The impact of mergers and acquisitions on professional liability insurance

The sale, merger or acquisition of a professional business such as Land Surveying, Engineering, Law practice or Insurance Brokerage business requires careful handling of both the merger agreements and the insurance policies to ensure that all parties are adequately protected from errors and omissions claims.

 In virtually all cases when a professional business is sold or merged the principal assets that get transferred are customer goodwill and the continued employment of key people. For the sake of simplicity we will call the parties to an outright sale the "vendor" and "purchaser" and we will call the parties to a true merger - "merging parties". It has to be recognised that any of these parties may be a corporation, a partnership or a sole proprietor.

The Agreements

When you buy real or personal property it is usually defined in fairly precise legal terms and if the property delivered varies in a material way from the specification the contract may be rescinded or price adjustment may be made. When you purchase or merge a professional business, that business will also be defined in precise terms, partly by its financial statements and partly by the warranties and representations made by the vendors or merging parties.

 In a typical agreement involving the sale of a business, both parties will make certain warranties. Some warranties are absolute, while others are "to the best of our knowledge". The purchaser will normally warrant that they have the funding and capacity to make the purchase. The vendor might warrant that they have the legal capacity to sell the business and that there are no known errors and omissions that might result in a claim or errors for which claims have actually been made, except as stated in the exceptions to the warranties. The vendor would also make representations and warranties describing their professional liability insurance and which claims or potential claims have been reported to their insurers. A typical agreement would also include an indemnification provision in which each party would agree to indemnify the other if the warranties prove to be wrong.

 In an outright sale the purchaser may either acquire the shares or certain assets of the vendor under a share purchase agreement, or an asset purchase agreement. These agreements should clearly define the responsibilities of the vendor and purchaser in general and in particular with respect to known, unknown and potential errors and omissions claims. In the case of a true merger the two organisations will, generally speaking, merge and form a single organisation that will be responsible for all claims arising out of the merged businesses.

In a typical share purchase agreement the purchaser will become the owner of the shares in the business and will, unless other terms are spelled out, assume full responsibility for the past, current and future obligations of the business. Most prudent purchasers will not wish to be responsible for circumstances known to the vendors, unless these known problems are reflected in suitable adjustments to the purchase price. For example the vendor may have made an error that resulted in a large claim that was unsettled on the closing date. In the event that the vendor's professional liability insurers paid this claim, there might be a large deductible and it is possible that the amount of the claim would exceed the policy limits. This claim would have to be declared by the vendors and the purchaser might assume responsibility for these amounts but would in all likelihood require an adjustment to the purchase price. The share purchase agreements are therefore similar to real or personal property sales agreements and attempt to define the business being purchased as precisely as possible.

The Insurance Policy

In general terms the insurance industry is flexible and the vendor and purchaser or the merging parties should be able to structure a transaction on a commercially and tax effective basis. In most cases the insurance industry will be able to properly protect the various parties, although the cost of insurance may vary significantly depending on how the agreement is formulated.

 It is essential to have a good understanding of professional liability policies so that a transaction can be properly structured and the correct coverage arranged. Most professional liability policies are written on a "claims made" basis, which means, generally speaking, that they cover claims made and reported to the insurer during a valid policy period.

 There are, in fact, three coverage periods or time slots that are important:
The first of these is the period within which the error occurred, for there to be coverage.
The second is the period within which the claim or suit has to be made for there to be coverage.
The third is the period within which the claim must be reported to the insurer.

In the most limited form of policy, all three events would have to occur during the policy period. More typically errors made at any time prior to the end of the policy period are covered, provided that the insured did not have knowledge of a claim or potential claim on the inception date of the policy. In this type of policy the claim must be made or the error discovered during the policy period, and the claim or circumstance must be reported to the insurer during the policy period. Some policies contain an extended reporting provision, providing a window after the expiry date for reporting claims made or circumstances discovered immediately prior to expiry.

Legal Responsibilities, Insurance and the Transaction

As the parties negotiate, various options with respect to errors and omissions insurance may be considered, some of these options are as follows:

1. The vendor may be responsible for all errors made prior to the closing date regardless of when a claim may be made. This is obviously an unattractive arrangement for the vendors, as they will have to continue their professional liability insurance for as long as they perceive the risk of a claim being made. (Purchasing a "discovery coverage" extension, which may be available for periods of up to six years can look after this type of exposure). A discovery extension will cover claims made and incidents reported during the discovery period that arise from an act, error or omission made during a period of time immediately preceding the discovery period. The period, during which errors that occur are covered, may be the entire time that you have been engaged in your profession or for a period as short as one year.
2.  In this type of arrangement, the purchaser is only responsible for errors made after the purchaser had taken over control of the business or professional office. The owner of a professional business that is contemplating a sale may wish to consider available renewal terms to ensure that his policy includes an option to allow him to purchase discovery coverage for an agreed premium in the event of a sale. Such options are not always available.
3. The vendor may be responsible only for known errors and known circumstances that might give rise to a future claim. In this type of arrangement, the purchaser will have carried out a "due diligence" search of the vendor's business to determine all known claims and circumstances likely to give rise to a claim. If the purchaser is satisfied with the outcome of this search, and if all known claims are reported to and expect to be covered by the vendor's insurers, the purchaser will assume responsibility for any new claims or circumstances discovered after the closing. Because these circumstances are unknown at closing, there is an insurable risk and the purchaser should be able to insure these unknown risks.
   
   In these circumstances the only risk to the vendor after the closing is the risk of a known error that was not reported and therefore not assumed by the purchaser. The vendor can cover this risk. The vendor may purchase an "extended reporting" provision allowing the vendor to report claims made before the closing, and more importantly, "circumstances" that might give rise to a claim of which the vendor was aware prior to closing, but which he had not disclosed to either the purchaser or his insurers. It is most unlikely that anybody would fail to report a claim that had been made, but it is possible that the vendor could be aware of circumstances that a "reasonable man" should have known might give rise to a claim.
   
   Extended reporting coverage does provide some comfort in these situations but of course the insurers might be able to take a reservation of rights letter and later deny coverage if their position had been prejudiced by late reporting. Anyone contemplating the sale of a business or professional office would be wise to try to include an option in their professional liability policy that gives them the right to purchase extended reporting coverage, if the policy is terminated. Such options are not always available. With respect to errors and omissions the general effect of this type of arrangement, is that the purchaser assumes full responsibility for all errors, except those that were known to the vendors and not disclosed to the purchaser at the time of closing.

Jardine Lloyd Thompson Canada Inc. is part of the worldwide Jardine Lloyd Thompson Insurance Brokerage Group. Jardine Lloyd Thompson and its subsidiaries specialise in professional liability insurance, handling of professional liability insurance claims and arranging captive insurance companies.


 The information contained herein is believed to be accurate, but individual circumstances, local business and insurance practice and the Law can vary extensively and Jardine Lloyd Thompson and its associated and subsidiary companies are not responsible for any errors and omissions or any loss or damage arising from the use of this information. In the event of situations such as are described in this bulletin, the reader should seek legal counsel and specific advice from Jardine Lloyd Thompson or your Insurance Broker.

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