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Litigation Risk Insurance: A Solution for the M&A Lawyer’s Toolkit

Stephen Davidson and David Hodges

Litigation Risk Insurance: A Solution for the M&A Lawyer’s Toolkit

The benefits of having representations and warranties insurance and tax insurance in M&A transactions are well known. But another insurance product can be beneficial for clients in the right situation: litigation risk insurance. Litigation risk insurance has experi- enced significant growth, with more awareness, more underwriters, more possibilities, and more policies and coverage being placed in the last year than ever before. Still, many law- yers and their clients re- main unfamiliar with the product’s benefits, par- ticularly in the context of M&A transactions.

Suppose a client is ready to sell their company while defending against an ac- tive litigation with a $100 million damages demand by plaintiff. What are its options? If a potential buyer raises the litigation as an issue, it could try to agree upon the value of the litigation risk with the buyer, and either adjust the sale price accordingly or set aside some of the purchase price in an escrow account to protect the buyer. Maybe the deal falls apart because the economics do not make sense anymore, so the seller must wait for the litigation to resolve or consider accepting an unfavorable settlement with its feet held to the fire to eliminate the obstacle prior to closing. By the time the litigation has concluded, maybe econom- ic circumstances have changed, and the window for a deal on terms that the parties find acceptable has closed.

In these situations, a litigation risk solution known as adverse judgment insurance can replace or reduce the need for an escrow account and potentially help salvage a deal by taking on the risk of an adverse outcome in a lawsuit. If such an outcome occurs, the insurers will pay the damages owed to plaintiffs up to the amount of coverage purchased, in excess of any deductible.

The plaintiff in our ex- ample above may be demanding $100 million in damages, but the defendant believes that the plaintiff is trying to extort a settlement be- cause it thinks that the defendant will never actually try the case or that the defendant will overpay to eliminate the roadblock to the transaction. Perhaps a reasonable analysis by un- derwriters allows them to conclude that, even if plain- tiff wins on liability, it is unlikely to recover more than $20 million. Still, the buyer does not want to assume the risk of a judgment in excess of $20 million, and the seller does not want sale proceeds to be tied up in an escrow account. In that case, a policy of roughly $80 million can be put in place, over and above that po- tential $20 million deductible. The defendant “retains” responsibility for the deductible in any judgment en- tered against it, and the insurance would cover the rest of that loss, up to the coverage limit. The deductible typically is bespoke based on the specific case and serves to ensure that: (a) the insurance is covering the catastrophic outcome rather than a likely outcome, and (b) the insured has “skin in the game” and will be motivated to litigate the case fully and not simply rely on the insurance.

Now, instead of $100 million, the escrow account could be as low as $20 million. Or, depending on how the buyer views this residual risk and its own appetite to take on that risk as part of the transaction, there might not be a need for any escrow account at all. The policy helps both the buyer and the seller achieve certainty about the costs and potential downsides, and thus both sides can build more accurate pricing into the deal’s terms.

Each adverse judgment insurance policy is structured to the individual needs of the client and the issues in the underlying litigation, so it can have numerous applications. But a few typical scenarios arise often in the M&A context. If a seller is involved in an active litigation and no potential buyers are identified yet, the insurance can be used to ringfence the risk before the company is marketed to potential buyers, which makes the sale more attractive to those buyers. Private equity sellers in particular should think about litigation risks among their portfolio companies and consider whether to pursue coverage before putting a company on the market. If the seller is involved in an active litigation and the anticipated total value of the litigation becomes a sticking point in negotiations with a known potential buyer, the insurance can be placed in parallel with closing the transaction, replacing the need for a traditional escrow account and accomplishing the same goals at a lower cost of capital. And even if an M&A transaction has closed already, if significant funds were set aside in an escrow account due to litigation, insurance can be placed post-closing to release those funds from escrow so that the parties can put them to a more productive use.

Beyond the M&A context, clients often have many different corporate goals that might motivate them to pursue defense-side adverse judgment insurance to achieve those goals. For example, if litigation is inhibiting their ability to secure financing or to conduct a round of fundraising, this insurance can be used to eliminate those concerns for lenders or investors and enable those transactions to move forward. In short, whenever a litigation is preventing some action that a company wants to take, as long as the legal issues involved in the litigation can be underwritten, then it is possible that adverse judgment insurance can be used to eliminate the roadblock.

Given that these policies typically cover the known risk of litigation that is underway with the proverbial house already on fire, the underwriters will conduct substantial due diligence on the case before agreeing to provide coverage, and the policy typically will cover final judgments only, meaning the insurance is triggered only after appeals have been exhausted and the policy ordinarily cannot be used to contribute to settlement. It follows, then, that the insurance is not a good fit for cases where the outcome is highly uncertain. This is not “bad case” insurance; rather, the insurance is meant for cases where a defendant has strong arguments, but the case is unlikely to be resolved within the timeframe necessary for the client’s transactional goals. The client does not want to pay an extortionate amount to settle within the deal timeframe, and so the insurance carriers step in to take on the risk of an unexpected outcome in the litigation and shift the time horizon in the client’s favor.

In addition to insuring against an adverse outcome in a particular case, there are similar insurance solutions that can be used to de-risk so-called “legacy” liabilities, such as asbestos liabilities or other long-tail tort liabilities. The underwriters on these policies look at the history of judgments and settlements to date, analyze the projected value of future claims, and estimate any remaining insurance that can be used to offset indemnity and defense expenditures. The policy then provides a cap on the liability (up to the insurance limit) at the combined value of the deductible and premium payment under the policy. With this insurance in place, not only can there be balance sheet benefits, but a company becomes more attractive to potential buyers, as it prevents the buyer from taking on the risk that projections about the value of future claims might be inaccurate. In the same way that adverse judgment insurance enables the parties to price the risk better by achieving certainty, this legacy liability insurance also enables potential buyers to price the risk properly.

Of course, adverse judgment insurance and asbestos legacy liability insurance are just two of the many types of legal risks that can be insured. On the plaintiff side, there is judgment preservation insurance, which can be used to insure some or all of a jury verdict so that a plaintiff will recover at least the policy limit no matter what happens on an appeal. There are also insurance products that can be used to insure a minimum return on a litigation funder’s investment in litigation, as well as products that cover a minimum recovery to a law firm on its contingency fee portion of a plaintiff-side case.

Litigation risk insurance is a valuable tool, not only for defendants in the M&A context, but for plaintiffs and law firms and litigation funders as well, and underwriters have demonstrated a willingness to be flexible and creative in expanding possible solutions. The potential uses and applications of this insurance are theoretically endless, so long as the legal issues can be analyzed, underwritten, and subjected to due diligence to a sufficient degree of confidence. All lawyers should be aware of how these policies can help their clients unlock value and achieve their goals.

This article was prepared by the Business Law Section's Mergers & Acquisitions Committee.