More and more parties to M&A transactions are utilizing representation and warranty insurance (“R&W insurance”) as a tool to reach agreement. While R&W insurance has been around for many years, its popularity has soared recently, especially in middle market transactions valued between $20 million and $1 billion. R&W insurance provides coverage for a breach of a representation or warranty that results in losses or an indemnification claim. While it is available to both buyers and sellers, it is more often used by buyers.
The increasing popularity is due to a number of factors, including the growth of the insurance market, which has developed better pricing for policies, expanded policy terms and features to better mirror traditional indemnification packages and established trust in the market regarding the insurers ability and willingness to administer and pay claims.
Structure of R&W Insurance Policies
Due to the nature of an R&W insurance policy and the developing insurance market, the terms of each R&W insurance policy are negotiated to suit the insured’s needs. All policies are “claims-based”, meaning that the breach must occur, and the claim must be filed, during the term of the policy in order to be valid.
Scope of a Policy
As its name suggests, R&W insurance will only cover breaches of representations and warranties in the transaction agreement. Generally, it does not provide coverage for breaches under the purchase price adjustment provisions, covenants or any provisions other than the representations and warranties. A policy will typically cover all “operating” representations and warranties,¹ but the insured can also opt to insure only certain reps and warranties. Most, if not all, policies exclude reps and warranties related to products liability, environmental liabilities, tax liabilities, FCPA violations, existing high-value litigation liabilities and securities laws, among others.
The scope of an R&W insurance policy may vary based on whether it is a buyer policy or a seller policy. For instance, seller policies generally mirror the seller’s obligations in the agreement. The policy’s definition of “losses” will mirror the definition of “losses” in the transaction agreement, and the policy’s aggregate limit will match the cap on the seller’s indemnification obligations in the transaction agreement. Buyer policies, however, may provide coverage beyond the terms of the agreement and beyond terms deemed to be “market.” For example, a buyer’s policy may encompass actual and alleged breaches in its definition of a “breach.” A buyer’s policy may also cover “losses” beyond those provided in the transaction agreement (i.e. consequential, incidental, punitive and other special damages). All terms are subject to negotiation and will be reflected in the premium of the policy.
In addition, a buyer’s policy will not cover breaches of reps and warranties if the buyer knew about the breach prior to closing, even if there is no anti-sandbagging clause in the agreement. On the other hand, a seller’s policy may distinguish between different degrees of knowledge whereby a seller may be able to make a claim against the policy if only certain members of management knew of the breach. However, seller policies will not allow the seller to recover if the seller was fraudulent. Because many buyer claims for indemnification allege that a seller was fraudulent, the seller policy should address how the insurer will handle such claims.
Term of the Policy
The length of a R&W insurance policy also varies. The period typically begins at the closing and lasts through the survival period of the reps and warranties in the transaction agreement. However, a buyer may obtain coverage for a breach of reps and warranties beyond the survival period in the agreement and extend the term of the policy.
Retention & Aggregate Limits
Typically, the retention under a R&W insurance policy amounts to 1%-3% of the transaction value, though the insured may be able to negotiate a step down of the retention amount over time. In most cases, the retention will exceed the deductible in the transaction agreement, which generally ranges between about 0.25% and 1% of the transaction value. This keeps the seller on the hook for some portion of the losses.
The aggregate limit in a seller policy will generally be the amount of the cap under the indemnification section in the transaction agreement. The aggregate limits in a buyer policy may exceed the cap and cover losses up to 30% of the purchase price. An insurer will generally cover up to $50 million individually, and if the insured wants additional coverage it will likely need to arrange a syndicate of insurers to cover the policy.
Cost of the Policy
Generally, the cost of a R&W insurance policy is between 2% and 4% of the aggregate policy limit, with a minimum premium of between $100,000 and $300,000. The cost is based on the following:
- the breadth and scope of the reps and warranties,
- the amounts of the retention and the aggregate policy limit,
- the length of the term,
- the scope of the coverage,
- the perceived quality of the due diligence process, and
- the target company’s size, geographic presence and type of business.
The party that bears the cost of the policy is subject to negotiation between the parties.
Underwriting and obtaining a R&W insurance policy can take a few weeks to complete. Coverage is typically obtained through a broker, and once a potential insurer is identified, the insurer performs due diligence on the seller. The insurer will form a team of M&A specialists (many of whom are lawyers) to review the transaction agreement, disclosure schedules, exhibits and any other ancillary agreements. The team will submit a list of due diligence questions and requests and follow up with supplemental requests and questions. To cover the costs of diligence, the insurer typically charges the potential insured a non-refundable underwriting fee of between $15,000 and $50,000. Oftentimes this fee will be applied towards the cost of the policy.
The underwriting process will affect the tenor of negotiations depending on how the buyer and seller choose to leverage the presence of the policy to their advantage.
Advantages of Using R&W Insurance
R&W insurance is useful in the following circumstances:
- Multiple sellers. In a transaction where there are multiple sellers, the buyer typically wants the sellers to be jointly and severally liable so that the buyer can recover the entire amount owed from any one seller. Not surprisingly, sellers want liability to be several so that each seller is liable only up to its pro rata share of the sale proceeds. R&W insurance resolves this incongruity and allows the buyer (or the sellers) to recover from the insurer and absolves the need to hold the sellers jointly and severally liable.
- Foreign or distressed sellers. Utilizing R&W insurance in transactions with foreign sellers helps mitigate collection risks for a buyer where enforcing a seller’s indemnification obligations may be difficult. The same holds true when a seller is in financial distress or may have insufficient assets to honor its indemnification obligations.
- Public company seller. Because public companies are widely-held they do not typically have post-closing indemnification obligations. Accordingly, a buyer may find R&W insurance valuable when acquiring a public company.
- Create a competitive bid. R&W insurance allows a buyer to distinguish itself in an auction process by offering the seller a more limited indemnification package with a more limited escrow, if any. This is especially valuable to private equity and other financial sellers because it enables them to distribute more of the purchase price sooner to investors and achieve a “clean exit.”
- Obtain better-than-market terms. Utilizing R&W insurance allows the buyer to obtain better-than-market terms. If an insurance policy covers the reps and warranties in the transaction agreement, the seller will more readily provide the buyer with broader and more comprehensive reps and warranties. In addition, a buyer can purchase coverage that goes beyond what a “market” indemnification provision would provide with a term that extends beyond the survival period and coverage for losses that exceeds the cap. While all of this will undoubtedly make the policy more expensive, R&W insurance is a tool that parties can leverage to reach agreement.
- Keep good relationships with sellers. When the buyers and sellers will have an important relationship post-closing, whether an employment or other business relationship, R&W insurance allows the buyer to recover losses directly from the insurer without disrupting the relationship between the buyer and the sellers.
Although R&W insurance is not appropriate in every transaction, both buyers and sellers should be aware of it, and consider it, when evaluating a potential transaction. The development and growth of the R&W insurance market has made it a valuable and useful tool for parties that are looking to strike a deal.
¹ A policy will not typically cover “fundamental” reps and warranties like those regarding capitalization, good standing and enforceability and authority to transact business.