterwards (especially if individual sellers are involved in the continuing business).
Due diligence will be a legal, accounting, commercial and perhaps actuarial investigation. Particular concerns are:
- Outwards/external insurance - for brokers or intermediaries, it is vital to know what the extent of errors and omission insurance is, the claims under such policies, and the policy excesses and deductibles.
- Employees - checks need to be done not only on the contracts of the employees, but upon their notice periods and their willingness to stay following the acquisition. There is nothing worse than the workforce leaving afterwards simply because they are concerned about security of employment or even before if confidentiality is not preserved during negotiations. In the acquisition of a broking company or business, particular attention is needed in relation to the terms of gardening leave provisions, restrictions on confidential information and restrictive covenants, and their enforceability.
- Regulatory restrictions - the impact of the Financial Services and Markets Act 2000 ("FSMA") should not be underestimated as it deals with all operations of a broking company. Breach of FCA Rules, particularly relating to the handling of client monies, is likely to give rise to large fines, censure, and even the withdrawal of the authorisation to undertake broking business. Strong warranties and even indemnities should be taken in respect of any non- compliance, but even these will not offer full protection.
- TOBAs and Coverholder Agreements- over recent years, these have become a fact of life for brokers and MGA’s. Each needs review to determine if there are any changes of control clauses, any special payment or commission terms, or any other terms that may be of concern. Profit commission formulae are notoriously contentious matters, and give rise to many regulatory issues too.
7. Recurring Issues in Insurance Broking and MGA Transactions
There are certain recurring themes that particularly arise in all insurance broking and MGA transactions. These include:
Regulatory and Competition Aspects
UK regulation of the insurance industry is currently the responsibility of the Financial Conduct Authority and the Prudential Regulation Authority.
The UK insurance industry will remain highly regulated though, perhaps more than any other European State, and a keen eye must be had on all aspects of this. For instance, a full review of FSA filings and correspondence must be undertaken, and a review of systems and controls should be undertaken at an operational level.
There are many key issues in play at any one time in the regulatory sphere. In brief, these include at the time of this Memorandum being written:
- the new EU Mediation Directive – this is still in draft form, and it is unclear how the UK and other EU Member States will implement it. It is unlikely to have much dramatic effect on the UK, although the proposals relating to commission disclosure to clients have received much criticism;
- client money and “risk transfer” rules – these rules are intended to ring-fence client or insurer monies from the broker or MGA’s own. They are perhaps the most important of all in the Regulator’s eyes, and breach is likely to give rise to serious fines and sanctions. These rules are currently being reviewed and revised, likely by the end of 2012;
- Profit Commissions and Commission Disclosure;
- Conflicts of Interest; and
- creation of Run-off Claims Provisions.
Of real concern to the buyer is that the FCA (FSA as was) may launch an investigation under Section 166 FSMA into the affairs of the target after completion. This has become increasingly the regulatory tool of first resort for the FCA over the last two years, and its likelihood should not be ignored. Such an investigation could be costly in terms of time and money to the target, terms of complying with the recommendations of any report made as a result, and sometimes costly in terms of fines. A buyer should seek specific protection against this risk.
Employees and Pensions
It is often said that insurance is a "people business", although this is becoming less so in the electronic age. However, know-how and personal contact is still important to the operation of insurance. As such, it is fundamental to retain staff in order to maintain continuity of the business or account that has been acquired.
On business transfers (not share sales or transfers of teams); consideration needs to be given to the Transfer of Undertakings (Protection of Employment) Regulations 2006 ("TUPE"), and also the consultation obligations of the seller. The seller is obliged to consult with representatives of the employees as soon as the decision to sell has been reached. The buyer must be made aware that he is not permitted under TUPE to alter the terms of employment immediately after the transfer. This can lead to some incongruous effects for instance with restrictive covenants which are often drafted in anticipation of the employee remaining in the seller's group. The law has yet to reach a firm decision on this issue, although a dictum has been given that the covenants should be read to accommodate the change.
The retention of employees is vital to brokers and MGA’s – their expertise is often vital. Retention can be achieved by a mixture of positive incentives (such as bonuses, share options, pensions etc.), and also by the imposition of well-drafted restrictive covenants relating to confidentiality and non-solicitation.
Restrictive covenants are of particular concern in broking companies, less so in MGA’s. This is simply because the solicitation of clients is more likely to occur in broking businesses than MGA’s. However, restrictions on brokers and agents setting up competing MGA or binder facilities may be useful.
In short, restrictive covenants are void, unless they are deemed reasonable for the legitimate protection and promotion of the business of the employing company. They need to be carefully focused and drafted towards the function that the employee has performed or is likely to perform for his employer. If they focus on other functions, or other types of business, or are generally drafted too widely, then they will be unenforceable. Enforcing restrictive covenants can be both difficult and expensive, but they have been upheld by the courts many times. It is particularly important to understand what the broker or underwriter does, the nature of his market and his likely contact with clients and his colleagues.
The Tail or Run-Off
Due to the nature of insurance business, liability and responsibility for dealing with contracts placed in the ordinary course of business continues until the extinction of the liability attaching under the policies. This essentially means that all entities involved in the insurance chain have a continuing obligation to adjust, collect and pay claims, together with the keeping of records. Where long-tail liability accounts are involved, this obligation can be for a considerable period of time, and the cost and difficulty of adjusting such claims can be enormous. Due to the revision of wording to a claims notified basis, and the advent of technology, this process has become easier, but companies with a lengthy history often have inadequate records or data, and reconstructing this can impose huge problems and cost for all concerned. Liability for lost files can also attach, and there is often little that can be done to determine whether this has happened.
- Generally - upon acquiring a company, a tax indemnity is usually asked for against tax liabilities arising outside the ordinary course of business. The difficulty with insurance is that tax issues are complicated by the nature of the business and can take considerably longer to resolve than those for normal trading companies. Consideration needs to be taken of this when negotiating any limitations as to the time upon the effectiveness of the tax indemnity. No tax indemnity is usually taken on the acquisition of a business, since the tax liabilities remain with the seller.
- VAT - Most insurance brokers and MGA’s either supply exempt or zero-rated supplies, and the recoverability of VAT is severely restricted. No VAT is chargeable on the transfer of shares or upon the transfer of insurance businesses as a going concern. VAT at the usual rate applies on the transfers of assets of an insurance business (outside the going concern exemption). VAT on outsourced supplies is also an issue following the European Court's March 2005 decision in this area, and the possibility for backdated VAT bills could be an issue here.
- Stamp duty - this is payable at the rate of half a percent on the transfer of shares, and a sliding scale of between one and four percent (depending on the aggregate sale value) on a transfer of a business (including its goodwill) and its assets.
- PAYE/NIC- it should be checked that these are up to date and not in default, especially checking that no esoteric NIC avoidance schemes have been used in the past. The greatest concern is to ensure that no PAYE/NIC investigation is likely to occur - not only may it give rise to fines, penalties and interest, but the management and professional time and cost involved can be significant. This can be a nuisance especially immediately after the purchase when the buyer wishes to concentrate his efforts elsewhere.
This is a particularly emotive subject to employees, but can also create large liabilities for employers, although this has become less of an issue in recent times for buyers. Many employers have moved towards money-purchase/defined contribution schemes rather than to final salary schemes. However, if a final salary scheme is involved, then great care needs to be taken in relation to the funding of that scheme and whether there is any deficit which may need to be made good by either lump sum payments, or additional contributions. An actuarial review may be required here, which may result in renegotiations of the purchase price. It should be noted that under FRS 17 that from 2005, companies with final salary schemes that are in deficit will be obliged to show the full amount of the deficit on its balance sheet. This reflects the employer's obligations under existing pension legislation. Alternatively, or perhaps additionally, the buyer may seek protection from the seller against any deficiency in the scheme.
If only part of a business is being acquired or the target company is part of a group scheme, and certain employees are transferring out of the seller's scheme, then the buyer needs to take great care in negotiating the terms upon which transfer value of the pension fund relating to those employees transfers is calculated. Strangely, neither the buyer nor the seller is directly involved in this, since it is a matter between the pension scheme trustees and the employees. However, a buyer should concern itself to ensure that the basis of the transfer value calculation does not act to the detriment of the transferring employees, if it wishes to avoid losing support from those employees. The basis of valuation will need to be set by way of various actuarial assumptions, and the transfer value will depend on how these assumptions are calculated. If proper care is not taken, the transferring employees could be severely prejudiced, which would not help the buyer's retention of them, and result in the buyer needing to make further pension contributions. It is to be noted that TUPE does not operate to transfer pension rights - they must be dealt with contractually.
Due diligence and Specific Protections
Undoubtedly due diligence will throw up particular issues which will need to be considered. These issues can often be covered by adjustments to the purchase price or by specific indemnities. Sometimes the issues may not be clear cut, and it may be that an indemnity is given, against which retention of purchase price is made, or monies are secured into an escrow account.
With regard to due diligence upon insurance broking and MGA’s entities, detailed questions will be raised with regard to:
- the funding of premium and claims – paying these form the brokers own monies;
- credit write backs (i.e. the taking of unallocated client credit balances into the brokers or MGA’s own account). This occurs where there is a "surplus" in the client money accounts. The seller of a company often asserts that it should be entitled to receive all or a percentage of such surplus. Such surplus arises usually from unclaimed balances (i.e. balances that remain outstanding to clients which have not been claimed for six years, and as such, are not payable to the clients beyond the limitation periods set by the Limitation Acts). Great care needs to be taken in this respect if any credit is to be given to the seller, and an indemnity for claims in respect of released balances requested from the seller. The FSA gave guidance on these at the end of 2009 and it is obvious that great care needs to be taken before any credit write back can be taken;
- policies for crediting brokerage and commissions, particularly relating to income recognition under FRS4 and FSA Rules;
- trading credit terms; and
- errors and omissions claims and notified circumstances.
Databases and IT
Often insurers, MGA’s and brokers have wide databases of clients and contacts in the insurance market, particularly those relating to domestic or retail accounts. These can be of considerable value, since they will entitle the buyer to cross-sell other products to the clients on those databases. Due care should be taken of the Data Protection Legislation when doing so, especially following the HSBC Decision.
When buying a company or a business, it is important to understand the nature of the systems upon which information is held, the completeness of such information, whether it complies with the requirements of the Data Protection Act, and how compatible it is with the buyer's own systems. Software and hardware licences and maintenance contracts need to be examined, as do disaster back up plans. If the buyer's and target businesses' systems are different, then care needs to be taken about their compatibility, how much this will cost, and how long it will take. Much of the goodwill of a company or business can be lost if this takes a significant amount of time. There are also FCA requirements that impact here which should be borne in mind.
If only part of a business is sold, then arrangements need to be made with the seller for the maintenance of the existing computer systems and software until such time as the data can be properly transferred. The buyer should take indemnities from the seller for any loss of data, or the use thereof pending transfer, but the seller will insist that the transfer is effected in as short a timetable as possible.
Insurance - outwards and external
With regards to broking and MGA businesses, a detailed review of the errors and omissions insurance policy should be considered (if any), together with details of deductibles, excesses claims notified (or circumstances that have not been notified but may lead to a claim), policy terms and conditions, and the history of such insurances. FSA requirements also need to be borne in mind. The Complaints Register should also be reviewed.
Some buyer’s insist on the purchase of “tail cover” by the sellers. Examination of the target’s existing policy and the buyer’s own group PI policy needs to be made to determine if there is any real necessity for this. Very commonly there is a “clash of covers” with duplicate coverage. This causes claims issues and duplication of premiums with often no benefit. The basic principle is that all regulated brokers and MGA’s must maintain PI insurances in the UK (all are now written on a claims notified basis) and provided that the buyer receives indemnity against claims deductibles and excesses, this cover should be adequate protection in most cases. The only real excluded peril is likely to be directors’ fraud and indemnity against such excluded perils should be sought.
Other insurances include standard policies such as physical damage, employer's liability, occupiers' liability, business interruption and health insurances. Each of these needs to be examined to ensure that they will continue, or if they do not continue, that replacement policies can be put in place.
It is not often that buyers and sellers disagree that restrictive covenants should be given. The seller will often wish to come out of a particular class of business, and not go back into it for the foreseeable future. Having paid consideration up front, the buyer will obviously not wish to allow the seller to come back into the market, and remove some of the goodwill associated with the purchase. The issues surround the length of the restrictions, their scope, and the carve outs. The Courts are more willing to uphold covenants given in the context of a sale, and covenants of 3, or even 5 years, are given. The seller must ensure that the scope of the covenants is limited to the business it is selling, and does not unduly restrict its on going business. Often the legal advisers do not know all the business activities of the seller, and will not be able to judge if covenants are unduly wide. However, even if the wording is accurate, it may still be necessary for the seller and buyer to agree a carve out of a particular client or activity. For instance, in the medical insurance world, there has been a tendency to dress medical expenses policies as permanent health policies for the purposes of IPT. The coverage provided is often similar, but unless the issue is addressed, then difficulties can arise. For employee restrictive covenants please refer to Paragraph 7.2 earlier.
The buyer will be concerned to ensure that he is getting what he paid for. The problem in insurance transactions is that some of the value attributed to the purchase will be the client and insurer contacts, and their ability to continue to generate income after completion. Buyers will sometimes look for comfort on this, especially when the income comes from the seller's group by some period of exclusivity after Completion, or alternatively, talking to clients before the deal exchanges. Sellers are often reluctant to allow this for numerous reasons.
Therefore the buyer will, if his price is based on a multiple of brokerage or commissions, and particularly if the future income is based on a small number of high value clients, ask for a deferral of payment.
Sellers will be reluctant to agree to this since it puts the risk of the loss of these clients or insurer contacts on to them, especially when they have no control over the conduct of business after the sale.
There is no perfect formula but here are a few considerations to be borne in mind:
- the seller will want to be guaranteed that payment will be made;
- the seller will want to make sure if the price is based on profits or turnover, that the turnover or profits cannot be manipulated in order to reduce the price. In particular, changes of accounting policies, management charges, and exceptional/extraordinary items should be considered carefully;
- the sellers will wish to make sure that the senior business producers are tied into the business (see above);
- the sellers’ involvement in the business will often give rise to discussions regarding “good” and “bad” leavers. A buyer will not want to pay the relevant seller if he walks out or the buyer is forced to dismiss him. A seller will not wish the buyer to have a simple mechanism to dismiss the seller unfairly and remove the need to pay earn out commission. As with all of these provisions, it is a question of balance. The main issue is often speed of resolution of disputes. Going through the Courts could take many months or even years. The use of alterative dispute resolution procedures (such a QC clauses) should be considered.
- the seller may benefit from a tax deferral if equivalent securities/loan notes are offered in exchange. Beware the tax issues and tax traps that may arise here. Note that if the consideration is ascertainable at Day 1, but not payable until some later date, then the seller is chargeable to CGT on the whole consideration, whether paid or not. There is a danger the seller may end up funding the CGT from his own resources without the cash to pay it; and
- if the buyer is intending to consolidate the target business or company in its own existing businesses, then the buyer needs to ensure that the target business or company remains identifiable for ensuring that the deferred consideration can be ascertained
8. Warranties and Indemnities
At the end of the day, there may be no choice but to buy a company or a business and take protection through warranties and indemnities.
There is much confusion as to the differences of warranties, representations and indemnities. Representations are, strictly, non-contractual statements which give rise to a remedy in tort for "misrepresentation". They have no place in modern commercial agreements since business buyers expect remedies to be clear and predictable, and they should not be referred to.
The difference between warranties and indemnities depends on the remedies that are expected to be available for their breach. A typical purchase contract will contain many "warranties". Many will be statements in absolute terms confirming ownership of assets, the existence of insurance coverage, and so on. The law generally provides that upon a breach of warranty, the aggrieved party is entitled to damages which are sufficient to put it in the position that it would have been in had the breach of warranty not existed. Sometimes the basis upon which damages are calculated means that the buyer receives damages on a "pound for pound" basis to the extent that the assets are less or the liabilities are greater than those warranted. However, warranties tend to be rather broad in terms and effect.
The parties should see warranties as having a two-fold purpose:
- to seek information - e.g. "The Company has no employees who earn more than £50,000 per annum"- if it has, then this will be disclosed by the seller:
- to apportion risk - e.g. "The Company has no debtors which will not pay their debts in the ordinary course of business" - usually, if it is agreed in principle that this warranty is to be given, the seller would disclose its provision, disclose those that are already looking likely to default, and bear the risk that the others will pay. This can be a difficult warranty to deal with in broking companies, and can lead to much argument.
Typically, most important warranties relate to:
- accounts – this is often where the greatest number of warranty claims arise;
- statutory and regulatory matters;
- pension schemes;
- broking/MGA activities - these would be extensive and affect all aspects of the broking operation. They would also deal with brokerage sharing and business production agreements;
- outwards insurances - particularly errors and omissions and fidelity covers;
- customers/clients/business introducers; and
The disclosure letter is the main form of protection against the "absolute" nature of the warranties available to the seller. In basic terms, matters that are disclosed in the disclosure letter are exceptions to the warranties (it is not usual that disclosure is allowed against indemnities due to the £ for £ remedy provided by indemnities), and to the extent disclosed, the buyer cannot sue the seller for breach of warranty. It is therefore in the seller's interest to ensure as much as possible is disclosed, and that this is done completely and clearly.
Matters disclosed in response to the buyer's due diligence questionnaires will usually be accepted, but buyers must resist the seller's attempts to make vague general disclosures of "the filing cabinet" where its contents are unlikely to be known!
From the lawyer's point of view, it is vital to understand the nature of the broker's or MGA’s business in order to extract the information to provide this letter. Clients should ensure that they know how the process works, what their exposures are or where they are likely to be, and ensure the disclosure letter is complete.
Another issue that often arises is the question of the buyer's knowledge outside of those matters disclosed by the seller. Often the buyer will commission a report from its accountants before exchange of contracts, and this may reveal matters that constitute a breach of warranty. Sellers will often wish to have this report disclosed, whereas the buyer will resist this. Common sense dictates that the buyer should not be able to profit from this knowledge, and the Courts are now willing to allow the seller to rely on the buyer's knowledge outside the disclosure letter as a defence to a breach of warranty claim. Therefore the reluctance to reveal the report seems irrelevant. Further, it seems more logical for the buyer to seek a reduction in the purchase price as a result of matters described in the report rather than involve the expense of time and money afterwards to recover it.
Compared to the nebulous nature of warranties, a more precise tool is the "indemnity". Remedies for breach of warranty rely on seeking damages for breach, whereas an indemnity is a mechanism which establishes an automatic right to the payment of a particular sum of money on the happening of a certain event. For instance, indemnities may provide against:
- particular pieces of litigation;
- large individual bad debts;
- pension shortfalls;
- breach of client money rules;
- monies taken by way of credit writeback which are subsequently claimed by clients;
- unprotected errors and omissions and also excesses and deductibles;
- taxation e.g. VAT on outsourced supplies is a current issue;
- penalties for fines for breach of regulatory or statutory duties, especially those imposed by the FSA, and Section 166 investigations;
- directors' breaches of duty and misfeasance;
- claims by clients against inadequate insurer security being recommended by the broker - these are not covered by errors and omissions insurance;
- clawbacks and return commissions - this really applies to IFA's, but can have a material effect on general brokers also; and
- repayments of profit sharing commissions.
Payment under an indemnity is normally made whether or not the value of the shares in the target company is proved to be depleted as a result of the indemnified amount being payable. Unlike warranty claims where the buyer will have a duty to mitigate i.e. try to reduce/contain the loss, indemnity obligations do not have such a requirement unless it is contained in the specific language. It is recommended that the seller should seek to do this, together with limitations as to time and amount.
Limitations for breach of warranty and indemnity
The other main protections for the seller against breach of warranty and indemnity are the limitations as to size and amount. It is not the focus of this paper to go into these in great detail, but there are particular ones that need consideration in insurance broking transactions:
- recovery from insurers - often the seller says that he will only pay to the extent not recovered from insurers. Care must be taken when considering this in relation to errors and omissions insurances;
- time limitations - often the seller will try to limit their liabilities for breach of warranty to two years or less. The buyer must be aware that insurance claims may only manifest themselves many years after the event, and at least six years (the limitation period) is perhaps advisable for matters such as breach of directors' duties, or errors and omissions claims (or perhaps even longer);
- buyer's actions after completion - the seller will usually say it will not be responsible for matters occurring after completion. In principle this is acceptable, but the seller must remain responsible for things that the buyer has to put right after completion, e.g. dealing with pre-completion breaches of regulatory matters.
This is often a real area of contention in earn out or deferred consideration transactions. The concern is that the buyer will not want to pay the seller if there is a breach of warranty or indemnity. However, the seller will not want the buyer to withhold cash on a spurious basis. Similarly, the buyer may have a good claim but not know the loss that he has then suffered.
Like issues relating to good/bad leaver, alternative methods should be considered to resolve the veracity of the claim and amount claimed, even if this is only on a pro tem basis until it is finally resolved or settled.
The only other issue is whether the withheld cash is held in escrow whilst all is finally resolved. The seller will want security for his consideration. The buyer will not wish to pay out more money, especially if he already has suffered what he sees as an actionable loss.
Warranty and Indemnity Insurance
This topic in itself could merit a whole paper. Insurance can be taken out by the seller to cover damages and costs payable in respect of claims for breach of warranty and indemnity. This may be where the seller does not wish to take the risk itself, e.g. an institutional investor, or the seller is dealing with an unknown exposure. It will not cover fraud (due to moral hazard), in which case the buyer may take out its own insurance against this exposure.
It can be a useful tool when the parties cannot agree who should bear the risk in respect of particular items.
9. Bringing in insurance broking and underwriting teams
Perhaps the simplest method of acquiring an insurance broking or underwriting business is to take on an individual or team to produce or deal with an insurance account, without acquiring the assets or other parts of the business. This assumes that there is an existing infrastructure in which he or they can fit. However, this has difficulties for all parties concerned.
The Former Employer's point of view
The Former Employer may be concerned with the following issues:
- he does not wish to lose the team - he will need to examine the existing service contracts to look at notice periods, the gardening leave provisions, and restrictions relating to confidentiality and non-solicitation. He will need to consider whether it is worthwhile trying to retain the employees by offering further remuneration or incentives, or whether to place other employees into the account to endeavour to retain them. Consideration should also be given to notifying professional indemnity insurers as a protective measure, since it may be assumed that the outgoing employees will not be actively involved, or be as concerned as previously, with conduct of the account after notice has been given, although admittedly, if they wish to retain their clients, they will do so.
- the run-off of the account and collection of premiums and claims monies - if all individuals who are aware of the transactions forming the account are to leave, there will need to be some mechanism with regard to how this is to be conducted in the future. Can this be passed over to a new employer and at what cost? Please see above for consideration of this.
- should written confirmation from the moving team, or if necessary injunctions, be sought to prevent such team breaching any restrictions as to confidentiality or non-solicitation? What evidence is there that they have been acting in breach of such covenants? All records and other confidential information of the Former Employer should be returned immediately (including computers and computer records). Should Lloyd's passes be withdrawn? Can the threat of litigation against the employees be used as a bargaining chip in effect to sell the whole of the business (including the run-off) to the new employer at a price?
An employee is subject to the terms and conditions of his existing service contract, and he must be very careful to ensure that any valid restrictions are observed in full. In particular, he should be concerned not to contact clients in breach of any restrictions. He should be careful about discussing any confidential information with any third parties since this may be confidential from the Former Employer's point of view. Whilst the contract continues, he must continue to act in the best interests of his Former Employer.
The New Employer is concerned to ensure that:
- the New Employees are properly incentivised - it may be possible to offer incentives that give them a tax beneficial incentive, the scope for offering these is reduced after the commencement of employment. However, great care must be taken of the new tax regime introduced by the Finance Act 2003. The use of a limpet company, flowering share and LLP structures could be considered.
- any restrictive covenants binding upon the employee are not breached - the New Employer will not wish to be seen to be inducing the Employee's existing breach of contract and receive a claim in tort from the Former Employer.
- the New Employer will be most concerned to ensure that the transition of the account moves as smoothly as possible so as to ensure that the goodwill and value of the team is secured to its best advantage. This will include ensuring records of account are passed across from the Former Employer with the clients' instructions. He will wish to ensure that a proper run-off is undertaken of the business of the team's clients (which is likely to require negotiation with the Former Employer).
- The New Employer may also seek assurances from the Employees that:
- they have no regulatory or disciplinary procedures against them, and there are no circumstances which may lead to such proceedings;
- there are no notified professional indemnity claims against them, and no circumstances likely to give rise to such proceedings.
The moving of teams often leads to very expensive litigation, which benefits no one. It is often better on a "without prejudice" basis to negotiate a form of business transfer prior to the threat of any litigation.
10. Financing Issues – External Finance and Banking Issue
Issues surrounding finance are fundamental by both the buyer and seller. The seller will wish to know that the buyer can pay the consideration, especially if there is a long-term earn out.
The buyer may be raising its finance either from venture capital funds or from its bankers.
Venture capital funds will require considerable protections to protect its investment and may require the appointment of a non-executive director or observer. The only aspect that is of real concern is that:
- Any non-executive director is likely to need regulatory approval, and will need to have requisite experience in the sector; and
- The protections that the VC house may be granted cannot be too wide – the directors of the regulated entity must be free to manage the business of the entity. The VC house cannot control the business, or even take the business over, due to regulatory restrictions upon this.
Banking into the insurance sector is much the same as any other sector. However, there are a few nuances to bear in mind:
- There should be no charges (especially floating charges) over any client monies (i.e. premiums and claims monies) and should waive all rights of set-off against these;
- There should be no floating charge over “client debtors”. These debts are collected by the broker or MGA on behalf the client or the insurer, and belong correctly to those parties and are not assets of the securing entity. These debtors (and corresponding creditor entries) should also be excluded from the financial covenants in the loan agreement; and
- The requirement for the creation of a run-off provision could have a significant impact on the balance sheet of borrower or target. This impact needs to be assessed.