Even Acquisition Consultants Get This Prior Coverage Question Dead Wrong

There is nothing worse than working with a self-professed expert who clearly is very misinformed, but has the audacity to educate you about how everything works. I recently had the misfortune of experiencing this exact situation with an ESOP expert as we’re working on placing coverage for a newly formed ESOP. Two things stood out to me about this experience:

1. For some reason, newly formed ESOPs almost never have the necessary underwriting information available.
2. People assume “full prior acts” applies to the former entity/structure.

In this article we’ll address both of these issues, but we’ll especially harp on the false full prior acts assumption, as it applies to all acquired entities, not just ESOPs.

Come On, ESOPs, Get It Together

For the uninitiated: an ESOP (Employee Stock Ownership Plan) is a qualified retirement benefit plan that buys, holds, and allocates company stock to employees. It operates like a trust, with a trustee holding the stock on behalf of the employees, who are the beneficiaries. ESOPs are usually formed by a business owner who sells their company to their employees. It’s a really cool way for business owners to enter retirement without having to sell their firm into private equity. They can take their firm and sell it directly to their employees. The ESOP will normally take some outside funds in the form of debt and pay the owner for shares of the company.

As you can imagine, there are many, many things that can go wrong when transitioning from a privately held company into an ESOP. Is the leverage the ESOP used to fund the transaction financed sustainably? Is the owner overpricing the value of the shares? And if you’re the D&O/Fiduciary carrier, you’re potentially on the hook should any disagreements arise from these exposures.

For the newly formed ESOPs I’ve helped place coverage for, I can’t remember any of them having a) audited financials or b) a share valuation report ready for review. This recent ESOP was no exception. But no worries, the ESOP expert assured me, it’s very normal… in fact it’s industry standard that these documents are almost never done until after the ESOP has been formed! That was news to all of my ESOP underwriters. And further, according to this expert, it didn’t matter when we placed the D&O/Fiduciary as long as the policy had full prior acts. Full prior acts means the ESOP will be covered regardless AND any liabilities the ESOP carries from before the transaction will ALSO be covered.

At this point I wanted to put my head through the wall.

I see people overestimate the power of full prior acts all the time. They believe that it applies to current claims stemming from wrongful acts that occurred prior to the acquisition. If only it were that easy.

Full Prior Acts…For the CURRENT Company

Most people don’t realize that when you purchase a company’s assets, you also purchase their liabilities. Just look at General Accident Insurance v. Western MacArthur. Western MacArthur took over a distributor it continued to operate. Later that distributor found itself the target of asbestos cases and the new owners were held liable for its predecessor’s products, which contained asbestos.

The predecessor did have insurance for product liability, written on an occurrence basis. So Western MacArthur sought coverage under the acquired entity’s policies, and was promptly denied. That denial was upheld in court. The court reasoned that the carrier could not be bound to provide coverage to an insured that has never paid a premium or been subjected to an underwriting analysis.

So while liability from acquired entities can be easily transferred, the coverage for those entities cannot.

The solution seems simple: have claims-made policies with full prior acts! Should a claim arise, the claims-made policy will consider coverage irrespective of when the wrongful act occurred.

But like I said earlier, it’s not that easy.

Look at Liberty Insurance v. Cocrystal Pharma for why prior acts coverage doesn’t reach a former entity’s acts. Cocrystal was carrying a D&O policy with prior acts coverage when the SEC subpoenaed them for an alleged pump-and-dump scheme. Initially Liberty provided a defense, but after confirming that the claim was related to a wrongful act committed by a pre-merger corporation the insured had absorbed, they denied coverage and sought reimbursement for the defense costs they’d paid.

The court affirmed the denial. It did not turn on a prior acts or retro-date issue at all. The court looked at the clear and unambiguous definition of a Wrongful Act in the policy, specifically, “any actual or alleged error, misstatement, misleading statement, act, omission, neglect, or breach of duty, actually or alleged committed or attempted by the Insured Persons in their capacities as such….”

So even though the accused insured persons were being pursued for a wrongful act, the policy was written to protect them in their capacity as D&Os for Cocrystal, not the former entity. The conduct happened while they wore the predecessor’s hat, before Cocrystal even existed, so it was never a Wrongful Act under the policy in the first place. The prior acts question never had to be reached. That’s the whole point: even with prior acts coverage in hand, the claim failed one level up, at the definition of what the policy covers.

To reiterate: these cases show a legal precedent that, even though you’re carrying a claims-made policy with full prior acts, if a claim is made in the current policy period for a wrongful act that occurred prior to policy inception, but the claim was for when the entity was under different ownership, then your carrier is not contractually obligated to provide coverage. Your full prior acts stops at the inception of the current ownership structure, not the company’s founding.

This is a big deal if you’re acquiring or merging with another company. When you acquire a company, you assume all of its liabilities. But getting coverage for those extra liabilities is a lot harder to come by than simply buying a claims-made policy with full prior acts.

Good Rules of Thumb for ESOPs…and Anyone Looking To Acquire/Merge

For those business owners who appreciate the vast amount of liability they acquire after a merger, having high-quality coverage is paramount. To that end, if underwriters and brokers alike are interested in strategies to help fill in these coverage gaps, I recommend the following:

Have the seller acquire “naked tail” as part of the purchase agreement. Naked tail coverage — an extended reporting period elected at policy inception — is a policy that goes into tail immediately at inception. With full prior acts, a naked tail policy provides coverage for the old entity, and the reporting period allows the tail to respond to claims made today or at any time in the future within the reporting period. Understand that after the naked tail expires, that exposure becomes functionally uninsurable (unless a future carrier/MGA creates a perpetual tail policy…?). Try to offer as long of a naked tail as you can find, preferably at least 3-year and 6-year options.

For ESOPs in particular, get your house in order before the sale. That means you need to talk to a CPA who has ESOP experience before you close. Push them to provide audited financials and an ESOP share valuation report. These items help the underwriters provide the best, most competitive terms the market has to offer.

Don’t get stuck thinking full prior acts applies to every iteration of the company going back to its founding. Unless you can negotiate prior entity coverage where the carrier clearly and unambiguously assumes the liability from previous iterations of the firm, make sure the insured understands the trap: if someone pursues them for damages caused by the previous owners, then it doesn’t matter if they have full prior acts or not. Without prior entity coverage or naked tail they’re still going to be left out in the cold. Look at these gaps today and get them filled.

We need to get these complicated matters crystal clear, because even the experts — ESOP or otherwise — can very confidently get these wrong, as I’ve been learning 😉.

Until next time, stay bindin’ and grindin’.

Meet the Author

Lucas Roberts

Management Liability Broker, Burns & Wilcox

This article references General Accident Insurance Co. v. Superior Court (Western MacArthur Co.) and Liberty Insurance Underwriters, Inc. v. Cocrystal Pharma, Inc. as publicly available court documents. It is provided for educational purposes only and does not constitute legal or coverage advice. For guidance on any specific policy or transaction, consult qualified coverage counsel.