The Basics

Representations and warranties insurance (R&W Insurance) protects a party from financial losses resulting from inaccuracies in the representations and warranties made about a target company or business in connection with certain corporate transactions such as mergers and acquisitions. R&W Insurance policies are made up of both buy-side (most common) and sell-side policies.

In a traditional buy-side R&W Insurance policy, the buyer is the insured and the objective is to provide coverage against financial loss suffered as a result of a breach of the seller’s representations and warranties. The parties’ exposure in the case of a breach of the representations and warranties is limited to a relatively low amount referred to as the retention amount. In most R&W Insurance policies, the retention amount is generally equal to between 1–3% of the enterprise value of the transaction. The R&W Insurance policy protects against any exposure in excess of the retention amount and up to a negotiated limit.

The reasons for obtaining R&W Insurance may include fear of an insolvent or financially weak seller, a private equity seller wishing to facilitate a “clean” exit, reluctance of seller to retain proceeds in escrow, investing in new or unfamiliar jurisdictions or industry sectors, improving the risk profile of a deal through insurance, or enhancing buyer’s bidder status in an auction context.

Keys to Avoiding Employee Benefits Related Policy Exclusions

For a buyer utilizing R&W Insurance, the goal is to obtain a comprehensive insurance policy with few, if any, policy exclusions. In order to obtain the most comprehensive R&W Insurance policy, buyers and their counsel should become familiar with the insurance providers’ underwriting process. During the underwriting process, insurance providers generally utilize outside counsel, including subject matter experts in the area of employee benefits, whose role is to review the diligence process and the documents underlying the corporate transaction and make recommendations regarding potential policy exclusions.

The employee benefits exclusions in an R&W Insurance policy are generally broken down into two categories: (i) Standard policy exclusions and (ii) transaction specific policy exclusions. The standard employee benefits–related policy exclusions typically include an exclusion for any losses related to the underfunding of a defined benefit plan and any losses relating to potential withdrawal liability associated with a multiemployer pension plan. These standard policy exclusions will be included in the R&W Insurance policy regardless of the diligence process.

The transaction specific policy exclusions are determined during the underwriting process (i.e., the insurers’ diligence process). To limit the number of transaction-specific policy exclusions, buyers and their counsel should ensure that they conduct a thorough due diligence process.

The following employee benefits arrangements are generally the focus of the underwriting process:

  • Retirement plan arrangements
  • Health and welfare arrangements
  • Equity compensation arrangements, including compliance with Section 409A of the Internal Revenue Code (Section 409A)
  • Any other employee benefits arrangement, including employment agreements, that are specifically covered by the representations and warranties in the acquisition agreement

To the extent applicable, buyers’ legal diligence report should cover the topics mentioned above in detail. The legal diligence report should address any areas of legal compliance concern and, if practicable, include a potential exposure amount related to the concern. Often, buyers and their counsel make the mistake of conducting a less thorough diligence process because they believe that the R&W Insurance policy will cover any potential exposure related to the representations and warranties; however, a failure to conduct proper diligence will often result in transaction-- specific policy exclusions covering any benefits arrangements not addressed in the legal diligence report. For example, if target has previously granted stock options but buyers’ counsel did not conduct any diligence to ensure that such options were issued in compliance with Section 409A, the final R&W Insurance policy will likely include a broad-based policy exclusion covering any losses relating to the failure of target to comply with Section 409A.

The employee benefits diligence process should not be limited to any specific materiality threshold. Many buyers make the mistake of categorizing a potential exposure as immaterial in light of the overall transaction value or justify the lack of diligence with respect to an employee benefits arrangement because they view the risk as immaterial; however, given the low retention amounts in R&W Insurance policies (1–3% of the transaction value), the level of materiality for purposes of insurance can be far lower than what the parties deem “material” in light of the overall transaction value.

The final step in the underwriting process is a short underwriting call (approximately 15 minutes of which will be dedicated to employee benefits topics) during which the underwriter and their outside counsel ask questions on the diligence process and inquire about any specific employee benefits–related concerns raised by the transaction-related documents. This call should not be taken lightly; preparation is the key to avoiding additional policy exclusions (always request an agenda and questions in advance). Failure to provide adequate answers during the underwriting call can often result in follow-up requests and, at times, transaction-specific policy exclusions if the answers indicate that insufficient diligence was conducted by buyer.