Risk and uncertainty has been pervasive throughout the first quarter of 2020. Mergers and acquisitions (M&A) has been no exception, and the allocation of the risk of loss due to a breach of representations and warranties is paramount to parties negotiating a deal. As a result, parties are increasingly hedging against uncertainty by relying on representations and warranty insurance (RWI). While RWI will not provide protection against all deal risks, it does provide some measure of stability and control to a deal at a time when instability reigns.
RWI has steadily gained prominence in M&A transactions during the past decade. It is now particularly common in transactions with a value in excess of $10 million in which the seller is an exiting founder or financial seller (private equity investor). RWI covers breaches that range in scope from tax liability and misstated financial statements to intellectual property infringement and environmental liability.
Buyers are frequently the insured party, bringing claims for indemnification to the insurer directly. Though less common, RWI is available for sellers to backstop their direct liability to a buyer. Prior to closing, insurers will work closely with a buyer and counsel to track the transaction due diligence and agreement structure. A buyer or its counsel will prepare a due diligence memo to be shared with the insurer, identifying risks, deficiencies and material disclosures. The insurer may then exclude identified liabilities and risks from the policy. Once a deal closes, the policy is bound.
RWI has become more common in mid-market M&A as more insured parties are successful in making claims. Proven viability has brought more insurers to the market, and increased competition yields a more cost-effective product with a streamlined process for incorporating RWI into a transaction. As these factors have improved, RWI has become more user-friendly. M&A principals and M&A advisors now have a better understanding of the benefits and limits of RWI, and it has become a less exotic feature to M&A transactions generally.
One important RWI consideration for a buyer is in a bid or auction scenario. Incorporation of RWI will likely make a bid more attractive since a significant portion of a seller’s risk will be allocated to the insurer.
RWI as the primary source of recovery also limits (or removes altogether) the need to escrow a portion of the purchase price and, therefore, increase the closing proceeds to seller.
With RWI, negotiating the representations and warranties in a purchase agreement is a more efficient process. Since the representations and warranties are insured, the parties may not need to negotiate as heavily over materiality, dollar thresholds and knowledge qualifiers. The primary focus on the seller’s representations and warranties can be limited to (i) the disclosure burden on the seller, and (ii) conforming the representations and warranties to market terms the insurer will accept. Notably, most RWI policies allow for a materiality scrape.
Buyers take comfort in the fact that indemnification will come from a financially capable institution, rather than an individual seller or holding corporation that may have already distributed the payout.
Deals frequently contemplate that key sellers will stay involved post-closing. This may be as a minority owner, an executive or a consultant, among other roles. Where the post-closing relationship will be important, being required to seek indemnification from a third-party insurer rather than the seller directly will help preserve the relationship. It is no surprise that the parties are more cooperative, and disputes are resolved quicker, when an insurer will pay out the loss caused by the breach of a representation.
Finally, a buyer typically obtains a longer indemnification survival period when indemnification is provided by an insurer, as opposed to indemnification directly from a seller.
As with any insurance policy, there are policy exclusions. Insurers will have standard exclusions for pension liabilities, asbestos or PCBs, as well as purchase price adjustments. Material items listed in the disclosure schedule that the buyer is not comfortable closing over will be likely to require a special indemnity. It is important to note that all known breaches will be excluded from a policy, whether or not reported to the insurer or included in a diligence memo.
RWI will not cover breaches of covenants or forward-looking statements, like a traditional indemnity escrow would. RWI will result in a higher up-front cost to the buyer by virtue of the (nonrefundable) underwriting fee and premium.
Lastly, the RWI process will add an extra layer to the diligence process. The buyer and counsel will have an underwriting review call with the insurer. This call will review the buyer’s diligence memo and contain a variety of specialist Q&A sessions. This call will serve to confirm that the buyer has completed sufficient diligence for the insurer to rely on before issuing the policy. While an extra step to the process, the time spent is outweighed by time otherwise spent negotiating an escrow and representations and warranties in an uninsured deal.
RWI and COVID-19
The COVID-19 pandemic will likely impact the use of RWI in the coming months. For deals that have closed, there will likely be no impact as RWI applies to representations and warranties made at signing/closing, not covenants or the impact of future events. For future deals, RWI is intended to cover the unknown. Time will tell if standard RWI exclusions develop with respect to COVID-19-related risks.
David J. Murray is a partner at Phillips Lytle LLP who concentrates in acquisitions, mergers, divestitures, joint ventures, corporate finance, corporate governance, public and private securities offerings, private equity and venture capital investments, and other business transactions. He can be reached at (716) 847-5453 or firstname.lastname@example.org
Timothy P. Kucinski is an attorney at Phillips Lytle LLP who focuses his practice on corporate law, with an emphasis on mergers and acquisitions, international and domestic business transactions, and corporate governance. He can be reached at (716) 847-7056 or email@example.com.