It seems inevitable that there will be an increase in private defaults as economic conditions deteriorate further. What portfolio management steps are you taking to prepare for the next D&O insurance cycle? In this article, we offer some practical advice in relation to change of control transactions and in cases where lenders appoint an administrator to the borrower’s board.
- Change of control transactions
Over the next cycle, we expect to see an increase in change of control transactions through debt-for-equity transactions, including “key launch” transactions,[1] Section 9 foreclosures and Chapter 11 credit offering or debt-to-equity conversion plans. When lenders acquire ownership of a borrower’s equity, the borrower’s D&O insurance becomes “run-off” and no longer covers claims for wrongdoing that arose after the change of control transaction. In this scenario, private lenders should be aware of at least two important issues.
First, in our experience, current directors typically insist on purchasing tail cover (usually for a period of six years) to cover their exposure to claims for acts, errors or omissions that occurred prior to the change of control that have not yet been asserted. The price of tail cover has increased significantly over the past few years and is typically 1.5 to 2.5 times the existing premium, all paid up front and on a non-refundable basis. While there’s no one-size-fits-all approach to the cost of tail cover, it can be a significant expense – sometimes millions of dollars – depending on the company, existing policy, and amount of coverage. tail cover purchased. This cost is often overlooked and should be factored into the budgeting process for any consensual change of control transaction.
Second, the acquiring company (often an acquisition vehicle formed by the lenders, “NewCo”) must also purchase new D&O coverage to protect NewCo and its new board in the future. The key here is to ensure that solid cover is negotiated, rather than simply abandoning the (sometimes poor) cover the borrower previously had in place. It is also important to confirm that NewCo’s cover is co-ordinated with the acquiring lenders’ own insurance policies (henceforth, the new shareholders) to ensure that NewCo’s cover first applies to claims against sitting directors on the board of directors of NewCo.
- Administrators appointed by the lender
There are also a number of restructuring scenarios – consensual or otherwise – that involve lenders appointing administrators to the borrower’s board. This often happens consensually as part of a forbearance agreement or amendment. Other times it happens non-consensually as part of the exercise of recourse. In either case, D&O insurance is critically important. We offer three important tips.
First, it is important to determine whether the appointment to the board constitutes a change of control transaction under the policy. Many clients are surprised to learn that a change of control transaction is not always limited to a change of equity control. In our experience, some policies will define “change of control” broadly to include a change of control over board composition. For policies where a “change of control” generally includes a change in the composition of the board of directors, the same considerations regarding terminal coverage and future new coverage described above apply.
Second, a newly appointed director in distress will focus on the adequacy of the borrower’s A&D insurance. It is therefore important to review the policy, including for problematic exclusions, to alleviate this concern. At this stage, it is also important to focus on policy renewals, as insurers often use the insured’s financial situation as an opportunity to increase premiums and add exclusions that severely limit administrator coverage. , such as insolvency exclusions or sponsor exclusions.
Finally, private lenders should consider their own insurance coverage for the protection of a lender-appointed director on a borrower’s board. Asset managers typically purchase their own D&O insurance as part of a combined insurance program that also includes professional liability insurance (also known as errors and omissions, or “E&O”). Errors and omissions coverage is generally broad, and there are usually opportunities to negotiate significant enhancements to this coverage, including coverage of SEC and other government investigations, reduction of policy exclusions, and provision related to the claims process (such as consent and cooperation provisions and suggested rate provisions) more favorable to the insured. This insurance can also play an important role in protecting individuals that private lenders appoint to boards of directors, whether in connection with change of control transactions or other restructuring scenarios.
Asset manager policies typically include “outside capacity” coverage, which typically covers individuals the asset manager has appointed to a holding company’s board of directors if indemnification and insurance at the holding company level is not available. This coverage serves as an important safety net to protect the private lender. The language of this coverage can vary widely, however, in terms of which board appointees are covered and under what circumstances. This external capacity hedging therefore needs to be carefully considered and also coordinated to work seamlessly with the assurance of the holding company.
In sum, A&D coverage is an important asset that should be carefully evaluated in times of distress.
[1] For more information on ‘key throwing’ transactions, see our previous client alert published in Bloomberg – Taking the Keys: Restructuring Advice for Private Lenders (bloomberglaw.com)
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