Managing run-off liability (following sale of the business)

At the big end of town, there has been a lot of discussion about the use of Warranty and Indemnity insurance as a risk management tool (for dealing with one aspect of run-off liability), for both buyers and sellers involved in M & A deals. 

Warranty and Indemnity insurance is a specialist form of insurance product and whilst the market for this type of cover appears to be developing, it is more commonly used by the buyer to manage the risk of the seller not being able to meet a warranty claim – by providing the buyer with recourse (for breach of warranty) to the insurer.  As a consequence, the seller may also be seen to achieve a clean break without ongoing exposure to contingent liabilities or funds being locked up for long periods post-sale.

Of course, Warranty and Indemnity insurance is not likely to be the ultimate panacea as most insurers offering this specialist type of cover have a list of standard policy exclusions (which often include matters known to the buyer – including those disclosed in due diligence and liability for environmental matters).  Also, to reflect the fact that each business has its own characteristics, there are likely to be exclusions that are transaction-specific or party-specific (or which reflect the issues facing a specific industry).

Whilst it is said that more insurers are entering the market and, as a result, there is a wider range of product offerings and increasingly competitive costs and terms, access to Warranty and Indemnity insurance will still be rare for M & A transactions in the local SME market.  Some of these businesses may have some liability insurance coverage affecting the conduct of the business, while it was in operation, but that coverage may be limited – and there may be little or no professional indemnity and/or D & O cover.

Consequently, there may be some tensions (and the need for a detailed understanding of the business and its risk exposures – and a plan for how to deal with problems) in the not-too-uncommon scenario where the stakeholders of an SME are presiding over a complete exit from the industry, the winding up of the business vehicle and a well-earned retirement. 

Warranties (and indemnity coverage)

At a fundamental level, warranty coverage (in an M & A context) is a means of reallocating risk between buyer and seller.  The buyer is seeking to protect its investment by (in addition to its due diligence investigation) seeking warranty coverage about certain key value (or cost) items affecting the business.  This may also have the practical effect of requiring the seller to pay particular attention to those areas identified as key risks – and promote the disclosure of information about known problems in those areas.  In turn, the seller will usually attempt to protect its risk by seeking to restrict the scope (and timeline) affecting warranty claims. 

In simple terms, a warranty is a contractual statement of fact made by one party to another (often about the information provided to the buyer and a series of assurances to the buyer about the condition of the business).  A breach of warranty, if proven, will lead to an award of damages that seeks to put the recipient (buyer) in the position they would have been in had the warranty been true.

Often, the warranty coverage will be “backstopped” by an indemnity from the seller in favour of the buyer, for any loss suffered by the buyer as a result of a breach of warranty.  At a high level, an indemnity backstop provides certain advantages both procedurally and in terms of the quantum of the protection.  However, a number of those distinctions (and advantages) start to become a little blurred when indemnity coverage is used, primarily, as a backstop to the warranties in the SPA and distinctions (such as the absence of a duty of mitigation) are overtaken by the specific terms of the SPA. 

Also, the usual tussle over the breadth of warranty coverage is often accompanied by an arm-wrestle about whether the warranty coverage excludes any liability that the seller might otherwise have under the Fair Trading Act 1986 (for misleading and deceptive conduct in trade).  This can take a variety of dimensions, including efforts (as part of an ‘entire agreement’ clause) to exclude the effect of all pre-contractual dealings between the parties.

Management of run-off liability

The practical likelihood, in an SME context, of the directors and/shareholders of the seller having personal exposure, in the shape of a guarantee of the (warranty) obligations of the seller underlines the need to give some thought to managing arrangements between all parties with run-off liability.

A key first step to ironing out sensible practical and legal arrangements (such as how is a make good obligation met and paid for) is to understand the nature of the risks and the practical implications. 

Next, it will be useful to understand the skills and resources available – should one of those risks materialise.  For example, is one or more of the guarantors able to fix a problem with something sold or built by the business prior to sale – or are the co-guarantors going to have to agree amongst themselves and with the buyer as to how the remedial steps are taken (and funded)? 

These planning and management steps become even more interesting/challenging where there is:

• a mix of working and non-working parties – who may have had different levels of culpability (amongst the co-guarantors) for the problem and differing levels of practical ability to fix a legacy issue;
• parties with different/additional layers of responsibility (for example statutory duties such as those affecting a licensed building practitioner);
• ongoing dealings with the buyer – for example where the seller only sold off part of the business and/or where some guarantors have ongoing roles with the buyer (or even relationships with the buyer through other businesses); or
• scope for some recovery from a third party – which may also involve navigational issues with the buyer.

In essence, the management of run-off liability should include a nuts and bolts plan – backed up with (formal) undertakings between all of those parties with run-off exposure.  Those undertakings are often similar to those which (now) typically accompany a warranty suite in a SPA, in terms of:

• obligations to consult (accompanied by hardwired acknowledgements to act in good faith and duties to co-operate);
• safeguards around the exercise of rights (including the taking of any remedial steps); and
• a requirement to adhere to a stepwise process before winding up the seller and distributing the net proceeds of sale (to ensure that all legacy issues have been dealt with – including any re-allocations to address the incidence and costs of remedial actions taken at the behest of the buyer).

Ultimately, the risk of not planning for and mapping out a clear process for dealing with run-off liability issues is that of fracturing links between people who have otherwise had a good working relationship over a long time.  Post-sale, people move on and become more focused on their retirement or their new project and don’t think they need to roll up their sleeves and deal with legacy issues.  Left untended, because its someone else’s problem, an unhappy buyer or local authority officers who think someone is about to leave their ratepayers flapping in the breeze, will set about finding the most expensive/painful way to tidy up a legacy issue that could have been tidied up more simply, quicker and cheaper – had there been a plan and some binding obligations to deal with run-off issues as they arise.

As a result, business stakeholders should be encouraged to think about the management of run-off liability issues at the same time as the SPA is being negotiated.

Further information

If you would like more information about any of the matters discussed in this note, please contact me.