The Covid-19 pandemic has significantly disrupted M&A activity and caused deal makers to re-evaluate traditional approaches to managing particular deal risks and the underlying agreement terms to address them.
Those sorts of changes are also affecting the market for representation & warranty insurance, with RWI carriers taking an increasingly cautious approach to Covid-19, demanding more detailed due diligence processes and considering broad Covid-19 exclusions—i.e., refusals to underwrite any breaches or losses arising from the pandemic.
Effect on the Due Diligence Process
At the outset of most underwriting processes now, RWI carriers are identifying the effect of Covid-19 as a “heightened” area of diligence—particularly for targets in disproportionately-impacted industries, such as travel and hospitality.
Among other areas, carriers are focusing on the target’s:
- supply chain management;
- key customer relationships;
- material contracts (including breaches thereof and any force majeure provisions at issue);
- workplace health and safety;
- geographical footprint relative to Covid-19 outbreaks;
- existing insurance coverage (including under business interruption policies);
- business continuity exposure relating to “work from home” and employee quarantine arrangements, including IT and data privacy/security issues.
In general, a buyer that can walk carriers through its diligence process on these points in credible and reassuring terms will be better able to resist, or narrow, exclusions and other terms that may limit coverage.
RWI carriers’ focus on the pandemic’s effects has also extended to post-signing diligence. Closing bring-down calls now generally include a robust set of questions from carriers on Covid-19’s impact on the target’s business during the interim period (particularly for deals with prolonged interim periods).
Carriers are particularly focusing on any breaches of, or consents given with respect to, interim operating covenants, new litigation, target financial performance and any supplier, customer and employee issues, including virus outbreaks, as well as the implications of the pandemic on transactional levers in the underlying agreement, such as the material adverse effect (MAE) closing condition.
Dealmakers are advised to request bring-down call agendas as early as possible, allowing for careful preparation and coordination among brokers, counsel and internal diligence teams, who given “work from home” arrangements will likely be taking these calls from separate locations.
Effect on Policy Terms
Unsurprisingly, in the current environment, the results of buyers’ and carriers’ due diligence are informing carriers’ decisions on the extent to which they are willing to insure for breaches of representations arising out of Covid-19 related issues.
While the market has not yet converged on a single approach, carriers are generally taking one of the following approaches with respect to Covid-19 exclusions:
- Blanket approach. A number of carriers are requiring exclusions in many, if not all, of their non-binding indications and, ultimately, their issued policies. In some circumstances, however, such carriers may be willing to carve out certain reps that may be unaffected by the pandemic from the blanket exclusion—e.g., fundamental reps or financial statement reps based on audited year-end financials that predated the pandemic.
- Industry-specific approach. Certain carriers are requiring upfront exclusions in their RWI policies for specific industries disproportionately affected: transportation, entertainment, healthcare, retail, hospitality, personal care and education. If a target doesn’t operate in these areas, the carrier may be amenable to binding a policy without an exclusion, subject to heightened diligence.
- Signing-coverage approach. Some carriers have been willing to issue policies without exclusions for purposes of the signing representations but have expanded the definition of “interim breach” to exclude coverage for a post-signing deterioration of business relating to Covid-19 that results in a breach of the closing representations. This approach may be short-lived, however, in light of carriers’ growing skepticism over the quality of due diligence and target disclosures at signing given “work from home” limitations on deal teams.
- Case-by-case approach. Other carriers are weighing the risk profile of each deal independently before determining whether to include an upfront Covid-19 exclusion in non-binding indications or to instead treat Covid-19 as a heightened diligence item and defer a decision on requiring an exclusion. Even where carriers include an upfront exclusion in non-binding indications, some may still be open to narrowing the exclusion pending underwriting outcomes.
Regardless of approach, carriers across the board are generally refusing to cover specific “Covid-19 representations” (such as those regarding the pandemic’s effect on the business).
Although some commentary has suggested that buyers with strong MAE clauses (i.e., those with limited exclusions which do not implicate Covid-19) may be more successful convincing insurers to be generous on exclusions (since in theory the buyer could claim an MAE and avoid closing if faced with serious Covid-19-related deterioration in the target business), sellers have been generally been succeeding in negotiating MAE definitions that prevent a buyer from walking over Covid-19-related reasons.
Drafting Exclusions Where Required
Where carriers require Covid-19-related exclusions, buyers should be wary of how the exclusion is implemented.
Specifically, some carriers have sought to carve losses stemming from Covid-19 out of the definition of “loss”, as the burden of demonstrating the extent to which a Loss has occurred is borne by the insured, whereas the burden for proving an exclusion applies is borne by the carrier.
Even where Covid-19 is addressed as an exclusion, buyers should be thoughtful about the exclusion’s scope. For example, if the exclusion generally covers any Loss “arising out of the Covid-19 pandemic”, the insurer may seek to exclude Losses that are only indirectly related to Covid-19.
Instead, buyers should consider narrowing the exclusion to losses “directly arising out of the Covid-19 pandemic” or arising from a specific Covid-19 effect, such as a supply chain interruption.
As the Covid-19 pandemic continues, deal makers looking to seal insured deals will need to be thoughtful in how they approach diligence, how they present their diligence to carriers and how they negotiate the underlying policies, as there is not yet a one-size-fits-all approach.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Paul Tiger is a corporate and M&A partner at Freshfields Bruckhaus Deringer who advises on public and private M&A transactions and private equity investments. He also counsels companies and their boards on stockholder activism, corporate governance, and fiduciary duty considerations.
Tomas Rua is a corporate and M&A associate at Freshfields Bruckhaus Deringer whose practice focuses on corporate and financial transactions, particularly mergers and acquisitions.
Matthew Heinz is senior managing director at Aon Transaction Solutions (ATS). He co-founded the ATS team in 2013 as the national practice leader for reps and warranties insurance and is the current co-practice leader of the group, which has become the largest and most diverse group of transaction liability insurance brokers in the industry.
Allyson Coyne is managing director and chief broking officer of Aon Transaction Solutions (ATS). She was a co-founder of the ATS team in 2013 and is the longest-tenured R&W broker in the North American marketplace.