Canadian M&A practitioners are increasingly using representation and warranty (R&W) insurance as a competitive tool in deal negotiations. The insurance, which provides coverage for breaches of a seller’s representations and warranties discovered post-closing, has gained traction in the Canadian market following widespread use by financial investors in the United States and United Kingdom.
The proliferation of R&W insurance internationally has produced a fairly efficient and tested product for Canadian deals when used in the right circumstances. The maturity of the market abroad means that Canadian deals now benefit from lower premiums, more fulsome protections and speedier underwriting processes. Many Canadian deal-makers and their advisers have become conversant with the insurance, its benefits and associated risks, and how it may be used effectively at times to execute on competitive transactions.
HOW DOES R&W INSURANCE WORK?
R&W insurance shifts certain transaction-related risks from the contracting parties to a third-party insurer who underwrites those risks for a fee.
An R&W policy may be purchased by either the buyer or seller. If commercially advantageous, a party may purchase the policy without the consent, or even knowledge, of the other party to the transaction. However, in practice it is more common for both parties to agree in advance that they will purchase R&W insurance. The buyer and seller will then negotiate the reps and warranties with the understanding that the bulk of any post-closing liability for breaches of reps and warranties will rest with an insurer. While breaches known to the insured party at the time of entering into the policy will not be covered, typically such knowledge is defined as the actual knowledge of management, the board of directors and deal team.
A “buy-side” policy may extend the seller’s indemnity obligations beyond the negotiated cap and, in some cases, for a longer survival period. The policy will provide the buyer with direct recourse against the insurer for a seller breach for amounts above the retention amount (the equivalent of a deductible), which bypasses the need to make a claim directly against the seller before seeking coverage.
Conversely, a “sell-side” policy will provide the seller with the amount of coverage purchased, up to the maximum indemnity amount under the purchase agreement, but the seller will continue to be directly liable to the buyer for a breach. Once the seller pays a claim, the insurer will reimburse the seller for the insured amount and any defence costs.
The U.S. market is generally of the view that, absent fraud, indemnity claims will be paid by reputable insurance providers with little controversy (notices of potential claims are reportedly given on approximately 20 per cent of policies written). However, certain buyers take less comfort from a policy when compared with more traditional protections, such as a seller indemnity coupled with a purchase price holdback or escrow.
WHEN IS R&W INSURANCE MOST HELPFUL?
R&W insurance may be particularly useful in certain kinds of transactions, such as:
- Those involving distressed targets, where the buyer is concerned it may not have recourse against a solvent seller down the road
- A competitive auction in which either the seller requires that R&W insurance forms part of the bid submission or where a successful bidder needs to distinguish its offer
- Time-sensitive transactions, where lengthy risk-allocation negotiations can be short-circuited with insurance
- Cross-border deals where the enforcement of an indemnity right in a different jurisdiction may be challenging
- Transactions in which the sellers have an overriding interest in securing a clean exit without holdback and providing the highest payout to investors at closing, such as private equity funds or multi-generational family-owned businesses
- Where multiple sellers have negotiated several liability (as opposed to joint or joint and several liability), making the buyer less assured of a full recovery
- Where the sellers will have a continuing business relationship with the buyer post-closing and an indemnity dispute would not be commercially desirable, such as when management shareholders continue with the target post-acquisition
R&W insurance may not be the appropriate, or only, solution in certain other types of transactions, including:
- Where there are particular concerns about environmental liabilities or future adverse tax rulings (both of which may be excluded from coverage, or require separate insurance policies), or pending litigation, which will be excluded as it is a “known” liability
- Where the perceived risk relates to a post-closing purchase price adjustment, which should be covered by a separate adjustment mechanic in the purchase agreement and escrow
- Those that are less than C$20-million, in which case the cost of the premium and size of retention may not be commensurate with the risk of a breach
- Those that are more than C$2-billion, in which case premiums may be too high, policy maximums too low or insurers may be unwilling to provide sufficient coverage
HOW MUCH DOES IT COST AND HOW LONG DOES IT TAKE?
R&W insurance has become an established product in the U.S. and U.K., in large part owing to the market perception that insurance carriers have a reasonable record of paying claims. The Canadian market is working to reach a similar comfort level; the product’s proponents believe that insurers will continue to satisfy legitimate claims in order to maintain reputational integrity and build market share.
Premiums have dropped sharply over the past decade: a premium in the range of three to four per cent of the coverage purchased is now typical. Retentions will range between one and three per cent of the purchase price. The seller will typically be liable to the buyer for claims up to the amount of all, or a portion of, the retention. This brings down the price of premiums, as the buyer maintains “skin in the game” and is sufficiently motivated to ensure its reps and warranties are accurate.
The reputation of the parties and their legal counsel, overall transaction quality, scope of buyer due diligence and breadth of reps and warranties to be insured will also directly influence a policy’s price.
The underwriting process should generally work for most deal timelines. Premium quotes can be obtained in advance based on the seller’s most recent financial statements and a draft of the purchase agreement. Typically, the underwriters will not begin their work until the buyer has secured exclusivity. If necessary, the full underwriting review process, which is similar in scope to an audit of the buyer’s due diligence process, can be expedited and a policy issued in one to two weeks.
HOW COMMON IS R&W INSURANCE IN CANADA?
The use of R&W insurance has increased steadily in the U.S. over the past decade. Comparatively speaking, the growth of the product in Canada has on an anecdotal basis been much faster, with one Canadian insurer reporting approximately 200 per cent growth in the number and dollar amount of policies issued, year-over-year, since it first introduced the product in Canada in 2010. A second Canadian insurer expects the dollar amount of its policies to increase by 25 to 50 per cent in 2015 based on annualized numbers. Both insurers compare the current Canadian market to that of the U.S. in 2011, which increased six-fold by 2014.