When we provided our thoughts on representation and warranty insurance (RWI) this time last year (Getting a Deal to Closing with Transaction Insurance), we anticipated that RWI would continue to grow in prevalence in the Canadian deal-making. A year later and we can confirm that 2015 was a banner year for the use of RWI in Canada and we expect this trend to continue in 2016. Our view is that greater awareness of the strategic value of RWI and heightened sensitivity to risk in the current volatile economy will continue to lead parties to investigate and obtain RWI in their deals.
The growing use of RWI to overcome deal hurdles illustrates the maturing RWI market and the upside it provides in various of transaction situations. Whether targeting improved indemnity protection or longer survival of representations and warranties, improving a bid in a competitive auction process, or being forced into a RWI policy when no vendor indemnity is possible, there are various ways RWI provides comfort to both vendors and purchasers.
Fundamentals of RWI
RWI protects against unanticipated and unknown breaches of representations and warranties. In its most basic form, RWI can take the place of or supplement indemnity provisions and survival periods in a transaction. Coverage is available for both fundamental and non-fundamental representations and warranties and can be provided for specific representations and warranties when appropriate. This occurs in a situation where there is a mismatch in the comfort level or risk tolerance between the vendor and purchaser. The parties can then have recourse RWI to get the deal closed.
Use of RWI
The following are a number of beneficial uses of RWI:
- When targeting distressed assets or companies, rarely will there be meaningful recourse against the vendor. Parties can employ RWI to protect against such risk. In the context of a public company target where limited representations and warranties are given, comfort on liability is nonetheless sought.
- Strategic application of RWI in an auction process allows a bidder to remove or limit indemnity provisions and survival periods to make its bid more favourable to a vendor. All things being equal, a vendor will accept a bid that limits or removes indemnity liability.
- RWI can also be used as a negotiation strategy to break deadlock. By moving risk away from a protesting party, RWI can overcome barriers to closing by creating safety around higher indemnity and longer survival periods.
- RWI also eases collection concerns relating to a breach of representations and warranties. As many RWI insurers are AAA rated institutions, RWI can step in to provide protection where the vendor is a high credit risk or a maturing fund selling assets to close out.
- Even if there is comfort the vendor will be able to pay claims, purchasers may want to protect their relationship within newly acquired management teams. Suing management teams, for example, for claims while at the same time trying to grow the business is not ideal. Moving claims to insurers keeps management happy and focused while still providing comfort on any claim that could arise.
Issues to Watch
Because representation and warranty insurers piggyback on the due diligence conducted by parties in order to assess the risks associated with any given deal, RWI cannot replace due diligence. The same applies to negotiating the underlying agreement and particularly the representations and warranties the insurance will be covering. RWI is not intended to fix sloppy work which is why insurers take great efforts to determine that everything has been due diligenced, negotiated and documented properly.
As RWI policies are bespoke and customizable based on numerous factors, they require a lot of care and attention in drafting. The definition of damages is critical to ensure that the appropriate coverage is included. This can be a challenge considering the numerous exclusions insurers typically include in their policies. Besides damages and exclusions, additional issues for negotiation include coverage amounts, term, deductible, premium and fees and cost allocation between the parties. As coverage is typically effective at closing, any risks that are realized in interim periods between signing and closing will not be covered unless it is expressly contemplated in the policy language. The final result should be a policy which fulfills both the risk and cost requirements of the parties.