As anyone who has been involved in the purchase or sale of a business knows well, the negotiations over the seller’s representations and warranties, and the corresponding indemnity provisions that provide the means by which to enforce them, typically are among the most contentious aspects of the transaction. A seller understandably wants to limit and qualify its representations and warranties and its related indemnity obligations as much as possible. Conversely, the purchaser wants to preserve as much opportunity as possible to recover whatever losses it may incur should any of the seller’s representations or warranties prove to be untrue.
The focus of these divergent interests typically centers on the length of time the seller’s representations and warranties will survive after the closing as well as the deductibles, baskets, caps and other limitations that serve to limit the losses the purchaser is entitled to recover from the seller. Naturally, the seller wants to leave as little of the purchase price at risk as possible for the shortest feasible time. On the other hand, the purchaser wants to make certain that for a reasonable period of time there is a reliable source of funds, commensurate with the size of the transaction and the nature of the business, with which the seller can fund any indemnity claims.
The most common way by far in which sellers and buyers address the funding source is to create an escrow fund, which serves many useful purposes. Since escrow funds typically are held by large banks and are invested in short-term government obligations, the purchaser is assured that a safe and liquid source of funds will be available to satisfy indemnity claims. For the seller, particularly one with multiple owners, an escrow fund eliminates the need to call upon the owners to refund a portion of the purchase price, assuming the funds are still available, to satisfy an indemnity claim. At the same time, however, a seller obviously must endure lost opportunity costs for the duration of the escrow period, as escrow funds earn very little return.
In the late 1990s the ever-enterprising insurance industry created a new insurance product as a substitute for an escrow fund – representation and warranty insurance, also known as "transactional risk" insurance. Rather than ask the seller to set aside a portion of the purchase price in an escrow account, the insurance industry promoted the prospect of instead using an insurance policy to underwrite the risk that any of the seller’s representations and warranties might prove to be untrue. According to the insurance industry, such a policy had much to offer since the policy premium would be only a fraction of the amount the parties otherwise would hold in escrow. For that reason, the seller could distribute a much larger share of the sale proceeds immediately following the closing and thereby minimize its lost opportunity costs. At the same time, it would provide at least the opportunity for the purchaser to negotiate for more generous indemnity provisions since, with an insurance policy in place to cover any losses, the seller presumably would be more willing to agree to terms more favorable to the purchaser.
The terms of a representation and warranty insurance policy will vary depending on the purpose the parties intend to serve. For instance, a policy might match precisely the seller’s indemnity obligations including the relevant deductibles, baskets and caps. In that circumstance, the insurance policy will likely replace the escrow fund in its entirety. Even in instances where the purchaser for whatever reason prefers to use a conventional escrow fund, the seller may want to obtain a policy as a safety net against its own exposure, which may exceed the amount of the escrow fund depending on how the acquisition agreement is structured. On the other side of the table, the purchaser may want to obtain its own policy coverage to the extent the seller is unable or unwilling to indemnify the purchaser to the full degree the purchaser determines is necessary. In other words, a representation and warranty insurance policy is not a one-size-fits-all proposition and its coverage – and whether the seller or the purchaser is the insured – will depend on the risks one or both parties seek to insure.
Representation and warranty insurance is likely to be particularly useful in situations where the seller – such as an investment fund – wants to quickly distribute to its investors as much of the sale proceeds as possible. A seller also may need the sale proceeds to pay down debt and cannot afford to sequester a substantial sum in an escrow fund for an extended period of time. A purchaser may find an insurance policy appealing where the amount of the escrow fund is smaller – as it often is – than the full extent of the seller’s contingent indemnity obligations. A purchaser also would benefit from an insurance policy where the target is a public company whose representations and warranties commonly expire at the closing. Similarly, a purchaser may wish to insure the risk of acquiring a company in bankruptcy since debtors and bankruptcy trustees will offer only the bare minimum representations and warranties. Representation and warranty insurance also may have strategic value in connection with, for example, an auction process where a prospective purchaser could signal its willingness to rely on an insurance policy instead of an escrow fund and thereby distinguish its bid from competitors’ bids. Conversely, depending on the circumstances, the insured may choose not to inform the other party about its procurement of insurance coverage.
Despite the efforts of the insurance industry, representation and warranty insurance has never really caught on. Investment bankers, lenders and lawyers often viewed the integration of an insurance policy – and the related negotiation with the insurer – as an expensive, cumbersome and time-consuming process that only would delay the closing. The recession in the early 2000s, the ensuing M&A boom and then the Great Recession, which especially damaged the balance sheets of many insurers, did not help. Depending on the time frame, many sellers and purchasers decided they either could not afford or did not need insurance protection. But now, with the financial industry slowly recovering along with the rest of the economy, representation and warranty insurance is once again being marketed in the M&A world. And market-savvy insurers are making special efforts to expedite their due diligence, to customize their policies to suit the insured’s particular needs and to price the premium at financially attractive levels (currently in the range of about 2 to 4 percent of the coverage). Insurers also are increasingly willing to provide coverage for such formerly off-limits risks as tax, environmental, IP, fraudulent conveyance and successor liability indemnities.
If either the seller or purchaser is interested in a representation and warranty insurance policy, it generally is wise to bring a prospective insurer into the process sooner rather than later. The insurer will need time to conduct its own due diligence in order to assess and price the risk it is being asked to underwrite. It also will need to draft the policy and negotiate its terms with its insured (parties should expect to pay an up-front, non-refundable fee to cover the insurer’s due diligence, the amount of which can range from $10,000 to $25,000 depending on the size and complexity of the transaction). If the parties delay the involvement of the insurer, this process almost surely will slow down the transaction and make it less appealing to the parties.
With insurers making a concerted effort to make representation and warranty insurance user-friendly and affordable, if nothing else, a seller or purchaser of a business may want to take a closer look at such a policy, either in place of, or in addition to a conventional escrow fund, particularly in those circumstances in which the use of a conventional escrow fund is problematic. Thompson Hine’s M&A lawyers can help interested parties identify the insurers that are active in this market and, if appropriate, also help to negotiate the terms of the policy.