Historically, negotiations over representations and warranties (R&W) and the related indemnification in M&A transactions have often been difficult, time-consuming and costly, even where the parties had fully agreed upon the purchase price.
Once the relevant terms and numbers were finalized, parties frequently resorted to escrows and holdbacks to secure sellers’ indemnity obligations. Although such arrangements have provided some level of security, they have always had limitations: (i) sellers assumed the risk that they will not be able to receive the remainder of the purchase price or will only receive funds after a significant delay; (ii) buyers assumed the risk that escrowed funds or funds held back would be insufficient to cover all indemnity claims and that funds would be released prior to discovery of a breach; (iii) both sellers and buyers carried an additional risk that the other may hold up the release of escrowed funds and that funds may not be released until a court order is issued after prolonged litigation; and (iv) the party that would ultimately be entitled to the escrow or holdback amount gave up opportunity costs by keeping funds in low-interest bearing escrow accounts or only received low interest on the holdback amount.
Over the last few years the availability of more reasonably priced representations and warranties insurance (RWI), the improved process of obtaining RWI (where coverage can be secured in a few days) and better terms and conditions of RWI (with higher limits on liability, longer policy periods and narrower exclusions) have permitted both sellers and buyers to shift a significant portion of the risk associated with breaches of sellers’ R&W in sale and purchase agreements (as well as certain other types of agreements) to the insurer, to address some of the shortfalls of the escrow and holdback arrangements and achieve other benefits described below.
Types of insurance
Generally two types of RWI policies are available: seller-side and buyer-side.
Seller-side policies protect a seller against risk of claims against the seller for breach of R&W made by the seller. The policy periods generally match the survival periods in the sale and purchase agreement and sometimes provide for an additional short period of time in order for the insured to make a claim. Policy limits generally match the indemnity cap under the sale and purchase agreement plus an additional amount for defense costs.
Buyer-side policies are the more frequently used and are intended to reimburse a buyer directly for losses arising out of a breach of R&W by the seller. Policy periods in buyer-side policies may extend beyond the survival period of R&W in the sale and purchase agreement (two to four years for general R&W and sometimes even five to seven years for the so-called “fundamental representations,” environmental and tax R&W). Buyer-side policies frequently provide coverage in excess of the indemnity cap under the sale and purchase agreement.
Benefits of RWI
For both sellers and buyers, RWI now allows parties to be more flexible on the scope of R&W and indemnities, including deductibles, caps and survival periods, therefore taking issues off the table in a much more expedited fashion.
RWI now allows the seller to:
- Reduce potential contingent and long-term liability, and negotiate lower deductibles and caps and shorter survival periods in sale and purchase agreements
- Exit “cleaner and faster” from a transaction by reducing or eliminating the amount of funds locked up in escrow or as a holdback, thus enabling a faster distribution of a larger portion of sale proceeds to the seller (and in case of private equity funds, their investors)
- Insist, in an auction context, that buyers rely mainly or entirely on the RWI policy for recourse
- Attract buyers with buyer-side insurance who otherwise would not consider a transaction with a seller of lesser creditworthiness
- Protect itself from liability for breaches of R&W in sale and purchase agreements where the seller has not been actively involved in the management of the target business or in the relevant negotiations
- Expedite the sale process and potentially increase the purchase price by eliminating obstacles to closing, such as indemnity negotiations
RWI now allows the buyer to:
- Supplement indemnification protection offered in the sale and purchase agreement through coverage that may be in excess of the indemnity caps set forth in the sale and purchase agreement, which has become even more important in recent years as the indemnity caps have been sliding from 40–50 percent to 10–15 percent of the purchase price1
- Obtain additional time to detect and report problems when policies provide coverage for claims made after the expiration of the survival period in the sale and purchase agreement
- Provide for an effective indemnity in public deals where it is not possible to recover from public shareholders
- Distinguish its bid in an auction by offering lower deductibles, caps, smaller escrows or no escrow, and in some cases offering that RWI be the sole recourse for breaches of sellers’ R&W
- Ease its concern about the ability to collect on seller’s indemnification due to poor creditworthiness of the seller (including in case of bankruptcy, where escrow arrangements are extremely rare) or from numerous sellers who may be geographically dispersed or otherwise difficult to locate
- Mitigate jurisdiction-specific risk on cross-border transactions, and explore transactions in jurisdictions with which the buyer is not familiar
- Obtain from the sellers additional R&W as long as the buyer’s main or sole recourse is the RWI
- Preserve relationships with sellers who may become joint venture or other commercial business partners of the buyer after the closing
Premiums, deductibles and limits
The major insurers offering RWI today include AIG and Chubb. Today, typical premiums in the US range between two percent and four percent of the amount of insurance purchased (compared with five percent to six percent in the early 2000s). Deductibles range typically between one percent and three percent of the transaction value, based, inter alia, on the type of business and the nature and the scope of the R&W. Deductibles (in buyer-side policies) often line up with the indemnity cap or size of the escrow in the transaction.
Generally insurers insure up to US$50 million individually, though higher amounts are possible, and parties have also reached higher limits by combining policies from several insurance companies.
Increase in use of RWI
As a result, the use of RWI has become more accepted, especially in middle market deals valued between US$20 million and US$1 billion.
According to Marsh, in the US and Canada the amount of buyer-side RWI used in acquisitions in 2014 increased by 225 percent compared with 2013.2
Claims notifications and payouts have also increased in line with market growth.3
Limitations and pitfalls
RWI, however, is not an answer to all problems associated with risk allocation in M&A transactions. Parties to M&A transactions should be aware of the limitations and pitfalls of such policies. Some of these include:
- RWI is issued on a claims-made basis only (i.e., claims with respect to a breach must be asserted during the policy period or any reporting period in order to be valid)
- RWI deals with coverage of breaches of R&W; sometimes specific indemnities may be also covered, but such policies rarely apply to breaches of covenants or to postclosing adjustments to the purchase price
- RWI can be structured as a “blanket” coverage for all R&W or only for certain ones; furthermore, the terms of the RWI may not completely mirror the terms of R&W in the sale and purchase agreement, so parties should pay close attention to gaps in coverage
- Although buyer-side policies can essentially provide an extension of the survival periods set forth in the sale and purchase agreement for many representations, in the case of the so-called “fundamental representations” where the survival period is indefinite, the RWI policy will not cover the entire survival period
- Similarly, while RWI policy limits are generally higher than the indemnity cap for breaches of certain R&W under the sale and purchase agreement, “fundamental representations” may not be covered in their entirety since indemnification for breaches of such R&W is generally uncapped
Not all types of risk are covered, and alternative means of protecting against the downside may have to be sought.
Environmental issues: Generally RWI covers costs of the cleanup of unknown pre-existing conditions, including associated permitting, but does not cover new conditions. Consequential losses, such as third-party bodily injury, or long-tail tort claims, such as asbestos, may not be covered. Coverage for non-owned disposal sites and divested properties is also not guaranteed. Coverage may not be available for companies in high-risk industries, such as chemicals. In such cases, the pollution legal liability insurance may be used in tandem with the RWI.
Tax representations: Although the scope of tax representations that insurers now cover has increased dramatically, insurers still tend not to insure certain tax risks, such as taxes in certain foreign jurisdictions.
Foreign Corrupt Practices Act violations: Many insurers tend to exclude such violations from coverage, but it is becoming possible to obtain such coverage in cases where one can demonstrate strong internal compliance programs and control.
Fraud: Sellers may not be able to insure their own fraud, but buyers may obtain coverage against sellers’ fraud.
Policies typically exclude claims in respect of matters of which the insured had knowledge prior to the effective date of the policy, though knowledge by the seller would not normally result in an exclusion under the buyer-side policy. One key consideration is to insist that the exclusion be limited to “actual knowledge” and be defined to refer to several specific individuals on the “deal team.” Any coverage for known items would have be to specifically negotiated.
Finally, standard forms of some insurers define “loss” by reference to “actual breach of, or inaccuracy of representation or warranty.” References to “actual” should be resisted by the insured, whether in the case of a buyerside policy or a seller-side policy. In the case of a buyer-side policy, it may be important for the buyer to ensure that a third-party claim alleging facts which are later proven incorrect would nonetheless cover litigation or other expenses related to pursuing the claim. In the case of a seller-side policy, it may be important that the seller will be able to recover costs of defense even if the seller is ultimately vindicated.
RWI offers a valuable tool for structuring M&A transactions more efficiently. While RWI does not negate the importance of negotiating robust R&W in sale and purchase agreements, or eliminate the use of other traditional means of addressing exposure to contingent liabilities in M&A transactions (such as escrows, holdbacks and other types of insurance), RWI does offer greater flexibility in structuring M&A transactions. Furthermore, even though claims and payouts are increasing as the RWI market grows, the expanding use of RWI in M&A transactions is a relatively new phenomenon and the claims-paying history is still in the developing stage.