An Insurance Prescription For the Buyer’s Environmental Fears

As the M&A market gained momentum across multiple industrial sectors in 2004, the environmental insurance market experienced a major increase in demand as buyers and sellers sought solutions to environmental-related deal impediments. The stakes have risen sharply with the passage of the Sarbanes-Oxley Act and its implicit demand for greater transparency with regard to environmental risks. The concerns of acquirers over inheriting environmental liabilities have consistently been one of the toughest points of contention during deal negotiations. While experienced negotiators over the years have developed some creative solutions – such as sliding earn-out provisions or phased consideration deferrals to pay for unforeseen pollution problems that arise after a deal – the new disclosure mandates have put an entirely new spin on the issue and increased the possibility of a deadlock that would halt negotiations prior to an agreement. The infamous corporate governance breakdowns of recent years and the associated company failures have dramatically increased pressure to avoid any reliance on third-party representations and to demonstrate that environmental liabilities are fully financed at the point of completion. Sarbanes-Oxley compels public companies to pay more attention to their environmental disclosure obligations. It directs CEOs and CFOs to personally endorse the completeness and accuracy of these disclosures. In addition, the high-profile focus on the adequacy of corporate disclosures has prompted increased scrutiny by shareholders, securities analysts, and lenders. With these liabilities now more clearly disclosed, corporations have felt increased pressure to better manage, contain, and transfer these risks. Insurance has been filling the gaps left by traditional remedies and providing a secure and transparent mechanism for dealing with the environmental concerns of buyers, targets, and others involved in m&a deals. Weakness of traditional approaches A variety of approaches traditionally have been used to mitigate the environmental risk posed by m&a transactions. But in the current climate, each poses fundamental inefficiencies and disadvantages. They include: Price discounting Risk estimates can vary widely and reliable third-party cost verification is often unavailable. One-off settlements typically lead to an overly cautious compromise, which will penalize sellers and may still fail to satisfy cash-sensitive acquirers. Buyer/Seller indemnification Indemnity provisions are notoriously difficult to negotiate and heavily dependent on the financial viability of the party issuing the indemnification, typically the seller. Escrows and holdbacks These provisions are difficult to structure and can require complex administration after the deal closes. In addition, these agreements can reduce the deal value for either side and, of course, prevent the seller from reaping full value at closing. Insurance alternatives An increasingly attractive alternative is to transfer environmental risks to the insurance market. For a single, fixed premium, environmental insurance can be used to cap the cost of known cleanup obligations and protect against the risk of unexpected future losses, providing cost certainty to all parties. Environmental insurance policies can be used to: * Eliminate or mitigate potential transaction barriers * Protect deal parties from long-term environmental liabilities * Replace or strengthen warranties and indemnifications * Allow a clean exit for sellers and immediate access to full sale proceeds * Reduce perceived transaction risk to lenders Insurance can be used to unlock stalled deals and help to focus negotiations on the core business issues and associated assets. Further, securely rated insurance companies can be used to underpin warranties and indemnities from parties with weak balance sheets. Key coverage types The design of an appropriate environmental insurance program ultimately depends on a number of factors including the nature of the environmental exposure and the risk appetites of the transaction participants. Programs are typically designed to fit the unique requirements of each individual transaction using some combination of the coverage options outlined below: Pollution liability insurance Pollution liability insurance protects against losses from sources of pollution liability that were not known when the deal was negotiated but may arise after closing – a traditional worry for buyers. These unknown sources may be existing contamination that has not yet been discovered or contamination resulting from releases in the future. Coverage is available for unanticipated cleanup expenses, third-party claims for damage or bodily injury and, importantly, associated expenses for legal defense. A variety of additional coverage options are available to address risks such as economic losses from business interruption due to contamination or even exposures associated with previous divestitures of an acquired company. Remediation cost cap Cost cap insurance is designed to minimize the cost uncertainties associated with known cleanup obligations. This insurance provides the funds for unanticipated cost overruns that might arise from a variety of factors, including discovery of additional contamination, underestimation of project costs, or changes in regulatory requirements. Blended finite programs These programs provide a way for buyer and seller negotiators to convert the financial uncertainties of a known contamination liability to a quantified cost item. They combine the efficient pre-funding of planned cleanup expenses with conventional insurance to cover the risks involved in unplanned cost overruns and unexpected contamination. Liability buyout mechanisms An increasingly attractive option for addressing environmental liabilities in an m&a transaction is to involve a third party that will assume cleanup liabilities for a single fixed cost. An expanding population of engineering service providers will accept liability and responsibility for the management of these risks and, if desired, assume ownership of contaminated assets. This transfer of liability is supported by a structured insurance program that provides long-term financial assurance and security. Sellers can transfer contaminated assets to buyers without either party retaining or assuming any cleanup obligations. A recent transaction involving the sale by a multinational corporation of a U.S. industrial operation to a local management team illustrates the value that environmental insurance can deliver. The seller wanted to be released from the multi-million-dollar remediation liabilities hanging over the main operational site of the business. While there had been no regulatory involvement at the site, the seller wanted the contamination issues addressed because of concerns about contingent liabilities should the buyer fail in the future. Since it was a management buyout, the business was highly leveraged to finance the deal. The buyer agreed to clean up the site in return for an appropriate financial consideration. The two sides where unable, however, to agree on an appropriate cost estimate for full site remediation. Both sides eventually agreed to transfer the responsibility and liability for the cleanup and the satisfaction of regulatory requirements to a remediation company on a guaranteed fixed-price basis. The one-off cost was netted off against the purchase price and the contract was supported by a fully funded insurance program that provided protection up to twice the value of the estimated liability. Michael Balmer is Senior Vice President in the Environmental Practice at Willis Group, a global insurance broker. Copyright 2004 Thomson Media Inc. All Rights Reserved. http://www.thomsonmedia.com http://www.majournal.com