The use of buy-side representation and warranty insurance has steadily increased in the past few years in the United States, particularly for middle-market M&A transactions. While the use of such policies has become relatively well established in transactions involving private equity firms, these policies have also begun to grow in popularity among strategic buyers. In part, this is attributable to practical factors, including buyers’ increasing familiarity with the availability of buy-side insurance, a decrease in the associated costs and buyers’ growing confidence in their ability to successfully make claims against policies.
Benefits to Sellers. For a seller, buy-side insurance has the appeal of limiting such seller’s contingent liability for indemnity claims that may be made against it under a purchase agreement and reducing the amount of the purchase price that may be required to be held back from distribution or placed in an escrow account. Where the transaction involves multiple sellers with joint and several liability, buy-side insurance can also help any sellers that are perceived to have “deep pockets” mitigate the risk that they may be forced to bear a disproportionate amount of any claims made against the sellers as a whole.
Benefits to Buyers. For a buyer in an auction process, a buy-side policy can offer an opportunity to differentiate itself as a bidder. As competition for attractive deals increases, this has become more important for buyers. A policy can also be valuable where a buyer may have a concern about the ease of collecting, or the ability to collect, claims from the sellers. Moreover, when the sellers are also the management team, an insurance policy can help mitigate the concernthat a buyer may have in bringing a claim against its existing management team. In addition, insurance will often extend coverage for general representations and warranties past the period contemplated by the purchase agreement. The coverage under a policy can also, if needed, be assigned to affiliates, collaterally to lenders or to future buyers of all or part of the acquired business.
Impact on Timing. Both sellers and buyers have found that they can increase the speed with which transactions are signed or closed through the use of buy-side insurance. If the use of insurance is proposed and agreed earlier in the transaction process, it can significantly reduce the level of negotiation required for the representations and warranties and indemnification provisions of the purchase agreement. It may also provide the party proposing insurance with an opportunity to adjust the purchase price to its advantage.
Furthermore, insurance may offer a way to bridge the gap between buyer and seller later in a transaction, where the parties have found themselves unable to agree on the amount of the purchase price to be placed in escrow or the terms of indemnification of the buyer.
Impact on Process. Of course, obtaining an appropriate policy entails its own expenses and negotiations. The party proposing the use of insurance will need to retain a broker to solicit non-binding indications from carriers, which will set out the general proposed terms of coverage, including the premium, any retention amount and the policy limit. Once a carrier is selected, the carrier and the buyer will need to negotiate and enter into a non-disclosure agreement and non-reliance letter before the underwriting process can begin, which will generally consist of a high-level review of material transaction documents and the buyer’s due diligence process (including any legal, financial and tax due diligence reports).
Negotiation of Insurance Policy. Once the buyer has received a draft of the policy, it will need to carefully review its terms, including any matters that are excluded from coverage, in order to ensure that it is sufficiently protected against future losses. Often, the policy will exclude coverage for any losses arising from pension withdrawals or underfunding, certain regulatory, tax and environmental issues, and industry-specific matters. The policy will also not generally cover any issues actually known to the buyer’s deal team at the time the policy was issued, including issues identified in any due diligence reports prepared by advisors or disclosure schedules.
Where there is a delay between signing the purchase agreement and closing the transaction, the parties will also need to determine whether and how any new issues arising during this period will be addressed by the policy. Other matters tied to indemnification, such as post-closing purchase price adjustments or losses arising from breaches of covenants, will also not be covered by a representation and warranty insurance policy. In addition, the buyer may wish to negotiate for indemnification for certain material items, such as fundamental representations, in excess of the policy limit. The parties will need to agree as to how these matters will be addressed—whether through a specific indemnification provision under the purchase agreement, supplemental insurance policies and/or purchase price adjustments.
Underwriting Fees and Premium. Finally, the buyer and seller(s) will need to decide who will be responsible for the underwriting fee and the premium of the insurance policy, as well as any amount of the purchase price that will be placed in escrow to mitigate the retention amount under the policy and, if so, the terms of any separate deductible or threshold applicable to indemnification claims made against the escrowed funds.
Buy-side representations and warranties policies offer another tool for buyers and sellers to use in coming to a mutually agreeable transaction structure. There are benefits for both buyers and sellers in obtaining insurance and we are seeing more deals where representations and warranties insurance becomes a key factor in the negotiations between the parties.