Publications

---

Does the acquirer in an M&A transaction have the right to access the target’s director’s and officer’s liability insurance coverage to compensate itself for indemnification of the target’s management? Last month, in AT&T v. Clarendon American Insurance Company et al., the Delaware Supreme Court essentially answered “yes.”

This decision highlighted an arguable difference of opinion with decisions in the Ninth Circuit, thus emphasizing the importance of insurance-related deal terms to avoid an expensive result for the acquirer, or even for the target’s shareholders or others who may have indemnification obligations to the acquirer.

This article reviews that opinion and provides an overview of best practices in an M&A transaction with regard to the target’s D&O tail coverage.

The AT&T Case

Through the acquisition of the majority shareholder of At Home Corporation (aka @Home) in 1999, AT&T obtained a controlling interest in At Home and placed ten of AT&T’s employees onto At Home’s board. At Home subsequently suffered one of the more notable dot-com flameouts and declared bankruptcy in 2001. Shortly thereafter At Home’s directors and officers were sued in multiple securities class actions.

Because At Home was in bankruptcy and thus could not indemnify its directors and officers, and because At Home’s D&O insurers had denied their claim (for reasons that are not fully explained, but which may have related to satisfaction of retentions), AT&T paid both the defense expenses of, and ultimate settlements involving, the AT&T-supplied directors. In turn, as an assignee of the rights of those directors, AT&T sought reimbursement for the expenses and settlements from At Home’s D&O insurers. However, since the insured directors had never paid anything themselves, the insurers denied AT&T’s claim on the basis that the D&O policies at issue contained the typical requirement that the insureds suffer “Loss” by becoming “legally obligated to pay” or “financially liable.”

AT&T then sued the insurers in Delaware. Relying primarily on cases originating from California, the Delaware trial court agreed with the insurers and dismissed the case, holding that At Home’s directors had suffered no “Loss” because they never paid their defense costs, or any judgment or settlement, in the underlying litigation.

The Delaware supreme court subsequently reversed the trial court. The supreme court concluded that, because the directors were primarily responsible for their legal expenses (i.e., their defense counsel had not agreed to look solely to AT&T for compensation), such expenses met the “legally obligated to pay” and “financially liable” definitions of “Loss.”

As for the settlement in which AT&T was contractually the sole obligor, the court admitted that the law was “less clear,” but then took a different tack. It noted the obvious: while the directors might not have been legally obligated to pay the settlement, had the settlement failed or never been executed, the directors would have been exposed to liability. The court reasoned that, had the settlement been in the form of a consent judgment, it would have constituted covered “loss,” and concluded that coverage should turn on the “economic substance and not transactional form” of the settlement.

In other words, for coverage purposes there was no need for the “idle exercise” intermediate step of requiring the directors to consent to a judgment that they would never have to pay, as they in fact would only be middlemen for funds ultimately coming from AT&T. (The court also concluded, admittedly unnecessarily in light of the above holding, that, in addition to its rights under the policy by assignment, AT&T’s payments on behalf of the directors also made it equitably subrogated under California law to the rights of those directors.)

The Pan Pacific Case

The Delaware trial court, in its denial of AT&T’s coverage bid, had relied in part on Pan Pacific Retail Properties v. Gulf Insurance Company (S.D. Cal.). In that case, Pan Pacific had acquired all the shares of Western Properties Trust as part of a merger agreement that ultimately unified the two companies. When Pan Pacific, Western, and their management were sued in a shareholder class action challenging the merger, Pan Pacific fulfilled its obligation, pursuant to the merger agreement, to indemnify Western’s management for their defense expenses. The trial court held, and the Ninth Circuit affirmed, that because Western and its management were indemnified by Pan Pacific, they had suffered no “Loss,” and Western’s D&O insurer was therefore not liable for the defense expenses of Western’s management. As additional support for its ruling that there was no “Loss,” the Pan Pacific court relied upon an alleged “reluctance” of California courts to allow an insured a “double recovery”: there, arguably, Western’s management’s indemnification from acquirer Pan Pacific, followed by the attempted indemnification from Western’s D&O insurer.

In a footnote, the Delaware Supreme Court in AT&T dismissed Pan Pacific as inapposite because it involved a potential double recovery by the insureds, whereas the instant case did not. However, that dismissal was perhaps too cursory. First, the holding of Pan Pacific -- that the insured management had suffered no “Loss” because they had been indemnified by the acquirer -- was relevant to AT&T, and the “double recovery” logic in Pan Pacific was only provided as additional support for the holding that there was no “loss.” Second, Pan Pacific also involved a potentially questionable reading of California law on the double recovery issue. In sum, Pan Pacific deserved some additional discussion by the Delaware Supreme Court, even if it ultimately was determined to either be inapposite based on facts and applicable law, or if it was adjudged simply to be incorrect (a position the court unabashedly took with regard to the relevant, but unpublished, Ninth Circuit case of PLM Inc. v. National Union Fire Ins. Co.).

Relevant D&O Insurance Best Practices In M&A Transactions

Because of the arguable uncertainty in the law regarding an acquirer’s right to access the target’s D&O insurance when satisfying the acquirer’s indemnification obligations, and the various types of transactions that are explored (each with potentially different or distinguishing arguments for and against coverage) both the acquirer and the target should ensure that the merger agreement expressly reflects the intentions of the parties, and that in turn the tail D&O insurance policy purchased by the target meets any requirements of the merger agreement.
In cases like AT&T, where the entity in question maintains its own active (non-tail) D&O coverage (as opposed to being covered under the controlling entity’s coverage as a “Subsidiary”), that coverage should be endorsed, if possible, to allow recovery for the controlling entity’s indemnification of the controlled entity’s management.

In situations such as Pan Pacific, where there is a merger agreement with the expectation that a tail policy will be purchased, regarding the tail policy purchased by the target there are generally three options. The first is most commonly demanded by acquirers that have considered the matter: that the tail policy be endorsed to specifically allow the acquirer access to the tail policy for any payments made to indemnify the target’s management (also known as “Side B” coverage). This is not an unreasonable demand, because the acquirer is both essentially funding the purchase of the tail policy (because the purchase simply uses the target’s cash), and assuming the indemnification obligations of the target.

This solution often is beneficial to the target’s management as well. For example, target management may hold equity and thus be affected by escrow obligations that could be triggered by a covered loss, or there may be shareholder indemnification obligations under the merger agreement that could be triggered by a covered loss. Thus, depending on the circumstances, it may be advantageous not only to give the acquirer access to the tail policy, but also to make sure that the merger agreement requires the acquirer to look to that tail policy before such other sources. Or management may have a post-closing interest in the acquirer, for example by responsibility for operating the target as an ongoing division or subsidiary or by holding equity in the acquirer, that may interest management in maximizing recovery to the acquirer.

The second option is to purchase a tail policy that is a reflection of the current coverage, something that is commonly required in merger agreements. In light of Pan Pacific and a few other cases, purchasing a tail policy that merely reflects the current coverage might provide an advantage to the target’s management by potentially providing them with a double layer of protection against loss. If the target’s directors and officers are sued, they might first look to an indemnification entitlement with the acquirer. Should that either fail (e.g., due to the bankruptcy/insolvency of the acquirer) or be deemed by former management to be an undesirable action (e.g., due to resultant depletion of escrow sums or target shareholder indemnification to acquirer for certain loss), they may have the tail policy as an ongoing, secure fallback.

The final option, and the one that can potentially be the most beneficial for target management (depending, again, on whether there are any relevant escrow or indemnity obligations), is for target management to purchase a tail policy that only contains coverage for such management, but contains no coverage rights for the acquirer, either expressly (as in the first option above, when the acquirer is named) or implicitly (as argued by the insureds in the AT&T and the Pan Pacific cases). This is also known as a “Side A only” policy. Compared to a traditional D&O policy, a Side A only policy can also offer the advantages of containing broader coverage terms than do traditional coverages, and is often less expensive.

While it sometimes can be argued that the acquirer’s D&O policy provides coverage for loss relating to acts of indemnitees at the target, such loss is expressly excluded in many policies, and even when it is not clearly excluded the carrier may still argue that the policy terms can only be fairly read to exclude such coverage (and there is little guidance in case law on this subject). It may be possible for the acquirer to ensure that its own D&O policy expressly extends to indemnification that the acquirer may pay to the target’s management.

Conclusion

While the target’s insurance is not the primary focus of a transaction, there are many aspects of that insurance that can have a profound affect on the ultimate financial outcomes for both seller and buyer. AT&T and Pan Pacific highlight one such aspect, with regard to the target’s D&O insurance. This component of a deal should get the appropriate attention on the front end when the agreement is being negotiated, and not when post-closing claims arise – as they often do.