Doing The Right Deal Right

Given the current focus on corporate governance, accountability, risk management, and compliance with Sarbanes-Oxley and the USA Patriot Acts, there is even more at stake in a transaction. Legacy liabilities and the effectiveness of the targets operations assume additional dimensions in this time of increased vigilance and expectations around internal controls. The buyers management team assumes greater responsibility for the scope of operations in the target company and a corresponding increase in risk if there are weak internal controls or failures in the targets risk management policies and procedures.

To fulfill their expanded fiduciary and corporate governance responsibilities, buyers are performing more thorough due diligence of target companies–typically going well beyond the financial and operational focus of prior years.

In addition to many of the traditional areas of due diligence–financial, tax, human resource/benefits, operations and technology–insurance transactions already require an acute focus on many other areas. Among those other areas are actuarial reserve estimates, asset liability matching, claims management, data integrity, reinsurance risk aggregations and risk management. The acquirer must undertake this multifaceted assessment to better evaluate its prospective exposures to, and management of, business, compliance and reputational risk. The examination of these areas must focus more than ever on internal controls.

Acquirers must also assess the compliance of their targets with regulations. Insurers are subject to a host of distinctive regulations. In a well-controlled environment, this may be helpful to a buyer trying to assess the targets approach to regulatory compliance. However, in the absence of an effective control environment, the myriad of state-by-state rules, regulations, filing requirements and other compliance matters can present a diligence challenge.

In addition, for insurers with broker-dealer affiliates or extensive asset accumulation products, effective due diligence requires a close examination of a targets response to the anti-money laundering (AML) provisions of the USA Patriot Act. Enacted following the terrorist attacks of September 11, 2001, this law requires all insurance companies with broker-dealer operations to designate a compliance officer with responsibility for the firms AML program and to maintain an independent audit function to test its effectiveness. No insurance companies or broker-dealers are exempt.

To the extent that a target company has not fully satisfied the provisions of the Patriot Act, a buyer would be assuming additional risk, including possible sanctions related to the targets pre-deal shortcomings or reputational damage if such compliance failures come to light.

Management also must contend with the impact of Sarbanes-Oxley and the new responsibilities for internal controls that the Act requires. Following an acquisition, the acquirer must certify that its next quarterly filing reflects, in all material respects, the companys financial position, including the results of the newly acquired entity. The maximum window from closing the deal to reporting on the new companys results is 135 days. Additionally, management will be required to report, and auditors will be required to attest to, the effectiveness of controls over financial reporting.

Particularly in p-c insurer transactions, the integration of processes and systems often gives rise to reconciliation issues. In light of the certification requirements associated with Sarbanes-Oxley, the SEC and other regulators (including state insurance departments) are subjecting transactions to additional scrutiny. Any reconciliation or other operational issues that give rise to post-transaction "clean-up" adjustments after the end of the first reporting period may well create a need to explain to the regulators how management could have "certified" under Sarbanes-Oxley at the end of the first post-close quarter if significant reconciliations had not been completed at the time of the report.

In this environment, its clear that the pre-deal phase is the best time to discover areas of concern that might affect Sarbanes-Oxley filings. During due diligence, the buyer must carefully consider governance issues and the prospective integration process, or run the risk of jeopardizing the support of the board and other stakeholders.

In recent successful mergers, highly detailed game plans have accompanied the "warm and fuzzy" messages broadcast to the general public about shared synergies and teamwork. Given the new focus on governance, its critical that open discussions of risks take place at the highest level.

Boards must hold management accountable for highly detailed merger analysesfrom the strategic rationale for the deal down to business, operational and personnel issues that entail risk.

In the insurance space, there are many potentially significant liabilities extraneous to the business itself: for example, market conduct issues, residual market exposure, and shareholder and policy litigation, among many others. There must be sufficient reserves and contingency plans to address the unpredictable, when shareholder litigation can disrupt the best-laid business plans.

The buyers board must challenge management to clearly articulate its plans for managing risks, combining two diverse control environments, integrating information systems, cutting personnel and deciding how much to spend to keep essential talent. But its not enough to ensure that management has developed an integration plan. Once the transaction is complete, the board must monitor plan implementation and require frequent management reports on progress.

Effective due diligence continues to require comprehensive analysis of the impact of the deal in terms of financial results and projections, the targets tax situation, its customer relationships, and its human resources. But now, buyers also must quickly develop an understanding of the targets corporate governance framework. (See related story.)

Its a new day. Gone are the days when an acquirer could rely on "reps and warranties" to address any skeletons that fall out of the closet once a deal is closed. In the current environment, the best–and only–real protection is a thorough examination of the target and its financial results before the deal is finalized. In some cases, the best due diligence may result in deals not getting done.

Kerrie MacPherson is a Managing Partner in Ernst & Youngs NY Financial Services Office where she leads the Financial Services Transaction Support practice. She can be reached at kerrie.macpherson@ey.com. Michael Brosnan, a partner in the practice, can be reached at michael.brosnan@ey.com.

Reproduced from National Underwriter Edition, July 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved. Copyright in this article as an independent work may be held by the author.