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The modern world of mergers and acquisitions, spin-offs, joint ventures and corporate consolidations is filled with challenges and opportunities. Complex deal and valuation issues for both buyers and sellers require insurance professionals to dig deeper and to negotiate longer about key issues before consummating a transaction.

A recent case, Tenneco Automotive Inc. v. El Paso Corp., illustrates the point. In that case, a buyer had not used sufficient due diligence to analyze a seller's potential claims under shared insurance policies. Though the parties negotiated an insurance agreement, it failed to resolve differences when the stakes rose. The dispute escalated and took years and millions of dollars to resolve.

When one company is negotiating to buy another, the first order of business is to review existing coverages and to ensure they will remain in place or be properly replaced immediately upon the transaction. But both sides of the transaction may make a serious mistake if they stop here.

For one thing, a seller may have hidden value in its historic insurance coverage not reflected in its balance sheet. Historic coverage for environmental liabilities is a common example. Many policies, especially occurrence-based comprehensive general liability policies issued prior to 1985, provide long-tail coverage for environmental liabilities.

In some cases, claims have not been pursued under these policies. Even if they have, the ultimate recovery is often sufficiently uncertain that no insurance recoverable is required on the company's financial statements. This situation is not limited to environmental liabilities but can arise in many contexts, including asbestos and other mass torts.

A seller who is aware of potential insurance recoveries for historic claims should extract value for them. Where a claim is recorded as an insurance recoverable and reflected as an asset on the seller's balance sheet, negotiations must determine who will receive any recovery and who will pay for the right to receive the insurance proceeds.

The buyer obviously views the issue from the opposite perspective. If historic insurance claims are part of a negotiation, the buyer has the same questions--who gets the claims proceeds and who pays whom how much. To some extent, this will turn on who will pay to pursue coverage, and who will have access to the people and information needed to do so. In today's world, seeking coverage often requires substantial information about the nature of the liabilities, the company's knowledge about the risk and the costs actually incurred. These issues are all the more difficult if the claims are old.

The value of historic policies may be substantial. In a recent case, our firm represented an acquisition target in extensive environmental coverage litigation. Like many such cases, litigation costs were high: more than $100,000 per month for discovery and technical assistance. The seller viewed the elimination of this litigation and associated costs as a tremendous benefit--the historic insurance issues would be the buyer's problem after the sale. The buyer, however, ultimately settled with the insurer for more than $25 million, even though it had paid nothing for the insurance claim.

As this example suggests, an insurance claim can be an important asset that may be viewed quite differently by buyer and seller.

The form of a transaction has important consequences for a risk manager. In general, if a company that is insured by a particular policy is sold to a new owner, the insurance remains in place and the company continues to be insured and entitled to coverage after the sale. This occurs because, in a stock sale, the change in company ownership normally does not change the rights to the coverage.

The opposite is often true in an asset sale. Here, the insurance sometimes provides no rights to the asset purchaser in the absence of additional agreements. Indeed, many policies expressly attempt to preclude any assignment or transfer of insurance rights without insurer consent. As a result, an asset sale may not result in the transfer of rights to insurance, though the seller may agree contractually to indemnify or provide certain insurance proceeds to the buyer in the event they are recovered.

To deal with these issues, it is important to understand past coverage and claims and how they will be handled. In the stock sale, the new owner needs copies of policies and an understanding of the program to be able to utilize the coverage. In an asset sale, the risk manager wants the old company to be responsible for preacquisition claims and to have new insurance in place going forward.

PROBLEM OF "SHARED" INSURANCE

Most companies today buy insurance for all the members of their corporate family under a single policy for a single premium. The corporate group may use various mechanisms such as written agreements, bookkeeping entries and allocations of premium costs among members of the corporate group, but these are internal arrangements to which the insurance company is not normally a party.

This practice of insuring multiple entities under a single policy can create difficulties if one of the entities is spun off or goes bankrupt. The problem arises most commonly where the policy at issue has aggregate limits, such as an aggregate limit for product claims.

A risk manager who purchases $100 million in products liability coverage subject to a shared aggregate limit is not normally concerned about which of the 10 companies in the corporate family uses the limits. The risk manager's objective is to obtain adequate insurance coverage and to leverage premium dollars by buying one policy for all the companies in the group.

The situation may change, however, if one of the companies is sold and encounters substantial liabilities, such as asbestos claims--for example, a company that is sold and may subsequently develop substantial asbestos liabilities, resulting in the exhaustion of shared insurance and no coverage for companies still in the seller's corporate family. Conversely, a buyer in a stock sale may be comfortable that it has insurance coverage, only to find that one of the seller's companies used up all of the shared coverage for its own claims.

These obstacles can be overcome if addressed carefully in contractual agreements governing insurance aspects of the transaction. A transaction may include agreements to allocate insurance proceeds among companies in a particular manner, no matter how claims develop, or the parties can agree to purchase certain insurance products to fill in coverage gaps. Without such special arrangements, however, most courts hold that insurance proceeds are first come, first served. Whoever has the claim first gets the limits.

A similar issue involves retrospective premium arrangements. Many large companies purchase low-level coverage to satisfy statutory or regulatory requirements, or to obtain claims-handling services. They accept retrospective premium arrangements or large deductibles because they are comfortable retaining these low-severity risks to decrease premium costs. In many cases, the parent company that purchased the policies is responsible for payment of the retrospective premiums and, less frequently, for deductibles. If transactional documents do not deal with the issue, there may be uncertainty concerning the ability of a spun-off company to access the policies and saddle the original corporate group with the bill.

These issues concerning competing claims for shared coverage can become particularly contentious in the context of a settlement or bankruptcy. We have encountered several circumstances in which one policyholder attempts to buy out all the coverage available under a policy to the detriment of other policyholders. The situation is common in negotiations with London market insurers that want to buy complete peace and protection from claims as part of a policy settlement.

The decision in Tenneco Oil v. El Paso Corp. is illustrative. In that case, El Paso was a surviving member of the old Tenneco Oil conglomerate, which had spun off many of its surviving companies, including Tenneco Automotive Inc. and Pactiv Corp.

The old conglomerate had bought common insurance for all entities in its corporate family. When certain companies were spun off, the interested entities negotiated a complicated agreement creating certain rights if a company used the insurance to the detriment of others.

Motivated in part by concerns about the continued financial viability of its London insurers, El Paso entered into an agreement with certain London insurers in which it purported to release all rights of its present and former affiliates to the insurance. It claimed that the payment of the settlement amount, which was for less than the total limits available from the London insurers, constituted a "deemed exhaustion" of the policies.

When Pactiv and Tenneco Automotive sued, the court rejected both of El Paso's contentions. Recognizing that "the deconstruction of a conglomerate into separate entities to carry out its various businesses can present vexing questions as to historic insurance coverages," the court concluded that the agreement did not adversely affect the rights of the plaintiffs.

This case demonstrates the difficulty of depriving a former subsidiary of rights to insurance except by agreement, and emphasizes the importance of dealing with the issue at the outset when both buyer and seller are motivated to make a deal, rather than years later when these interests have diverged and litigation may be the only path for resolution of the issue.

The obvious lesson is that mergers, acquisitions and shared insurance provide complex challenges for risk managers. Clearly, risk managers play a critical role in any transaction and should be included on any due-diligence team. If counsel responsible for a transaction does not have the requisite experience to evaluate insurance assets and negotiate agreements explicating the rights of the parties with respect to insurance after a transaction, other professionals with such expertise should be on the team. Careful attention to these issues may unlock value and avoid complex and costly uncertainty and litigation over future rights.

STEVEN R. GILFORD is a partner at Mayer, Brown, Rowe & Maw in Chicago where he specializes in commercial litigation and insurance.

November 1, 2006

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