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Representation and Warranties policies (R&W policies) insure representations made by a Seller to a Buyer in a merger or acquisition. While these policies were first introduced around 1998 they have become far more common since 2014, with more than 20 insurers currently offering R&W policies. R&W policies implicate a variety of coverage issues due to their uniqueness in both the insurance industry and in their reflection of the specific deals for which they are purchased.
R&W policies primarily exist only in connection with mergers and acquisition (“M&A”) transactions. In M&A deals the Seller makes representations and warranties in the purchase agreement. These typically include representations and warranties concerning financial statements, taxes, compliance with laws, material contracts, employee-related issues, intellectual property, operations related issues, litigation, fundamentals, and environmental issues. The Seller is responsible for losses to the Buyer resulting from breaches of its representations and warranties.
Prior to R&W policies, Seller’s would establish an escrow account against which Buyers could make claim for Seller’s breach of representations and warranties. This required Sellers to set aside substantial dollars from the sale of the business into an escrow account for 12 to 18 months. The Buyer would then make claims for breaches subject to the escrow or indemnity agreement negotiated during the M&A transaction.
R&W policies largely replace this process by shifting these risks to the R&W policy. The policies have become more popular for multiple reasons. These include:
- Sellers, especially investment firms, like to limit both their indemnity exposure and the amount of sale proceeds that would be tied up in escrow accounts to cover hold back obligations;
- Sellers prefer to close out transactions, pay off debt and make distributions to investors;
- In some deals, management of the Seller will continue to run the acquired business after closing. It is awkward for the Buyer to bring indemnity claims against the Sellers who are now running the merged business;
- R&W insurance also helps Buyers in a competitive auction process because it improves the competitiveness of their bids by increasing the amount of sale proceeds the Seller receives at closing as compared to non-R&W insurance transactions where 10% to 20% of the transaction proceeds are put in escrow for 12 – 18 months after closing;
- R&W insurance gets Buyers protection where the ability to collect on the Sellers indemnification obligations is uncertain such as in bankruptcy sales, take private transactions, distress sales, and ESOP transactions;
- When there are multiple Sellers and there is several liability policies but not joint liability; and
- Cross-border transactions where it may be difficult to enforce the Seller’s indemnity obligations.
Types of R&W Policies
There are two types of R&W policies: Buyer’s side policy; and Seller’s side policy.
The Buyer’s side policy is the most common. This insures the Buyer for losses caused by a breach by the Seller. This policy may replace the Seller’s indemnity obligations or it may be in excess or in addition to the Seller’s obligations.
As Seller’s side policy insures the Seller for a loss the Seller incurs as a result of the Seller’s own breach of representations and warranties. Sometimes these are used if the Buyer is unwilling to buy a Buyer’s side policy. Sellers sometimes are able to negotiate R&W policies that mirror their indemnity obligations under the Purchase Agreement. Accordingly, the Seller’s only potential exposure is for the deductible or for a loss in excess of the policy limits. A Seller’s side policy is used to backstop the Seller’s indemnity obligations. Therefore, the policy limit is determined by, and is normally not larger than, the contractual indemnity.
Coverage limits are typically 10% of the transaction value. Premiums are typically 3% to 4% of the coverage limit of the policy as compared to setting aside 10% to 20% in escrow without the R&W policy. Premium costs are typically borne by the Buyer although parties sometimes split the cost of the premium. Retention amounts are typically 1% to 2% of the transaction value. It is common for Sellers and Buyers to split the retention with the Seller’s portion funded through a small escrow under the Purchase Agreement. Retentions typically step down to half of their original amount 12 – 18 months after closing. The term of the policy is typically 6 years for fundamental and tax representations and 3 years for all other representations and warranties. R&W policies tend to be utilized in deal sizes between $20 Million and $1.5 Billion.
How is Coverage Evaluated in an R&W Policy?
The first step is to determine whether there is a “loss” as defined by the policy. This typically requires there to be a breach of a representation or warranty. “Loss” is a defined term in the policy and it is typically a negotiated term in the policy. It sometimes incorporates one or more provisions within the Purchase Agreement. If there is no “loss’ then the claim is not within the policy.
If there is a “loss,” the next step is to determine whether any policy exclusions are applicable. Exclusions are negotiated and defined within the policy which sometimes incorporates provisions from the Purchase Agreement. Across the industry, exclusions seem to have shrunk and have become somewhat more uniform. Exclusions generally include:
- Covenant Breaches
- Known Breaches
- Interim Breaches (new breaches arising and discovered between signing and closing)
- Purchase Price Adjustments (and other payment obligations under the Purchase Agreement such as specific indemnity)
- Pension underfunding liabilities
- Certain tax matters (such as transfer taxes, net operating losses, other types of deferred tax assets and known tax liabilities)
- Working capital adjustments
- Forward-looking statements
- Medicare/Medicaid exposures
If an exclusion applies, the next step is to determine whether any policy provisions add additional coverages so as to bring the excluded “loss” back within coverage.
Throughout the coverage analysis, it is important to understand that typically the policy and the Purchase Agreement interface and integrate definitions and obligations between the two documents. With R&W policies, it is important to understand that the coverages are bespoke, reflecting the uniqueness of the M&A transaction underlying the policy. Understanding the nature of the transaction is important in understanding the scope of coverages that were negotiated and intended to be a part of the policy as part of the risk transfer. With such an understanding, one can make a more informed and accurate coverage determination that is in harmony with the expectations of the parties to the underlying M&A transaction.
For additional information regarding R&W policies and insurance coverage analysis, contact Jeffrey A. Wothers, Esq., Partner at Niles, Barton & Wilmer, LLP who practices in the litigation department concentrating in property insurance law, related first party insurance matters and commercial litigation. Mr. Wothers is admitted to practice in Maryland, Pennsylvania, Virginia, West Virginia, North Carolina, New York and the District of Columbia.see all Business and Corporate Law articles »
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