Merger and acquisition activity among design professionals is on the rise. In a 2015 survey* of architecture, engineering, and planning firms, 68 percent reported that mergers and acquisitions were in their strategic plans for the next five years, and 42 percent indicated that they were considering buying another firm within the year.
When design firms join forces, they bring more than talent, expertise, and reputation to the newly constituted firm: they bring the risk of claims arising from professional services provided prior to the merger or acquisition.
This is true even when the transaction is an asset purchase in which the parties intend for the acquired firm to retain the professional liability for its prior acts. Both parties – acquired firm and acquiring firm – have an interest in making sure there is insurance coverage for that liability.
The acquired firm retains the risk, so they need to manage it. But the acquiring firm has a dog in this fight, too. If a prior acts claim against the acquired firm cannot be satisfied by insurance or by the acquired partners’ assets, claimants may seek to draw the acquiring firm into the fray. They might allege that the acquiring firm had something to do with the negligence alleged in the claim, or was for some other reason responsible for the acquiring firm’s prior acts.
All professional liability policies (and insurers) are different – there are no guarantees that any of the solutions will be available from any particular carrier. However, here are two possible options:
One Option: Purchasing a Tail
A “tail” or “extended reporting period” gives the acquired firm an additional period of time to report claims to a carrier after the expiration of their final professional liability insurance policy. A typical policy might offer tail periods of one, two, and three years, and the cost of these terms is usually expressed as a percentage of the annual premium charged on the policy, say, 100 percent, 150 percent, and 185 percent, respectively.
- High initial cost
- Limits don’t refresh
- Once the limits are gone, they’re gone
- Tails are shorter than many states’ statutes of repose
- Moving parts that can malfunction or operate in unintended way
Another Option: Add Coverage to the Acquiring Firm’s Policy
The acquiring firm could ask its own professional liability insurer to add coverage for claims arising out of the acquired firm’s pre-acquisition services to the acquirer’s policy.
The key word here is “ask” – the parties should not assume that this the insurer will agree, and should open this discussion with the carrier as soon as possible.
- Facilitates the deal if acquired firm is balking at buying a tail
- Same carrier handling the acquiring firm’s claims and acquired firm’s prior acts claims
- Acquirer exposing its professional liability insurance limits (and its future claims history) to whatever claims arise out of acquired firm’s pre-acquisition work
The real question is whether or not the added risk to acquirer’s limits and loss history is worth taking at all, and, if so, how to account for the perceived cost of this risk in the deal.
If the parties add coverage for the acquired firm’s pre-acquisition services to the acquiring firm’s policy, they – and the carrier – must reach agreement on the following questions:
- How long will the acquiring firm carry the prior acts coverage on its policy?
- What limits will apply to the prior acts claims?
- What deductible will apply to the prior acts claims, and who will pay?
- Who will make decisions about defending or settling a prior acts claim?
The risk of professional liability claims arising out of the acquired party’s prior acts must be intentionally managed and agreed to by both parties and their professional liability insurance carriers. This should not be an afterthought or an 11th hour consideration. Early, well-advised planning for prior acts claims will prevent many problems for the new venture and enable both parties to make rational decisions about risk.
*Zweig Group’s 2015 Merger & Acquisition Survey of A/E/P and Environmental Consulting Firms