As M&A practitioners well know, the availability to a buyer of a remedy for a seller’s breach of representations and warranties (“R&W”) is a critical component of deal structuring, documentation and execution. A seller of a business (where there is a seller that survives closing) typically is required to provide some contractual indemnity with respect to such breaches as well as with respect to violations of covenants. In a situation where the buyer questions the seller’s credit, the indemnity may be accompanied by an escrow of part of the purchase price. However, escrows often do not provide full protection to the buyer, either because the funds in escrow are insufficient or may require litigation to obtain. Likewise, sellers often resist escrows because they tie up funds for extensive periods of time.
One technique to reallocate the risk associated with breaches of R&W is provided by the insurance industry. Increasingly being offered by a wide variety of carriers, R&W insurance covers the buyer against the seller’s breaches of R&W (in the nature of first-party coverage) or, alternatively, the seller against losses recovered from it by the buyer resulting from such breaches (third-party coverage). The remainder of this article will focus on some of the key uses and features of this specialized coverage, including a discussion of the impact that R&W insurance can have on the dynamics of a particular transaction.
Purpose and Role in the Transaction
Because the R&W policy provides protection from an independent third party to either the seller or buyer, it can enable the protected party to be more flexible in the sale agreement provisions, including the scope of representations and warranties, the applicable deductibles and caps under the indemnification provisions, applicable contractual survival periods for asserting claims and whether, and the extent to which, the seller is required to place a portion of the purchase price in escrow to support the indemnity obligations. Thus, R&W insurance can help narrow gaps in the parties’ negotiating positions, can provide the seller greater and quicker access to the full amount of sales proceeds by reducing or eliminating escrow requirements and can give a buyer who is trying to win a bid a competitive advantage.
Types of Policies: Buyer-Side vs. Seller-Side
Policies can be tailored to meet the specific objectives of the buyer or the seller. Thus, policy coverage decisions (all representations and warranties in the sale agreement or only particular representations and warranties), policy duration, policy limits and other economic terms can be fashioned in light of the sale agreement and the risks the insured is most concerned about.
Buyers and sellers have distinct motivations for obtaining R&W coverage. Fundamentally, the seller is seeking to reduce or eliminate its exposure under the sale agreement resulting from a breach of the seller’s representations and warranties. The buyer, on the other hand, is seeking to obtain protection from loss caused by a breach of seller’s representations and warranties, regardless of whether such loss is not covered or only partially covered by the applicable indemnity provisions, without being exposed to the risk of the seller’s inability to pay an indemnity claim.
Consequently, although seller-side and buyer-side R&W policies share many common characteristics, they can differ in key respects. For example, while all such policies are claims-made (i.e., a claim with respect to a breach of an R&W must be asserted during the policy period in order to be valid), the R&W policy periods are typically different for seller-side and buyer-side policies. The policy period for the seller-side policies is typically coextensive with the applicable survival periods in the sale agreement (or slightly longer to provide time to furnish notice). If this were not the case in a given context, a seller could be exposed to the risk of having to satisfy an indemnity with respect to a breach as to which the policy term has expired. By the same token, the policy period where the buyer is the insured may extend well beyond the survival period provided in the sale agreement (but generally not for more than six years) if the buyer desires coverage regardless of whether the loss is covered by the contractual indemnity.
Likewise, the policy limit in the seller-side policy might be no greater than the indemnity cap under the sale agreement (plus some additional amount to cover seller’s defense costs), while a buyer might want coverage in excess of the indemnity cap and would also take into account the seller’s indemnity in fashioning any retention amount.
There are also coverage differences. A seller may not be able to insure against its own fraud, but the buyer-side policy would cover a seller’s fraud. On the other hand, a buyer-side policy will not cover seller’s representations breaches known by the buyer even if the sale agreement contains a pro-sandbagging clause, but the seller-side policy would cover the buyer’s claim in such situation.
Pricing varies of course based on a number of factors, including an assessment of the risks, the scope and nature of the risks insured, the amount of the retention, applicable time periods and other terms. However, typically the range we have seen in recent years is from 2% to 4% of policy limits. The premium charged typically includes the commission payable to the insurance broker, but this should always be confirmed.
In addition, insurance companies often require the proposed insured to agree to pay the insurance company a fixed amount for the insurance company’s due diligence expenses. However, the insurance company will often agree to waive such fee if the policy is ultimately purchased.
Who bears the cost of the policy premium can be part of a negotiation between the buyer and the seller. For example, the seller can reduce the sales price in return for a buyer agreeing to reduce or eliminate escrow arrangements and obtain an R&W policy instead.
Key Policy Terms
In addition to those described above, policy provisions should be carefully reviewed and refined in any M&A deal context to reflect the objectives of the parties. Among the provisions that can be the most meaningful in achieving the appropriate level of insurance protection are the following:
Definition of “Insured”
Any of the buyer, the seller or the target itself or the seller can be the named insured under the policy, i.e., the principal insured identified in the policy that is usually entitled to exercise remedies in the event of a claim or a dispute with the carrier. Others (such as corporate affiliates) may be “additional insureds” depending on the specific provision. In fashioning this provision, parties should identify the universe of persons and legal entities for which coverage is sought. These distinctions can be meaningful and can also be sensitive to nuances in terms such as “subsidiary”, “control” and “affiliate”, which are generally not terms of art unless defined in a specific context. The practitioner will want to exercise care in fashioning the “named insured”, “additional insured” and related definitional provisions to make sure that the desired universe of related parties are covered. This could be particularly relevant, for instance, in a fund context where “control” over portfolio companies or companies in “silos” or parallel funds can be a matter of (sometimes purposeful) ambiguity.
Definition of “Loss”
The definition of “loss” in R&W policies, while typically straightforward and similar to such definitions in similar contexts, does sometimes involve important details that can make a difference in resolving disputes and recovering awards. Consider the following definitions of “Loss” and certain related provisions from two buyer-side R&W policies we have recently seen:
- “Loss” means the amount to which the Insureds are contractually entitled in respect of a Breach pursuant to the terms of the Acquisition Agreement . . .
Other Insurance Coverage. The Insureds shall, or, if applicable, to the extent possible shall cause their respective Affiliates to, maintain or purchase insurance coverage for the acquired business in a commercially reasonable manner. The coverage provided under this Policy shall be excess coverage. . .
- Loss” means the net sum of the following amounts sustained as a proximate result of a Breach: Net Provable Damages plus Defense Costs less Adjustments; . . .
“Adjustment” means . . . all amounts recovered by the Insured or the Acquired Company under applicable insurance policies other than this Policy; . . . any reserves established in the books and records of the Insured or the Acquired Company as of the Closing Date, prepared as of the date on which the Closing Date Balance Sheet is finalized; and . . . any right of set off, or any other gain or benefit that will be realized by the Acquired Company or the Insured arising from the matter(s) giving rise to the Breach other than the right to indemnification under the Agreement.
These definitions raise potential interpretive issues. The latter “Loss” definition may have the effect of reducing the buyer’s recovery by amounts reserved on the balance sheet of either the target or acquirer (implicitly this must refer to reserves established in respect of the particular contingency), unlike, arguably, the first one. Another textual difference that bears mentioning relates to the status of other insurance coverages that may be available. The second policy quoted above uses the word “recovered” in specifying what amounts may be netted out of a claim. The first policy quoted above provides that it constitutes “excess” cover, a term that has been litigated numerous times. Whether these two phrasings could result in a difference in what a policyholder may recover relative to another policy is open to question.
Claims and Dispute Resolution
We have seen R&W policies providing for judicial resolution of claims disputes, but these are the exception, with most requiring arbitration. Arbitration is a common forum for insurance and (especially) reinsurance disputes between sophisticated parties; seasoned arbitrators in this space are well-versed in the interpretive canons associated with insurance contracts. However, in R&W policies, the validity of the claim may rest not only on interpretive issues arising out of the policy but also on the proper construction of provisions in the underlying acquisition contract. In other words, whether a “loss” has occurred in a given instance may hinge on the meaning of a particular representation in the acquisition contract. Deal participants may want to consider whether they would feel comfortable relying on an arbitrator for interpretive resolution in such a situation or if, instead, they would prefer a court.
In any event, the insured party should notify the carrier as promptly as possible when it becomes aware of possible grounds for a claim under the policy. Failure to give prompt notice may give rise to a basis to deny a claim, particularly where such delay can be shown to have caused a detriment to the insurer (as contemplated in many states’ insurance codes).
Issues from Insurer’s Perspective –Due Diligence and Underwriting
The underwriting process varies from transaction to transaction, but insurance companies have attempted to minimize the inconvenience sometimes associated with the application process in order to make their product more appealing. As a general matter, the insurer typically will review various transaction-related documents and have discussions with the insured (buyer or seller) and their advisors to understand the business being sold, how key business and legal issues have been analyzed and addressed and how the disclosure and due diligence process was structured. The perceived thoroughness of a seller’s disclosure process or a buyer’s due diligence process will be important factors in the underwriting decision (both in general or with respect to specific representations and warranties) and the pricing of the insurance.
Document review may include, among other things, the sale agreement and disclosure schedules, legal and financial due diligence reports, financial statements and other financial information and some or all documents contained in a data room. Insurers (or an outside underwriting firm engaged to perform such services) may use not only chartered underwriters but also lawyers and actuaries in conducting such review, which may also entail a review of key contracts that are incidental to the target business such as financing documents with banks or other lenders, major contracts with customers, supply contracts and vendor contracts. In the sale of an entire business, the insurer may focus on the target’s existing risk assessment techniques such as the use of Enterprise Risk Management or similar techniques and programs.
The proposed insured will want to discuss at an early stage with the insurer the process to be followed to confirm that it will meet the timing and other objectives of the buyer and seller.
Issues from Perspective of Deal Participants
Certain categories are often excluded from coverage, subject to specific negotiations with the insurance company. Depending on the particular objectives and needs of the buyer insured or the seller insured, such exclusions may obviate the need for, or reduce the appeal of, an R&W policy. Typical proposed exclusions include:
- Environmental liabilities. However, coverage for these might be obtained by means of a separate pollution liability policy.
- Federal Corrupt Practices Act (FCPA) violations. However, coverage for this may be obtainable if the insured is able to demonstrate a strong compliance and internal controls program.
- Certain tax representations, in particular taxes in certain foreign jurisdictions.
- Certain securities law violations in respect of the target’s publicly-traded securities. However, certain coverage for these might be available from existing D&O policies.
- Misrepresentations known by the seller (in the case of a seller-side policy) or by the buyer (in the case of a buyer-side policy). However, these exceptions can be narrowed through careful drafting, such as restricting knowledge to specified individuals on the “deal team.”
Credit Risk and Regulation of the Insurer
The degree of regulatory oversight over an insurer may be of interest to a prospective policyholder considering R&W
coverage insofar as such policyholder will be exposed, after all, to the credit risk associated with that insurer. In this context it is worth noting that, while all U.S. insurers are generally subject to some solvency regulation, the extent to which a given policy and its related premium rates have been subject to regulatory oversight can vary. Much R&W coverage is written in the so-called excess and surplus lines, meaning that such coverage is less subject to “rate and form” regulation (that is, policy wording and cost of coverage) than typical retail policies. Among other things, insurers have more freedom over the premium rates and policy wordings associated with such policies, and such coverage may not entitle the policyholder to coverage under the state “guaranty funds” (state-organized bodies, funded by the insurance industry, that provide partial payments to policyholders when a carrier becomes insolvent). Carriers organized outside the U.S., in addition, may be subject to regulatory standards that differ even further. For all these reasons, an M&A participant may want to consider the regulatory posture not only of a given insurer (in terms of its financial condition) but also of the particular coverage and rates being proposed.
R&W insurance can be an effective tool in helping the seller or buyer (or both) address critical issues in allocating risk, providing protections and resolving impediments to completing the negotiation of a transaction. Careful review and negotiation of the specific terms of the R&W insurance policy (ideally with the assistance of knowledgeable insurance counsel) are required in order to make sure the objectives of the proposed policyholder are satisfied by the final policy.
However, the utilization of R&W insurance will only be effective if obtained in a time-efficient manner. The process should start early by the proposed insured contacting an insurance broker to confirm that one or more insurers will be interested in providing the proposed coverage, and then proceeding to work out an acceptable and timely due diligence process by the insurer while negotiating the terms of the policy.