A New Seller Fraud Policy for Buyers in Lower Middle Market M&A Deals

A New Seller Fraud Policy for Buyers in Lower Middle Market M&A Deals

One of the main risks in M&A transactions is a so-called innocent, or accidental, misrepresentation.

This is when a Seller makes an untrue statement about their company. They’re not doing it maliciously or “on purpose,” so it’s not fraud. Seems hard to believe, but in our quickly evolving regulatory environment, these issues can pop up more often than you think.

But, in any case, even if not done intentionally, this misrepresentation is a big problem.

Because… what the Seller said, and laid down in the Purchase and Sale Agreement, is not true.

That means a misrepresentation like this can result in a claim that the Seller has to pay. And thankfully, an innovative insurance product makes this process easy.

With Transaction Liability Private Enterprise (TLPE) insurance in place, the insurer will pay the claim.

In a broad sense, TLPE is designed to fit a gap in the M&A insurance market where deals priced from $1M to $20M in EV are either ineligible or unaffordable for traditional Buy-side Representations & Warranty (R&W) insurance. TLPE is a Sell-Side policy where the Seller, rather than the Buyer, is the policyholder.

TLPE policies are designed to cover transactions from $1M to $30M to the full purchase price – for a maximum of $20M – at a cost that is a fraction of Buy-Side policies.

A huge benefit is that TLPE coverage is a breeze to get, with virtually no underwriting necessary. Plus, when the Buyer brings a claim for damages against the Seller, the insurer pays those claims with no fuss.

With all these advantages, it’s no surprise that savvy Buyers are beginning to recommend TLPE to their targets.

TLPE Fraud and Negligent Misrepresentation Policy – Complementing TLPE

TLPE covering innocent Seller misrepresentations is not new. But what about cases where a misrepresentation appears to be intentional?  The great advantage Buy-side policies have over Sell-side policies is that under a Buy-side policy, Buyers are covered in the event of Seller fraud.  In response, the Underwriters at CFC have developed a new product to compliment the TLPE Sell-side policy which covers Buyers for fraud and negligent misrepresentation by a Seller.

Two-Part Protection for Buyers

As its name suggests, the new TLPE Fraud and Negligent Misrepresentation policy protects Buyers from two specific exposures – Seller Fraud and Seller Negligent Misrepresentation defined below:

What constitutes seller fraud?

Here’s how it is defined in policy documents for this specialized coverage. The Seller engaged in the following that resulted in damage to the Buyer:

  1. Represented false material facts as true;
  2. Actively concealed and prevented you from discovering the truth; or
  3. Remained silent in the face of a duty to speak, (a false representation) with the seller making such false representation with:
  4. Knowledge or belief that the false representation was false, with reckless indifference to the truth; and
  5. The intention to induce you to take action or refrain from acting based on the false representation.

This is how Seller negligent misrepresentation is defined:

  1. The Seller had a pecuniary duty to provide accurate information;
  2. The Seller supplied false information;
  3. The Seller failed to exercise reasonable care in obtaining or communicating the information; and
  4. The Buyer suffered a pecuniary loss caused by justifiable reliance upon the false information.

Like “standard” TLPE, it is a product created by CFC Underwriting, which has been an innovator in the transactional liability space. This policy fills the gap created by Seller Fraud exclusions common in Sell-side policies and evens the playing field with Buy-side R&W. At a cost of $5,000 (plus fees and taxes) per $1M in Limits, it’s a small price to pay for peace of mind.

A claim about the breach must be filed under the TLPE policy first, and in the event fraud triggers an exclusion with the main TLPE policy, the claim is immediately moved over to the Fraud & Negligent Misrepresentation policy, so Buyers are assured of remedy.

Insurers traditionally do not cover fraud; however, the theory here is that the Buyer is innocent of the Seller’s fraud and should be protected.  Distrust among parties to a deal is never a formula for a successful transaction, but it’s understandable when experienced Buyers are suspicious of targets where not all the “I’s have been dotted and the T’s crossed” in diligence.  Sometimes, an owner/founder is simply not as organized as they should be. In some cases, they learn something very late in the game, and just don’t want to kill their deal.  These are situations where some more risk can be transferred.

As we’ve seen with “standard” TLPE coverage so far, I do expect claims to be paid… and done so in a timely manner.

If you have any questions about this new Seller Fraud TLPE insurance or the standard variety, I’m happy to help. I have been involved in several deals using TLPE as it has rolled out over the last few years.

Please contact me, Patrick Stroth, for more information on TLPE and other M&A insurance options at pstroth@rubiconins.com.


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