Types of Purchasing Agreements
The precise type of purchase agreement and the contents of such an agreement vary from transaction to transaction. However, there are basically two types of purchasing agreements used in connection with the purchase or sale of an agency or a brokerage: a stock purchase agreement and asset purchase agreement. There are substantial differences between the two types of transactions. Obviously, when buying a book of business, the transaction is more akin to an asset purchase agreement.
(a) Stock Purchase – This type of transaction involves the purchase of the shares of stock of the selling corporation – in other words, a purchase of all the selling entity’s business. There is no need to list the particular assets that are being purchased in this type of transaction, since by definition a stock purchase includes all assets owned in the name of the selling entity. One or more of the new stockholders are replacing the previous stockholders in the selling entity, or a new entity can be created to purchase the stock.
However, along with the purchase of all the selling entity’s assets in a stock transaction, the purchasing entity also assumes all the liabilities of the selling entity. This includes any tax liability and any potential errors and omissions liability incurred by the entity being sold, and any such liability will become the new owner’s responsibility. Accordingly, the existing or contingent liabilities of the selling entity must be fully disclosed and carefully scrutinized by the purchaser in any such transaction. Appropriate indemnification provisions are important to protect the purchasers from future claims of liability which the sellers may have honestly overlooked or may have been unaware of at the time the agreement to sell was executed.
Tax considerations must also be addressed in advance of entering into a stock purchase agreement. Most, though not all, insurance agencies incorporated as stock companies are classified as Subchapter S corporations, meaning they are “pass through” entities for tax purposes. The profits and losses realized by these companies are passed through to the owners in proportion to the percentage of ownership of each owner. Such entities file federal tax returns for informational purposes only and do not pay federal income tax. Relevant tax rules differ from state to state.
(b) Asset Purchase – An asset purchase is the more frequently used method for the purchase of an agency/brokerage or book of business. In an asset purchase agreement, the purchaser is only acquiring a particular list of assets from the seller for a specific price. This type of transaction generally includes the book of business of the selling entity, along with any goodwill associated with that business. The sale need not include all of the selling entity’s assets, although it may also include computer hardware and software, the right to use the selling entity’s name and other furnishings or “hard” assets. Although variations exist, the purchaser in this type of transaction generally is not assuming any liabilities of the selling entity. There is still the need, however, to delineate the specific financial documents provided to the purchaser in connection with the transaction. And, depending upon the facts of a particular transaction, the deal would include appropriate and complete indemnification language in the agreement for both the purchaser and the seller. The same considerations come into play when purchasing a book of business since the book of business is the only asset being purchased.
Consideration should also be given as to the manner of payment for the assets. Payment can either be made in a lump sum, over a period of time or by a combination of the two. What is most appropriate depends upon the specific nature of the business being sold and the financial situations of both the purchaser and the seller.
A popular alternative to stock corporations is the limited liability company or LLC, which has been authorized by all states, including New York. This entity combines the protection from liability to owners afforded in traditional stock corporations with simpler formation and treatment of income and losses. A purchaser may acquire the entire business of a selling entity that is a limited liability company (along with all of the liabilities of the seller) or buy all or a portion of the assets of the selling limited liability company.
Sometimes, it is prudent for a purchaser to form a new entity for the purposes of purchasing the assets or business of a selling insurance agency. In such instances, it is often appropriate to form an LLC for that specific purpose.
Depending upon the particular transaction in question, the other considerations of a buy/sell transaction are numerous and vary. Some issues to consider are the reactions of existing clients to the selling of the entity. For example, what effect, if any, would occur on the purchase price if a substantial portion of those clients transfer their business from the new owners within a specific time period? In addition, any issues regarding the appointments of particular insurance carriers should be addressed in connection with the sale.
Future Disputes Between the Parties
No one enters into a buy/sell agreement anticipating that a dispute will develop in the future. However, disputes often arise no matter how carefully the buy/sell agreement has been drafted. It is for this reason that the agreement should contain provisions as to how and where any such future disputes will be handled, including whether to arbitrate those disputes or submit the disputes to the jurisdiction of a particular court for adjudication.
Arbitration and alternative dispute resolutions have gained popularity in recent years, however, that mechanism of dispute resolution may not be the panacea touted by arbitration proponents. Our experience has shown that arbitration can often be much more expensive than anticipated by the parties, and sometimes not substantially faster than litigation in court. In addition, the arbitration clause must be carefully drafted in order to provide for payment of administrative and other expenses, and it should set forth the precise powers of the arbitrator(s). The decision as to whether or not to include an arbitration provision in the agreement should be jointly made by the parties and their counsel. It has been our recent experience that arbitration has become much more costly, especially if there is an arbitration panel as opposed to a single arbitrator. Thus, the decision to litigate in court or arbitrate must be weighed carefully. Another issue the parties might want to consider is whether any dispute should be first submitted to mediation before any arbitration or litigation is commenced. Surprisingly, many disputes are settled during the mediation process.
No matter which type of purchase transaction is involved, there are often other agreements the parties need to contemplate and possibly execute supplemental to the buy/sell transaction. Often, the owner or owners of the selling entity will remain with the new owners as employees or as independent consultants. The preferred approach is to have such arrangements set forth in a separate agreement that contains all the terms of the arrangement; that separate employment agreement should be referred to and incorporated into the buy/sell agreement. Our firm can also assist in the preparation of these types of agreements.
Potential E&O Claims in Purchase or Sale of Agency
With our specialty in handling E&O matters, we would also mention here that both the buyer and seller may have potential E&O exposure that must be considered. Obviously, some of the exposure will be managed by the indemnification clause in the agreements as discussed above. However, the seller should always seriously consider the purchase of tail coverage for any potential E&O claims that arise before the sale. Due to the fact that the statute of limitations for an E&O claim may be as long as six years, the recommended practice is to purchase a tail policy providing coverage for six years after the sale takes place. The buyer on the other hand must always make sure that its E&O carrier is aware of the purchase, and the acquired agency/brokerage must be added to their E&O policy.
Selecting the Right Counsel
Choosing the appropriate counsel to assist with the transaction can save substantial time and money in the purchase and sale of an insurance agency/brokerage or book of business. Getting the lawyer involved earlier rather than later is always prudent and avoids the situation where the client believes all necessary items have been agreed upon. Doing so also helps prevent the misunderstanding that all that is needed is to “formalize” the agreement in writing – only to discover that counsel on both sides have raised additional questions and concerns for the protection of their respective clients. The clients then may be frustrated when they realize that the agreement they thought was all but completed still needs to be finalized. The involvement of an attorney at an earlier date will help avoid any misconception as to the realistic closing date for the transaction and can actually save time and money by dealing with all issues upfront.
The transactional team at KWC regularly handles transactions involving the purchase and sale of large and small agencies/brokerages and books of business. KWC also regularly litigates issues that arise in connection with these types of buy/sell agreements. Accordingly, KWC is cognizant of many of the potential pitfalls that might exist for the client in the drafting of the buy/sell documents. An insurance agency or brokerage contemplating the purchase of another agency or brokerage or book of business should make certain that, whether it is KWC or another law firm, the attorneys handling the purchase or sale fully understand all the issues that need to be addressed in order to fully protect the agency/brokerage.
If you are contemplating a purchase or sale of your agency/brokerage or a book of business and you would like to discuss how we may be able to assist you, please feel free to reach out to us.