Insights

The Lowdown on “Naked Tail” D&O Insurance
POSTED 1.7.20 Insurance

In insurance parlance, if you insure a particular exposure, you’re covered. If not, you’re bare. If you’re looking for a policy that covers something that’s never been covered before, you’re… naked.

That’s the situation many privately held, small and middle market companies find themselves in when they seek to sell their business.

The Buyer asks them to secure Directors and Officers Liability insurance (D&O), specifically a “tail” policy to make sure there’s a source of insurance coverage in case the Seller is held liable for any wrongful acts against an employee or others – things like human resources issues or fraud – committed before the closing date.

Essentially, the Buyer doesn’t want to find out six months after the closing date that there is some sexual harassment lawsuit or anti-trust complaint against the former owners.

As the new owner, the Buyer doesn’t want to be on the hook for incidents that happened before they purchased the target, so they require Tail coverage that extends the target’s D&O Liability, Employment Practices Liability, and Fiduciary Liability coverage for up to six years from closing.

Tail policies provide virtually the same protection as a traditional D&O policy that has a Tail Endorsement. On the acquisition date, the Tail kicks in and covers lawsuits brought against the directors and officers of the target company. This covers any allegations that they committed a wrongful act prior to the acquisition, all the way back to the incorporation date.

This sort of coverage is standard in the M&A world. I’ve been working in this space for years. As I mentioned in a previous article, when Representations and Warranty insurance is not a fit for a deal, Naked Tail coverage is one of three alternatives.

(To put it in to perspective, the cost of D&O Tail coverage is about $20K to $50K. That’s a fraction of the cost of a R&W policy. And the deductible on a Tail policy is $25K to $50K, which is also a fraction of what it is for R&W.)

There are literally thousands of privately held companies in the $30M to $50M range that have never held D&O insurance and now need it to satisfy the terms of their acquisition. Today, this can be done quickly, easily, and broadly.

For example, a small business, run by husband and wife for 20 years. They never felt the need for D&O coverage and had gone the whole 20 years without any sort of legal claim against them. But, when they were ready to sell and enjoy a well-deserved retirement, they were forced to scramble and find coverage because the Buyer required a D&O Tail. Since the couple had never carried D&O previously, their options for finding suitable coverage were limited. That is until now.

Insurance companies didn’t look at these Naked Tails favorably in the past. Generally, they wanted to see three to four years of successful coverage under a regular D&O policy (and wanted three to four years of premiums).

What happened to people who didn’t previously have a policy and are about to sell or merge? The insurers would provide scaled down policies with multiple exclusions at rates that were substantially surcharged.

Things have changed. Now, insurers understand that the risk of anything that the Seller didn’t know about blowing up post-closing is very small. And they are willing to offer these Naked Tail policies for even small transaction size deals.

Today, Underwriters need only a statement from the Seller warranting that, as of the closing date, they know of no fact, event or circumstance that would give rise to a claim. Such warrants are hardly problematic because the Seller is already making these warrants to the Buyer on a much broader scale.  Therefore, the Naked Tail is a relatively low risk for Underwriters.

Three Reasons You Need a Naked Tail Policy

There are a couple of reasons you need a D&O Tail policy when you’re going through any M&A deal, besides the fact that it is contractually required. (For those who’ve never had D&O insurance and don’t see why you need it now, pay close attention.)

  1. If you are getting purchased, this is major liquidity event. You become a deep-pocketed individual overnight. There’s nothing like some press release touting the $20M sale of your company to bring people out of the woodwork who are motivated to take some legal action. Could be past competitors (like a company hoping to be purchased but you were selected instead). Also, former employees who quit before the transaction happened and who now feel they want part of the payday. You need to be protected against such situations.
  2. D&O insurance will cover your costs. The cost of litigation is only going in one direction as time passes – up, especially as states, California foremost among them, pass court costs on to litigants. You’ll also have to pay defense costs and settlement costs. If you have a Tail policy, the insurer covers those costs. The more limits, the more protection, the more dry powder you have. You want to preserve your nest egg.
  3. If you don’t have R&W coverage, you have no protection from Buyers alleging you committed fraud or misrepresentation when you affirmed you knew of no potential breaches of the Reps in the Purchase and Sale Agreement. In these cases, they usually want to keep your escrow, and even clawback more funds to pay for the financial damages – up to 100% of the purchase price. That’s not good.

D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.

D&O Tail coverage doesn’t cover fraudulent behavior, but it will give you money to defend yourself against allegations of fraud. An allegation is not proof. But if you want to keep your escrow, you must defend yourself in court, no matter how frivolous the claims. Without D&O coverage, you’ll pay your own legal costs.

How to Get Your D&O Tail Policy

As I mentioned, if you’re looking to sell your business, you’ll most likely be contractually obligated to take out a D&O Tail policy. There’s no getting out of it, so to speak. And with the legal and financial protection it offers, why wouldn’t you want a policy anyway.

I would recommend not going to your regular commercial insurance broker, even one with experience in standard D&O insurance. A Naked Tail policy is a whole other animal.

You need a broker experienced in insuring M&A transactions and Naked Tails in particular. It’s a slightly different skillset. And because this issue usually comes up close to closing, you want a pro who can get the paperwork processed in a day or two.

I’ve worked in this world for years and would love to answer any of your questions about setting up a D&O Tail policy to your deal. It’s low cost and easy to do. 

You can contact me, Patrick Stroth, at pstroth@rubiconins.com