Representations and Warranties Insurance: Salient Issues to Consider

Benefits of R&W Insurance

Just about 10 years ago, had a lawyer or a business team member on either side of an M&A transaction tried to initiate a conversation with a private equity firm or an M&A lawyer on the other side regarding representations and warranties (R&W), he or she would have received a negative response and the parties would have moved back to the negotiation table. An escrow mechanism would have also been proposed causing numerous concerns, primarily for the seller

The negotiations surrounding R&W and related indemnification provisions in the context of M&A transactions have always been particularly burdensome, since buyers and sellers generally have remarkably opposite incentives.

R&W insurance can offer both buyers and sellers the additional assurances needed to close the deal and may be especially useful in global M&A transactions, not only by contributing to the successful closing of the underlying acquisitions but also by enhancing the delicate day-to-day dynamics for deals providing for continued business relationships between sellers and buyers.

History and Development

R&W insurance policies have been offered by a number of insurance companies since the early ‘90s. For at least the first 15 years, however, their use was fairly contained due to factors such as an unrealistically long underwriting process, the high cost of the policies and generally unattractive policy terms.

Over the course of the past few years, the cost of obtaining R&W insurance has fallen dramatically, and the underwriting process has improved. More global insurers have entered the market as well. As a consequence, the purchase of R&W insurance dramatically increased starting in 2012, even while overall M&A activity decreased from 2011. The most active brokers in this space are reporting significant year-over-year upticks between 2014 and 2015 in terms of both the number of programs written and the limits placed.

Better terms and conditions are offered by insurance companies which include higher limits and longer policy periods.

Today R&W insurance policies are being offered by most global carriers. These policies cover either (i) the buyer against the seller’s breaches of R&W (“buyer-side”) or (ii) the seller against losses recovered from it by the buyer resulting from such breaches (“seller-side”). Buyer-side coverage represents approximately 80 to 90 percent of the total number of policies currently issued. Differently, in 2008 and throughout the financial crisis, seller-side policies dominated the market. Buy-side will also typically cover breaches due to seller fraud, whereas sell-side policies generally will not.

The Underwriting Process

In a regular M&A transaction, the insured party, independently or through the assistance of deal counsel, appoints an insurance broker that assists identifying potential R&W insurers.

The broker then selects a pool of insurance companies and requires that each such company conduct an initial high-level review of the acquisition. As a result of their reviews, the insurance companies present proposed quotes to the insurance broker referred to as a “non-binding indication.” At this point, the insurance broker prepares summaries of each of the quotes for the insured party’s selection. Both brokers and insurance companies understand that the need for insurance quotes is typically on a very fast track. For this service, which typically takes approximately 24 hours, the insurance broker charges in the U.S. a fee equal to a percentage of the insurance limit purchased (between 0.5 and 1 percent) or a percentage of the premium (typically 15 percent) that becomes due and payable only when a policy is actually purchased.

The underwriting process follows the selection of the insurance company. During the underwriting process, the insurer will conduct a review of the transaction to assess whether the process has involved sufficient negotiation among the parties and due diligence review. The insurer’s diligence requests typically include a copy of the acquisition agreement, the legal and financial due diligence memoranda, any ancillary transaction agreements and financial statements, as well as a list of follow-up diligence questions. The insurers often charge an underwriting fee for these services, typically ranging between $25,000 and $50,000, depending on the complexities involved.

Upon completion of the insurer’s due diligence review, the parties, assisted by legal counsel, proceed to negotiate the insurance policy. The entire process (beginning with the selection of the broker) typically takes between one to two weeks to complete, though policies have been underwritten and placed in as little as three business days under exceptional circumstances.

R&W Insurance’s Common Terms and Exclusions

In the majority of instances, R&W insurance policies cover all of the target company’s and seller’s R&W as they are drafted in an acquisition agreement. In some circumstances, however, policies only cover certain R&W.

The policy period usually commences immediately at the closing of the transaction,. Buyer-side policies can be negotiated to survive past the expiration of the R&W of the sellers in the acquisition agreement, while seller-side policies typically have terms mirroring exactly the term of the survival period of the R&W agreed upon in the acquisition agreement.

The coverage limit in seller-side policies is often equal to the indemnification cap, while in buyer-side policies a 10 to 20 percent of purchase price limit is common. Policy premiums are transaction specific.

Interestingly, for global M&A transactions, policies purchased with a U.S. insurer tend to be slightly more expensive but generally also have better terms.

Both in seller-side and buyer-side policies, the premium is normally paid in full at the closing of the transaction. The actual determination as to who pays the premium is a matter of negotiation.

Although exclusions are not as numerous as those contained in other types of policies such as traditional D&O or E&O policies, R&W insurance policies do not cover all types of losses. Common exclusions include losses resulting from:

• (i)   breaches of covenants;
• (ii)  issues related to purchase price adjustments;
• (iii)  matters of a risk level that is deemed uninsurable;
• (iv)  forward-looking statements;
• (v)   intentional and criminal acts and fraud; and
• (vi)  matters known by the insured’s deal team prior to closing.

Issues to Consider When Negotiating Transaction Documents

The necessity of procuring R&W insurance can be determined by the parties at any point in a transaction. For example, a buyer may insist on an IT rep capped at purchase price, which could lead the seller to purchase a sell-side policy to cover that exposure and allow it to distribute the proceeds of the sale. Certain auctions by private equity companies represent an exception as sellers in such deals may require insurance as a prerequisite to the transaction.

Particularly Effective in Cross-Border Transactions

Increasingly, cross-border deals can benefit from the availability of R&W insurance. The global insurance market is becoming more mature and insurers and brokers are gaining cross-border experience, becoming more sophisticated and willing to begin to offer global insurance policies and underwriting services that are very attractive in cross-border transactions involving a variety of jurisdictions. Buyers may lack knowledge of new locations in which they will be operating post-closing. Also, cross-border transactions in today’s world entail certain cultural, jurisdictional, legal and political risks that are difficult to quantify with any degree of precision. R&W insurance becomes an extremely valuable tool in these contexts.

Europe

According to Fortune, European M&A deals were down 41 percent in the second quarter of 2016 to $147.3 billion. In particular, Britain’s vote to leave the European Union earlier this year has dented some of the confidence required by corporate boards to approve M&A transactions. While R&W insurance has been around for some time in Britain and Europe, an increase in the use of transactional insurance will certainly encourage European transactions.

LatAm Countries

Given the current economic and political environment in Latin America, the use of R&W insurance there will, in all likelihood, continue to grow exponentially during 2016 and beyond. While lower commodities prices, an economic deceleration in major trading partners (including China, primarily) and political challenges among some of Latin America’s largest economies have significantly slowed down M&A activity in the region already since 2015, other political and economic factors will create attractive transaction opportunities that will likely be available over the next few years.

There is no doubt that, especially for U.S. buyers interested in buying assets in Latin American countries, R&W insurance can provide the additional deal security that, due to economic, jurisdictional or political considerations, buyers increasingly are and should be seeking.

Asia

Similar considerations apply to Asia where a number of insurance companies have offered these policies for the past few years. While R&W is still far from being considered for every Asian acquisition, the number of transactions in this area of the world in which the parties are utilizing this type of insurance product has increased exponentially and will likely increase further.

In Conclusion

As the global economy and political landscapes become more and more volatile, R&W insurance may be just the type of salve needed to soothe the nerves of even the most jittery transactional counterparties.