The news has been rife of late with announcements of intended mergers, including Amazon and Whole Foods, Sprint and Comcast, and the National Enquirer and Time Inc., to name a few. Although such deals are nothing new, the use of representations and warranties insurance (R&W insurance) is increasingly becoming a key component in the decision-making process for buyers and sellers alike. R&W insurance provides coverage for breach of representations or warranties contained in deal documents in addition to, or as a replacement for, indemnity provisions. R&W policies allow buyers and sellers to shift enough of the risk to third-party insurers to provide the certainty necessary to close the deal.
In a typical transaction, the seller agrees to indemnify the buyer for losses resulting from breaches of reps and warranties, usually subject to a cap. The seller will often commit to placing an agreed upon amount in escrow to secure its indemnification obligation. However, tying up funds in escrow can sometimes present a significant obstacle to closing the deal.
Moreover, indemnification, escrows and holdbacks may offer insufficient protection to a buyer for significant breaches. For example, the seller may require a substantial threshold before any indemnification obligation is triggered. Further, the buyer’s sole remedy for indemnification after the escrow is exhausted is to bring a claim against the seller. This could be risky, particularly because the buyer is relying on the seller’s creditworthiness, not to mention the additional time and resources necessary to pursue the seller.
R&W insurance can either replace or supplement the seller’s indemnification obligation. Although R&W insurance is not appropriate for every deal, it may be a valuable tool to assist getting parties to the closing table. R&W insurance is available for both buyers and sellers, but as it is more commonly utilized on the buyer’s side, we will focus on that.
With a buyer-side R&W policy, if the seller breaches one of the representations or warranties in the purchase agreement, the buyer is able to recover the resulting losses from the insurer. Like other insurance policies, a retention must be eroded by claims before coverage is provided, so it is important to consider deal size when determining whether to obtain an R&W policy. Given the amount of limits that can be purchased in the marketplace, insurance pricing and the size of a typical escrow or indemnity requirement, R&W insurance is most effective for deals between $20 million and $2 billion.
Although many parties look to R&W insurance to spread risk, the policies can also be used as effective bargaining tools in some of the following situations:
- Bid Enhancement. In an auction process, a potential buyer may wish to distinguish his or her bid from others by arranging and agreeing to look at an R&W insurance policy to reduce or take the place of an indemnity from the seller. The presence of the policy substantially minimizes the seller’s risk, allows the sellers to take more money “off the table” at closing, and can make the overall offer more attractive.
- Distressed M&A Indemnity. Additionally, if a buyer is concerned about the credit risk of a seller post-closing, R&W insurance would allow the buyer to be indemnified for breaches of representations and warranties in the acquisition agreement, while avoiding the seller’s credit risk.
- Negotiation. In a non-competitive setting, buyers may be able to negotiate a lower purchase price by offering to obtain R&W insurance, reducing the seller’s risk in the transaction.
- Finalizing Deals. Agreeing on the terms of the indemnity, cap, threshold, escrow, and/or survival period for each representation and warranty may prove challenging for buyers and sellers. R&W insurance shifts a portion of the risk to the insurer, allowing the parties to bridge the gap between potential roadblocks more easily.
- Enhanced Survival and Coverage. R&W Insurance allows buyers to obtain a longer survival period of representation and warranties than may be typically obtained from sellers and coverage limits not tied to a percentage of the purchase price.
Coverage at a Glance
Although each policy is unique, an R&W policy typically covers “Loss” from “Claims” made by the buyer for any breach of, or an alleged inaccuracy in, any of the representations and warranties made by the seller in the acquisition agreement. Coverage is generally afforded on a blanket basis for all representations and warranties to the extent such representations and warranties fall within normal ranges and are not overly buyer-friendly, (and subject, of course, to policy exclusions).
For example, R&W policies generally do not cover known issues, such as issues discovered during due diligence, described in disclosure schedules, or “new” matters occurring and discovered by the insured in the interim period between signing and closing. R&W policies likewise do not cover purchase price, net worth or similar adjustment provisions, underfunding issues, certain environmental liabilities, or foreign corrupt practices.
Time and Cost to Obtain Coverage
Similar to other insurance, once a buyer has decided that R&W insurance is appropriate, coverage can be solicited through an insurance broker or agent. Many national insurance brokerages have specialized units that deal with R&W insurance, and are familiar with the fast-paced nature of M&A transactions. The premium for R&W insurance will vary based on numerous factors, including the size of the transaction, the level of risk involved, the deductible and the cap. Premiums typically range from 2-5 percent of the limit of liability. For example, a $20 million policy typically costs between $400,000 and $1,000,000. Before writing the policy, the carrier will require the buyer to complete some due diligence and allow the carrier access to the data room, and may charge a non-refundable fee ($25,000-$50,000 which if coverage is placed, comes out of the premium cost usually paid at closing) to cover its costs during the underwriting process. Most deals can be underwritten in seven to ten business days.
R&W policies can assist sellers and buyers alike in getting to the closing table, and to provide protection to the parties after the deal has closed. It is important, however, that an R&W policy be carefully structured to appropriately shift the risk. This often requires changes to a typical purchase agreement to confirm that the policy is reflected. Moreover, it is likewise important that the policy and declarations be evaluated to guarantee that the underwriter provides all the coverages expected. Having coverage-savvy lawyers on the deal team will help ensure that the right coverage is secured and that it is well-suited to the deal.