Effective representations and warranties in M&A
June 2015 | 10QUESTIONS | MERGERS & ACQUISITIONS
FW speaks with Deborah McBrearty, head of transaction risk insurance at HCC Global, about effective representations and warranties in M&A.
FW: Could you provide a brief overview of representations and warranties in M&A? What general trends and developments have you seen in this area in recent years?
McBrearty: We are still seeing considerable differences in approach between jurisdictions. Warranties and indemnities continue to be a very important part of the UK transaction process, in terms of risk allocation between buyer and seller. In addition, there is still considerable negotiation around both the content and level of warranties that are being given in transactions, as well as the ‘cuffs and collars’ in terms of limitations of liability and thresholds for the attachment point of risk allocation. So a key trend is the increasing use of warranty and indemnity insurance (W&I) to assist parties with their negotiation process around warranties. W&I, or ‘representations/reps and warranties’ as it is also known, can be used as a tool to bridge the gap between the expectations, or risk appetite, of the buyer and the seller. Prior to the global financial crisis we very much saw a seller’s market, in the sense that a lot of private equity and venture capital funds had money to spend; equally, there were many competitive auctions where the sellers effectively had the upper hand and were able to limit their liability regarding indemnities for breach of warranty and tax covenants. After the financial crisis, things changed completely, becoming much more of a buyer’s market. Increasingly, sellers were in a position of needing, and wanting, to sell and were looking for ways to make their target business attractive to potential buyers. At the end of 2009 and in early 2010, when M&A activity levels started to recover, we also saw an increased usage of transaction risk insurance solutions – sellers approaching the insurance market at an early stage of the transaction. This has become a more widely accepted way of dealing with warranties and indemnities in transactions, and the level of take up of policies has doubled year-on-year since 2010.
FW: Based on your experience, what are the drivers for using insurance in the context of negotiating representations and warranties in M&A?
McBrearty: W&I insurance can often be utilised in negotiations to help break deadlocks in the allocation of risk. There are a number of factors to be considered. Firstly, companies must focus on securing a clean exit. Private equity funds and other sophisticated investors may view W&I insurance as a tool to facilitate a clean exit and provide greater certainty of the extent of any liability exposure associated with the transaction. However, the seller still has exposure for loss suffered as a result of a breach of an insured warranty or indemnity if the breach is caused by the fraudulent conduct of the seller, as such matters are excluded from coverage in sell-side policies. Although covered in buy-side policies, insurers will have a right under the policy to subrogate and pursue the fraudulent seller directly. Buyers may also have a direct right of action against the seller pursuant to a carve-out to the no recourse provisions in the sale document. Credit risk must also be considered. Indeed, W&I insurance may provide a buyer with confidence in its ability to recover for a breach of warranty or indemnity, as the insurer’s balance sheet will effectively replace any perceived credit risk associated with the seller. This may remove the need for an escrow or deferral of purchase price. The debt aspect must also be considered, the existence of W&I insurance may provide a prospective financier of the buyer with the comfort it requires to provide the debt component of a purchase price. A buyer may also attempt to enhance its proposal in a competitive tender process by structuring W&I insurance into its bid. For example, the bid could propose low caps and broad limitations on the warranties on the basis that the buyer intends to obtain W&I insurance to provide additional coverage for breach of warranty – over and above that which will be given by the sellers in the transaction documents. How the transaction is being carried out should also be considered. Is the seller the company’s founder, management, or is the company a joint venture? If the seller or its representatives – for example, a founder – are employed by the target post acquisition, the buyer may want W&I insurance so that it can make a claim directly with the insurer, effectively preserving the relationship with the founder or management team who are likely still managing the business. The same principle applies to joint venture parties. The question of insolvency might also be considered, liquidators and administrators may want to provide greater comfort to purchasers of distressed assets by offering W&I insurance as a component to the transaction. The jurisdiction that the company operates in will also be a key consideration. A buyer entering a new jurisdiction may want certainty about its ability to recover for breach of warranty or indemnity under the transaction documents. Equally, a seller exiting a jurisdiction may want certainty about its liability exposure in that jurisdiction. The possibility of multiple sellers can also be considered. A buyer may be concerned with its ability to recover on a claim against multiple sellers particularly in circumstances where they are located in different jurisdictions.
FW: What steps need to be taken to ensure that fraudulent misrepresentation does not lead to serious repercussions for the parties involved?
McBrearty: Fraudulent misrepresentation is a key feature which needs to be considered when looking at any transaction from an insurance perspective. The underwriting process is not about recreating or trying to redo the diligence process that the parties have undertaken, but rather to gain an overview of the way in which the transaction has been handled. In order to establish a comfort level that fraudulent misrepresentation is not a risk on a particular transaction, a large number of risk factors need to be taken into account, such as the background of the target business, the historical operations of the business, the jurisdictions in which it operates and the quality of the management team involved. If the business has been through a couple of rounds of capital raising, has had private equity influence, has independent board members and a greater level of external oversight, then these factors will provide a higher level of comfort. There are also certain circumstances where parties, particularly a buyer, may want to take a deeper look at the people involved in both the ownership and running of the business. Another factor would be the types of advisers that are involved in the transaction, and understanding the process those advisers have gone through with their clients to give them a full understanding of their responsibilities and obligations when negotiating warranties. A full disclosure process which enables the buyer to gain a clear picture of the transaction is one into which the advisers have a high level of input, particularly if the process involves dealing with buying and selling parties who don’t undertake M&A transactions as a day-to-day part of their business. They therefore would need stronger guidance in order to gain a clear understanding of what their obligations are in terms of that representation and disclosure process.
FW: Following a breach of representations or warranties, what remedies are available? What impact can these remedies have on the dynamics of an M&A transaction?
McBrearty: The remedies available will depend upon the applicable law of the transaction, as well drafting of the sale and purchase agreement – including the limitations, damages and definitions of loss – the parties have negotiated. A variety of provisions exist, and often the seller will seek the right to remedy the breach in advance of any claim for damages. The first step might be that the seller is notified of a potential breach, then given the opportunity to mitigate that by taking steps to put things right. If that is not possible, the traditional remedy of damages under UK law would be to assess the diminution in value of the target business. In this case, the buyer’s loss relating to a breach of warranty would be assessed on the basis of the price paid for the target business, versus the price it would have paid had it have known about the considered-to-be breach of warranty. Alternatively, and more common under US style sale agreements or Australian law agreements, damages are assessed on an indemnity basis where those issues are put right on a pound-for-pound basis. In terms of the impact of these remedies, often in M&A transactions there are personal dynamics to take into account, such as the warrantors potentially being founders or members of the management team prior to the acquisition. They are giving the warranties but in many cases they are also moving forward with the business, so it’s conceivable in a private equity transaction that they are going to retain the same management team to help build the business and grow it in the future. One factor that can come into play is that in trying to build a relationship with warrantors, a private equity buyer may sue its own management team for breach of warranty in the event of any unknown issue emerging, which is very counterproductive in a commercial sense. This is one reason why W&I is becoming more popular.
FW: What advice would you give to parties involved in drafting representations and warranties in M&A transactions? How might these provisions impact due diligence processes?
McBrearty: A balanced negotiation process is a key requirement to developing an insurable set of warranties. Insurers do not want to see a set of warranties that is highly ‘buyer friendly’ – meaning, one which is effectively just a buyer’s wish list or charter to have the broadest possible recourse. When insurers look at a transaction, they want to see that the warranties are both relevant to the type of target business and sensible in the context of the particular transaction, considering both materiality and detail. You might think that a transaction with a brief set of warranties would be more attractive to an M&A insurance underwriter, but what you find is that if warranties are too brief, they also tend to be very broad in their context, making it harder to direct the warrantors and the sellers as to what might constitute a breach of that warranty. A set of well-negotiated, relatively detailed warranties will provide confidence that the warrantors have had sufficient guidance to be able to turn their minds to the issues that need to be disclosed to the buyer and are the types of things that the buyer might be concerned about when asking for a particular warranty. The real underlying purpose of the warranties is, from a buyer’s perspective, not so much about potential recourse in the future, but about guiding the warranty, disclosure and diligence processes and being able to find out as much information as possible before it buys the business. In this deal environment, buyers are not buying companies with a view to claiming on the representations and warranties and getting their money back – they are seeking to make a good acquisition. The process should be detailed enough to draw out the information that a buyer wants to know.
FW: In cross-border transactions, how can interpretations of representations and warranties in M&A transactions differ between regions? What is your advice on managing different expectations?
McBrearty: There are considerable differences in terms of the style of representations and warranties across jurisdictions. US style warranties, for example, tend to be more narrative and cover a lot of different aspects within one sentence, whereas a UK style tends to break elements down into individual items. A US buyer looking to acquire a business in Europe may prepare a first draft of the sale agreement, but there is probably more work involved and the seller’s advisers need to be really focused on breaking down long, wordy paragraphs of warranties and must be able to identify the key elements within that warranty. We have also seen examples where one warranty might contain five different points that we would usually see broken down in a different way elsewhere. It is therefore incumbent upon the advisers involved in cross-border transactions to ensure that they are utilising their international network as much as possible in order to understand whether the warranties are being drafted in a way that is appropriate to the target business. They must also be prepared to repel any foreign buyer trying to impose their own jurisdictional standards in regions where they are not appropriate. As insurance providers, this is one of the reasons why we engage external counsel to assist in assessing the transaction, because they are able to give us advice as to market standards. If they were advising a seller, what would they be advising the seller to agree to, in the context of the particular target sector and the particular target jurisdiction? Cross-border transactions are always challenging. They are about ensuring the buyer doesn’t just focus on the headquarters of the target business, but also takes steps to properly analyse subsidiaries which might be located in other jurisdictions.
FW: Why should parties consider representations and warranties insurance? Are there certain types of deal where this insurance is more appropriate?
McBrearty: A 2014 study conducted by a multinational law firm across its pan-European book of transactions indicated that in 9 percent of M&A transactions the parties were discussing the use of reps and warranty insurance. However, when talking about UK transactions, the actual uptake of this insurance was starting to approach the 10 percent region. In the first instance, we are talking about a conversation being held between parties or by a lawyer with its client. It is obvious that across a European-wide approach, there is still a long way to go in terms of insurance being discussed on every deal. In terms of UK mainstream transactions, legal advisers are starting to see it as part of their obligation to advise their clients that this type of insurance is actually available for the transaction. Having discussed it with not only brokers and other insurers in the market, but also legal advisers and regular deal advisers, it is possible that we are seeing insurance put in place in only 5 percent of insurable transactions worldwide. There are certain types of deal where insurance might be more appropriate than others, but overall interest continues to grow and we expect to see consideration of this type of insurance. The most common type of transaction where we see insurance being considered is mid-market share sale agreements with private companies, not publically listed companies. We are also seeing the use of insurance in asset deals where it is the business and the assets being bought, as opposed to a share sale. And there is increasing movement in the property field where real estate is sold by way of a sale of shares in the holding company, rather than the land simply being bought from the company. For numerous reasons, it may make more sense for a buyer to acquire the actual holding company and therefore it will want to receive warranties around the operation of that holding company.
FW: In terms of buy-side and sell-side insurance policies, what should parties be aware of when evaluating coverage?
McBrearty: There is definitely a trend toward buy-side coverage, however we are still seeing some use of sell-side policies. Sell-side tends to be used when the sellers are more heavily involved in the day-to-day running of the business and feel that they know the business inside out, and just require a ‘sleep easy’ in case an issue arises. It is rare that we ever see large market placements of sell-side insurance. For a large sell-side transaction in the hundreds of millions sized range, we often see sellers limiting themselves to 10 percent of the overall enterprise value in terms of the amount of liability they are willing to leave on the table. If that is acceptable to the buyer, then the sell-side insurance policy might be £10m to £20m. However, if the buyer believes this is inadequate for its purposes, and its board may, for example, require recourse of at least 50 percent of enterprise value in order to sign off on this transaction, it is more likely to flip to a buyer-side policy because the buyer retains the underlying liability or responsibility to stand behind those warranties. On the buyer-side, the seller is able to effectively cap its responsibility for the transaction and the seller does not retain the liability up to the level of the buyer’s insurance policy. The buyer, in a buyer policy, has direct access to the insurer without the necessity for a seller to retain that liability. This is the big difference, and why we see most large placements of insurance on the buyer-side, because it doesn’t require the seller to keep that underlying responsibility for the limit of liability that has been agreed.
FW: What mistakes or oversights do you see parties make most frequently with respect to representations and warranties in M&A transactions?
McBrearty: A common oversight is failing to consider using W&I at an early enough stage of the transaction. Parties will often approach the insurance market once the agreement is all but final, or perhaps when the transaction has been signed already. This can make it challenging for the insurance market to respond with a solution that is truly back-to-back with what has been negotiated. If the insurance is considered at an earlier stage, and the input of brokers and insurers is requested during the process of actually negotiating the sale agreement, the parties will receive a more balanced set of warranties, representations and indemnities with which they are comfortable, but which are also fully insurable. That will mean a better match between the risk-allocation of insurers, providing the broadest possible coverage. Another issue that we see quite frequently is in smaller transactions, where buyers come in with a first draft of warranties that effectively includes every possible warranty under the sun. Sellers, rather than trimming those warranties down to a sensible set, might instead conclude that they are not relevant to the business and so not bother to negotiate them since they don’t apply. A better approach would be to remove irrelevant warranties, leaving a sensible set of warranties that can be properly disclosed against.
FW: What developments and trends do you expect to see in this area over the next 6 to 12 months?
McBrearty: Generally, we are seeing a strong level of M&A activity but we will continue to see the slightly cautious, risk-averse approach which plays into the hands of using W&I in transaction insurance solutions. As the market grows in confidence, deals will start to happen over a shorter timeframe, which means less time to put an insurance policy in place. The key message to deal advisers that are considering the use of insurance is to make sure they get insurers on board at an early enough stage so that they have an opportunity to produce a quality product for the transaction. We are seeing increasing numbers of auction processes where a final, preferred bidder is being selected and then expected to effectively sign the transaction within a week or 10 days. As the pressure to speed up transactions starts to increase again, preparation is key for putting in place a quality insurance solution. In terms of deal flow, we have already seen double the number of transactions compared to this time last year. This should persist, and the market will continue to grow for some time.
Deborah McBrearty is a dual qualified (UK/NZ) solicitor who holds over 20 years’ experience in private practice and the insurance industry. Since 2000, she has specialised in the Transaction Risk Insurance (TRI) field and is recognised as one the few professionals involved in this line of insurance since its infancy in the London insurance market. Her experience includes both broking and underwriting bespoke insurance solutions for M&A including: Warranty & Indemnity, Tax Indemnity, and Prospectus Liability products, amongst other forms of contingent risk transfer. She can be contacted on +34 93 530 7393 or by email: firstname.lastname@example.org.
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