Managing the risk of recovery in financial transfer transactions
We’ve recently noticed that both buyers and sellers have heightened concerns about their risks and exposures when transferring financial advice portfolios. Both are looking for different ways to manage their financial risk of recovery.
Sellers want to know what their liabilities and obligations to the buyer are and when they will end. While buyers want certainty about what they can make a claim for and whether the seller has the financial resources to meet their indemnity and warranty liability.
I outline five ways that the financial risk of recovery can be managed in these transactions.
1. Professional indemnity (PI) insurance
It’s standard for a seller to be required to hold PI insurance in sale agreements for financial advice portfolios. But for PI insurance to be effective in mitigating risk, the buyer must have confidence that it will cover the seller’s exposure for a period of time after the sale. Without this, the indemnities are worthless because there is essentially no safety net if the seller can’t fund the payment of a claim. The PI insurance run-off period is a critical element of this.
Traditionally, sale agreements have required PI insurance to be current at completion and maintained in run-off for a minimum of six years. But following the Hayne royal commission we’ve seen a hardening in the PI insurance market for the financial services industry. This has made it difficult for most sellers to obtain PI run-off insurance for more than three years.
PI insurance also may not cover the seller if they haven’t complied with community standards or practices, or if they’ve breached the law. For example, if they charged clients for services that were never provided. The government has also recently extended its reach to consider eligible financial disputes dating back to 1 January 2008.
These issues are making it difficult to determine what is an acceptable PI insurance run-off period. So I’ve had to identify other creative ways to help buyers limit their exposure and mitigate their risk of financial recovery.
2. Warranty and indemnity (W&I) insurance
W&I insurance is often used to cover the buyer for financial loss when the seller breaches the specific warranties and representations they gave in the sale agreement. This is often referred to as a buy-side policy.
In a buy-side policy, the buyer may recover directly from the insurer for any loss suffered. This mitigates their risk that the seller won’t be around or have sufficient funds to cover a claim. This makes W&I insurance a useful tool to bridge the divide between the seller’s need to limit their liability and the buyer’s need for comprehensive warranties and indemnities that they know they can recover financially.
W&I insurance isn’t a new concept but it’s been gaining favour in Australia recently and I don’t see this changing. But it isn’t easy to obtain and can be expensive. Whether it’s suitable for your transaction will come down to a number of factors including:
- Deal value: The cost of the insurance may exceed the amount you’re insured for
- Your commercial drivers: it’s often looked to when there are multiple sellers or the seller wants a “clean” exit
- Other available options to reduce the financial risk of recovery
- Whether the parties are willing to do a deep dive due diligence: insurers will require this before providing a W&I policy
3. Escrowed funds
Holding a portion of the purchase price in escrow is a relatively simple way for the buyer to know that there will be funds available to meet any warranty and indemnity claims. Obviously the level of comfort depends on the amount held on escrow and how long it will be held there.
When negotiating an escrow fund, parties need to agree:
- Who controls the escrow account
- The amount to be held on escrow
- How long the funds will remain in escrow
- When the funds can be paid out
- Who the funds can be paid out to
- When unused funds can be released to the seller
All these details can be covered in the sale agreement.
If the deal is complex or high value, you could use an escrow agent. You may also need to put in place more complex documentation to regulate the arrangements. For smaller deals, the escrow account could be jointly directed by the buyer and seller, or at the sole direction of the buyer.
4.Payment by instalment
When you pay by instalments, the buyer essentially defers payment. This reduces their upfront payment and increases their subsequent payment(s). Paying instalments over a period of time is a well-accepted practice in the financial planning book buy/sell space.
Current deals I’m seeing are pushing these out to 60 per cent upfront with the balance paid over 12 months to 24 months. This is usually on a 20 per cent/20 per cent basis. In the past, the norm was a 70/30 split over 12 months. The current trend keeps the seller at risk for longer and gives the buyer a longer period and larger amount to claim back.
I’m also seeing new and extended clawbacks and adjustments. These are being added to the traditional “rise and fall” protections. This is being achieved with bespoke provisions that cover specific risks including:
- Remediation costs
- Extension to breach of warranty claims
- Changes in the law affecting remuneration, including fees for no or limited services and possible changes to life insurance commissions
The challenges faced by sellers are compounded by buyers expecting to pay lower multiples. Transactions are currently trending at the 2 to 2.3 x multiple. Fixed purchase prices are also gaining favour.
As noted in my last post, buyers are now also asking sellers to give personal (owner/director) guarantees. But these are only worthwhile if the buyer does due diligence on the guarantors and their financial position to make sure they can pay a claim.
Katie Johnston, senior associate - Brisbane, The Fold Legal
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