Last week the issue of public companies having to do quarterly reports popped up in the news in a big way with the President tweeting and then speaking on the possibility of ending quarterly reporting. There are a lot of opinions out there on whether this is a good idea or bad idea. Some people believe this would help companies think more long term rather than operating quarter to quarter. Others believe it is too long and it allows companies to be less transparent. I see pluses and minuses on both sides. For example, I previously worked for a Fortune 500 company and I saw firsthand that companies do operate to an extent knowing they have quarterly numbers to meet. On the other hand, investors want to know what is going on and there could be much bigger surprises if investors are only updated every six months.
I am not hear to argue that either way is better but talk about how this could impact D&O insurance if it were to be implemented. I think the first thing to be concerned about is guidance, the further out you forecast and provide guidance for the more inaccurate you become. Another danger is that a CFO or CEO that has a longer time horizon could inevitably fall behind where they projected they would be but believe they can right the ship because they have more time. As we saw a couple of weeks ago with the Sonus Networks case (CFO Magazine), CFOs can do creative things to meet the quarter end (I am not saying CFOs blatantly mislead or act in a criminal way but the article demonstrates how numbers can be moved around to appease analysts). I am not sure why that would change with extending the reporting period out to six months, in fact it could exacerbate the issue because they feel they have more time to make up for lost revenue or cost savings.
Conversely, there is a lot of merit to the idea that meeting quarterly deadlines can lead to practices that might not be to the benefit of long term growth. We can look at companies that had founders/CEOs that controlled enough shares that they did not have to be bound by the share price nearly as much and could think long term. A great example of this would be Amazon, they have historically operated at a loss but that was because they invested in the business and now they are one of the most valuable companies in the world. They reported courtly earnings but were far less concerned about the volatility around the stock if they failed to meet analysts’ expectations. They were playing the long game.
How this could impact the public company D&O space is uncertain. If companies are still required to report quarterly earnings but not provide guidance I think that would result in the D&O insurance marketplace remaining stable. A company’s balance sheet is one of the most important drivers of D&O insurance pricing and terms; if this information was still available quarterly it would eliminate some uncertainty. I think carriers would take a deeper look at corporate governance and also compare past guidance to the actual results, essentially underwriting the CFO. In the end, insurers like certainty and the less there certainty there is the more cautious they are resulting in higher premiums, more restrictive terms and higher deductibles.
You can find a couple of good write-ups on the implications both broadly and in the D&O insurance marketplace here and here.
I recently read that Illinois Tool Works (ITW) prevailed in a case against the IRS. The IRS challenged that a loan from ITW’s foreign subsidiary to its parent company was a nontaxable return of capital as ITW contended. The IRS dtermined that it was not a loan but a dividend and as a result a taxable event. ITW challenged the IRS and the case was brought to the US Tax Court. In early August the court released their decision and sided with ITW. A short write-up can be found here.
Why I bring this up is that many companies have tax positions they are aware of that could be challenged by the IRS. Companies rely on their accountants to determine whether certain events have tax implications and then proceed accordingly. Unfortunately, this is not foolproof strategy, the IRS can and will challenge these events even if you are using the best and biggest accountants. What few companies are aware of is that there is an insurance policy that can protect them in these instances.
Tax Liability insurance can protect against many types of tax issues, including, but not limited to, spinoffs, M&A, multinationals, tax exempts, related party transactions, and foreign investors. The policy can cover the taxes, interest, defense costs, in some cases fines and penalties, and gross-up. What is different with this type of insurance compared to traditional property and casualty insurance is that we are covering a known event, or tax position, that may not be 100% clear cut but that we are confident is correct.
The underwriting process is specific to that event and coverage is tailored accordingly. Information is collected on the event and might include commentary from a tax attorney and/or an accountant. After preliminary info is collected it is presented to the insurance market and the carriers come back with non-binding pricing and terms. At that point a carrier usually identified that would be a good fit and a more exhaustive underwriting process commences. At this stage an insured typically pays an underwriting fee that is used to pay for the due diligence (think lawyers and accountants that really dig into the info) that allows the insurer to put together the actual terms and pricing. Assuming all is in order, the insured can then bind the policy that can have up to a 7 year policy term.
If you are a company and have uncertain tax issues then a tax liability policy is worth looking into. There is no upfront cost to get a non-binding pricing indication, but be aware that policy pricing is in the 6 figures to start, however, it is a one-time premium and not annual. The policy limits usually start at $5MM and can go up from there.
Skin in the game – that means your insurance broker actually having a vested interest in your success and the level of service you receive year in and year out. Skin in the game does not mean your broker having a greater financial interest in year one compared to subsequent years yet that is how most brokers are paid. Most brokers get paid a set percentage for new business and then see that drop significantly after year one, and at some of the largest brokers that percentage might actually go to zero. If your broker is always looking for the next deal to maintain their income how do you think that aligns with your interests? You might say that the service team is incentivized to keep the account, but that is rarely the case, the service team’s is usually paid a salary and a small component of their bonus might be based on how well they service the customer.
At Alliant we believe that we should have a vested interest in your success and that your success leads to our success. How do we do this? We as individuals get paid the same percentage every year as long as we retain you as client, we don’t get paid more to bring in new clients or take a haircut after year one. In fact, if we lose you as a client we feel that in our wallets because that income is gone.
Why am I telling you this? I tell you this because it demonstrates that we value our existing clients just as much as our new clients. A lot of brokers come in and tell you a story about service and how good their service is but can’t point to a reason as to why that service level will continue – we can. We can point out that we actually get paid or, if the service is not good, not paid based on how we service your account – we put our money where our mouth is, we have skin in the game. How many times has your service fallen off, even just a little bit in each year (cumulatively this could add up and you might not even recognize what good service is anymore), from the initial engagement? Unfortunately, this is just considered part of how insurance works and what one can expect but it shouldn’t be. That is why my firm strives to be different, we are not interested in a slow deterioration of service for our clients but a firm and consistent model of service that is the same in year one as it is in year eight.
I probably will get emails from brokers saying you shouldn’t be sharing this information but if we are being transparent about how much the firms are getting paid shouldn’t we be transparent about know how the individuals servicing your account are being compensated? I am not saying W2’s need to be shared but knowing the structure and how it aligns with a service model I believe are good pieces of information to have because it can be a predictor of the future. Maybe you are different than me, but when I deal with a “service” provider I want those individuals servicing my account to have repercussions if the level of service is not there but sadly in the insurance industry that is seldom the case. With Alliant that is exactly the case, if the service drops we feel it in our wallet.
Cornerstone Research always puts out great data and this report on Securities Class Action Filings for the first half of 2018 is no exception. I recommend you check out the full report which you can find here.
These visuals really speak for themselves but the big takeaway is that if you are publicly traded company the chances of being subject to a Securities Filing are rising. In 2017, 8.4% of exchange listed companies were subject to a filing and in 2018 it is projected to be 8.5%.
If you are a member of the S&P 500 the chances of a filing are even higher at 9.6%.
Breaking this down even further, the industry you are in can change the odds dramatically as the chart below demonstrates.
The clients I work with are in the Life Science and Healthcare space and this is how filings breakdown in that group.
I believe companies need to believe a Securities Class Action filing is inevitable and should prepare accordingly. Of course, one way to prepare is buying having a broad Directors & Officers Liability in place, but risk prevention is even more important.
Once again I recommend you check out the full report from Cornerstone Research which you can find here.
Happy Friday! Here is what I am reading as we head into the weekend:
- Talk about hitting on a lot of points, super insightful article – Regeneron’s Billionaire Founder Battles The Drug Pricing System (Forbes).
- Bio Roundup: An Alzheimer’s Head-Scratcher, OUTBio, GSK & Gilead Shakeups (Xconomy)
- When healthcare devices go over the counter. An important trend contributing to the consumerization of healthcare is the transformation of select prescription categories to over-the-counter (Med City News)
- Six big things: Funding for females and cash pouring into China shape the week in VC (Pitchbook)
It’s a new week and this is what I’m reading to get going:
- While Tech Waffles On Going Public, Biotech IPOs Boom (Crunchbase)
- Smart Bandage Can Dispense Drugs, While Keeping An Eye On Your Wound (FORBES)
- Tendyne investors sue Abbott over $50m milestone (MassDevice). In case you missed, my thoughts on how a company can protect themselves financially from missed or delayed milestones (MattCorc).
- Why the Theranos saga and Holmes’ trial is good for innovation (MedCity News)
Almost every day I read about a company receiving a milestone or grant payment, but sometimes milestones aren’t met and it is not for lack of science. I often wonder how a company would be affected if the milestone or grant were not received because of a fire or some other natural event rather than the science simply not working? Even worse, how would a company and its shareholders feel if they knew this financial loss could be covered by insurance?
For many life science companies these payments allow them to continue operations or avoid having to raise additional money that will dilute shareholders. The financial loss of a missed milestone due to an event that is insurable but not covered by your insurance policy is inexcusable. For R&D companies where there is no cash flow, a missed milestone could put you out of business or significantly impact operations. Sadly, many clients never have the conversation with their broker regarding this important coverage. As you look through the chart below, how deep of a dive have you and your broker done?
Typically when I speak to new clients they have rarely gone deeper than the second question, “has your broker discussed what limit is appropriate?” Milestones and their applicable payment are usually well-known in advance so this is actually a rather straightforward coverage to determine the correct limit of insurance if the right questions are being asked. However, if you don’t know the coverage is available and your broker is not asking the correct questions it can turn into a costly coverage gap that is either uninsured or under-insured (limit is not adequate for the loss exposure).
If this is as deep as you have gone, what other coverage are you missing in your policy? If you think this is the only aspect of business income insurance commonly overlooked I am sorry to say you are mistaken. In future posts I will discuss other business income issues that are not often not covered properly or not covered at all.
If you have questions on whether your policy is correct, feel free to shoot me a message and I would happy to discuss.