Representations and Warranties Insurance in M&A Transactions—Utility and Procedural Considerations

Representations and warranties insurance (RWI) has been available for more than 15 years, but has emerged as a more viable tool in mergers and acquisitions only in the past two to three years, mainly due to increased cost effectiveness and improved terms of coverage. This article takes a closer look at RWI in the mergers and acquisitions context by highlighting the utility of RWI to the transactional parties, outlining the procedures and timing for putting a policy in place, and discussing some of the more heavily negotiated provisions of a typical policy.

Use of RWI in the M&A Context

In M&A transactions, RWI policies primarily are used to substitute all or a portion of the seller’s indemnity obligations under the purchase agreement, meaning that the RWI policy (a) will serve as the buyer’s sole remedy for breaches of the seller’s representations and warranties, or (b) will provide recourse only for breaches of a limited set of representations and warranties while the seller remains liable for breaches of all representations and warranties not covered by the policy.

In addition, RWI policies can serve as a tool for broadening the indemnification package under the purchase agreement by providing additional protection to the buyer beyond the monetary and survival limitations negotiated with the seller. Further, the seller can utilize a RWI policy to insure against its own indemnification obligations for breaches of representations and warranties, with the insurance carrier reimbursing the seller for amounts paid to the buyer on account of indemnification claims under the purchase agreement.

Regardless of its purpose, a RWI policy can be obtained by the seller (a “sell-side” policy) or by the buyer (a “buy-side” policy), depending on which party is seeking the benefit of coverage. The marketplace, however, tends to favor “buy-side” policies given their broader coverage, which includes seller’s fraud. According to Peter Lambert, senior vice president of insurance broker Willis North America, more than 80 percent of RWI policies placed by Willis in 2013 were “buy-side” policies.

Cost and Allocation of Cost

Cost

One of the main factors that has contributed to the increased usage of RWI in the M&A context is that insurance premiums have decreased significantly over the years. Ten years ago, a potential insured probably would have considered the premium for a RWI policy to be reasonable when it was in the range of 4 to 10 percent of the covered amount. Today, these percentages would no longer be competitive.

Says Peter Lambert: “Nowadays, RWI policies generally are priced in the range of 2 percent to 3.5 percent for each dollar of coverage purchased based on a number of factors, including the coverage limits sought under the policy; the higher the amount of coverage, the lower the rate.”

Generally, the coverage amount should be at least $5 million for a RWI policy to be cost effective. RWI policies typically provide coverage ranging from 10 to 20 percent of the target company’s enterprise value.

In addition to the insurance premium, insurance carriers generally charge a non-refundable underwriting fee in the range of $10,000 to $50,000 prior to initiating the underwriting process described in greater detail below.

Allocation of Cost

The question of who pays the premium for the RWI often is a function of who receives the greatest utility from the policy. Because those circumstances vary from deal to deal, it is difficult to generalize. However, as explained below, both the buyer and the seller frequently benefit for different reasons and may agree just to split the cost.

Utility to Buyer/Seller

Utility to Buyer

From a buyer’s perspective, RWI can provide additional protection and comfort in situations where the seller potentially presents a credit risk or where there are multiple sellers and the buyer is concerned about its ability to collect for losses directly from those sellers. In addition, it has become increasingly common for a buyer to introduce the concept of RWI in a competitive auction process to distinguish its bid from others.

For example, the use of RWI may permit a buyer to offer only minimal or no survival of the seller’s representations and warranties, and/or refrain from requiring a holdback or escrow of any portion of the purchase price as security for the seller’s indemnity obligations. For private equity buyers specifically, an additional advantage of RWI is that it may alleviate potential problems associated with the buyer having to pursue indemnification claims against selling stockholders that continue as management and other equity holders of the buyer post-closing.

Lastly, buyers can use RWI policies in connection with public company acquisitions where the representations and warranties typically do not survive the closing and there is no indemnity.

Utility to Seller

RWI also can be used in a number of ways to a seller’s strategic advantage. In particular, RWI is beneficial for sellers that want to reduce, or eliminate entirely, the amount of sale proceeds that a buyer holds back or that are placed into an escrow account. We have come across multiple transactions where a seller rejected an escrow or holdback concept from the outset based on the argument that it would lock up a significant portion of the purchase price for an extended period of time. Although the buyer in most cases could not get comfortable without any such protection, a RWI policy frequently saved the day and bridged the gap between the parties.

Another key benefit of RWI is that it may allow the seller to avoid any ongoing liability for indemnity and to exit an investment with the assurance that it will not be subject to contingent liabilities arising from breaches of its representations and warranties under the purchase agreement. The foregoing benefits are particularly useful for a private equity fund because it will allow the fund to distribute more proceeds to its investors at the closing of the transaction or to redeploy these proceeds into another investment, while reducing the risk of a clawback.

Finally, by relying on a RWI policy, sellers can avoid or minimize issues relating to joint and several liability in the case of multiple sellers, which can be particularly challenging in transactions with minority or passive sellers with little knowledge of, or involvement in, the day-to-day operations of the company being sold.

Process and Timing

Once the determination has been made that RWI is a viable tool for the transaction at hand, the parties must consider the process for putting the insurance policy in place.

Obtaining Non-Binding Quote

As an initial step, the party seeking the benefit of coverage should contact an insurance broker that has experience in placing RWI policies. Says Peter Lambert:

One of the major benefits of involving an experienced insurance broker early on in the process is that we are familiar with the major carriers in the RWI area, such as AIG, Ambridge Partners, Concord Specialty, Allied World, Beazley and Hartford, and can assist the parties in selecting the best carrier for their specific needs. In addition, we can be instrumental in securing non-binding price and coverage quotes from one or more carriers based on preliminary information about the transaction and the parties. Typically, non-binding quotes can be obtained within two or three business days at no cost to the potential insured.

To prepare a non-binding price and coverage quote, the insurance carrier generally will ask for copies of the offering memorandum or other document containing a business description of the target entity, a draft of the purchase agreement and a copy of the target’s most recent financial statements. Prior to the potential insured making any materials available to the insurance carrier, it is advisable that the parties enter into a non-disclosure agreement to adequately protect the confidentiality of any such information.

Underwriting

As soon as an insurance carrier has been selected, the carrier will proceed with an in-depth underwriting review during which it will conduct its own due diligence. The insurance carrier’s due diligence, which is typically done with the assistance of counsel, involves a detailed review of the data room contents as well as a review of existing due diligence reports and related materials prepared by the potential insured or its advisors. This review may culminate in one or more conference calls with the deal team members, including legal counsel, outside accountants and financial advisors, to discuss their due diligence findings and to answer the insurance carrier’s questions.

As part of its due diligence, the insurance carrier also will review the negotiated representations and warranties in the purchase agreement together with the accompanying disclosure schedules. Because even minor changes to the scope of the representations and warranties in the purchase agreement or the related disclosure schedules may have an impact on the coverage available under a RWI policy, it is advisable to keep the insurance carrier apprised of any changes in a timely manner.

Adds Peter Lambert:

Based on our experience, any major insurance carrier with expertise in the space will be able to familiarize itself quickly with the transaction, to run an efficient due diligence process and to readily assess potential risks associated with the transaction. However, in order to provide for sufficient lead time to respond to the insurance carrier’s due diligence requests, which sometimes can be fairly extensive, we urge anyone interested in RWI to start the process as early as possible.

Assuming the insurance carrier is satisfied with its due diligence review, it will issue a draft insurance policy that the parties then will negotiate. Upon conclusion of the underwriting and policy negotiation process, which can be completed as quickly as seven to 10 business days if prompt attention is given to the insurance carrier’s requests, the insurance carrier will bind coverage and issue the RWI policy at the closing of the transaction.

Key Negotiated Provisions

In negotiating the RWI policy, careful consideration must be given to ensure that the policy is consistent with the parties’ expectations and, to the extent applicable, the provisions of the purchase agreement. Based on our experience, the negotiation of the insurance policy focuses on several key provisions that include the following:

1) Scope of Covered Losses and Exclusions:

As outlined above, RWI policies can be structured to provide coverage for all or a specific subset of representations and warranties in the purchase agreement. In either case, it is common for a RWI policy to provide for one or more of the following exclusions from coverage:

• RWI policies typically do not cover issues of which the insured had knowledge prior to the inception of the policy. From the insured perspective, it is therefore advisable to limit the definition of “knowledge” in the RWI policy to the actual knowledge of a limited number of its internal deal team members.

• In addition, RWI policies exclude from coverage information described in due diligence reports or matters set forth in the disclosure schedules to the purchase agreement (e.g., pending litigation).

• A RWI policy also may have deal-specific exclusions where the insurance carrier cannot get comfortable in insuring all or a portion of a particular representation or warranty. For example, in situations where environmental issues are a principal risk factor of the target company, a RWI policy may exclude from coverage the representations and warranties regarding environmental matters, and the insured may need to resort to a customized environmental insurance policy designed specifically to cover the environmental exposure. We also have encountered situations where the RWI policy itself modified, solely for purposes of the RWI policy, the language of a representation in the purchase agreement so as to ensure that the representation (as modified) falls within the coverage afforded by the RWI policy.

2) Term of Coverage:

Frequently, the terms of a RWI policy mirror the indemnity terms in the purchase agreement, including with respect to the survival period of representations and warranties that the parties negotiated. Some buyers, however, want the RWI policy to run beyond the 12 to 24 months survival periods commonly found in purchase agreements.

In this case, an insurance carrier may be willing to underwrite a RWI policy for a longer period with respect to selected representations and warranties under the purchase agreement and to cover claims that become apparent only after the survival period under the purchase agreement has ended.

3) Subrogation:

Under the terms of a RWI policy, the insurance carrier generally will be subrogated to any rights of recovery that the insured may have for the loss paid by the insurance carrier. Here, the negotiation typically revolves around any exclusions (e.g., a RWI policy may provide that the insurance carrier may not assert subrogation claims against the officers, members or partners of the insured) and whether the insured will be required to take any actions to secure the rights and remedies of the insurance carrier in subrogation.

In the case of “buy-side” policies, insurance carriers typically agree to waive subrogation rights against the seller, except for fraud for which the insurance carrier will preserve subrogation rights in the event it pays a loss to the buyer based on the seller’s fraudulent conduct.

Conclusion

We have successfully incorporated RWI in several recent transactions and it has proven to be an effective tool for bridging gaps that otherwise stood to threaten the entire transaction process. Given its improved economic viability in the M&A context, a RWI policy can offer alternative benefits to the transaction parties compared to the more traditional escrow and holdback arrangements.

Although insurance carries and brokers have streamlined the process for implementing a RWI policy over the past couple of years in response to market needs, the transactional parties and their respective advisors will have to understand that coverage cannot be obtained overnight. Accordingly, the parties should initiate the process as early as possible, but no later than three to four weeks prior to the anticipated binding of coverage at the closing of the transaction.

Knowing the utility of RWI in certain circumstances and the lead time and process of obtaining RWI in the context of an M&A transaction is something every transactional professional should have in his/her toolbox.