The role of representations and warranties insurance coverage in M&A activity
May 2018 | EXPERT BRIEFING | MERGERS & ACQUISITIONS
Representations and warranties insurance (RWI) remains a hot trend, and because it is a category of insurance that is highly competitive and flexible as to its terms, purchasers benefit from careful negotiation of RWI policies.
M&A activity is increasing
The number of M&As should rise, in both size and number, in 2018. While 2017 saw the fewest deals since 2010, the total value of deal activity increased over 2016. The value of private equity deals also increased in 2017, according to Ernst & Young. Technology acquisition will likely be the primary driver of dealmaking, followed by expanding customer bases in existing markets, adding new products or services, digital strategy and talent acquisition, according to Deloitte. Deals are also expected to get bigger. While both corporate and private equity firms expect M&A to increase, the largest firms are the most likely to engage in M&A in 2018. A further area of strong M&A activity should include mergers between construction and energy companies, energy concerns and manufacturers, retailers and technology companies, healthcare plans and healthcare providers, as well as technology companies and telecommunications providers. Also, changes and reforms in US tax law may encourage more M&A deals. The bottom line is that corporations have more money to spend, and more funds to support M&A activity.
M&A dealmakers are facing growing financial exposures including transactional risk, according to Chubb. This is due, in part, to the high pressure on dealmakers to execute transactions quickly. The biggest concerns include financial statements, tax and material contracts and compliance with laws. Breaches in the largest M&A deals can result in seven and even eight digit claims costs, according to AIG.
What is RWI?
RWI provides a specialised risk transfer mechanism which permits a transaction to proceed with less risk. The average RWI policy covers deals in the $150m range. The minimum deal size RWI will cover is approximately $5m. According to Law 360, the number of RWI policies in place, globally, has nearly doubled in the past decade, and the market is now worth more than $15bn. RWI can protect a buyer or a seller against unknown or unanticipated post-closing financial losses caused by inaccuracies in, or breaches of, representations and warranties in M&A agreements. Available for more than a decade, RWI has become a common way to allocate risk, particularly over the past five years. RWI is maturing as the market grows. Also, as demand for RWI coverage has increased, more insurers have entered the market, causing premiums to decrease.
Traditionally, sellers would provide indemnity protections for potential breaches of representations and warranties they make about the target company’s assets. However, such indemnities often do not adequately protect buyers because they rely on the seller’s capacity to pay claims. In addition to a seller’s financial inability to respond to claims for breaches of reps, sellers now frequently insist on monetary caps, either overall or for individual classes of claims, on their liability for breaches that leave the buyer exposed to risk in excess of the cap. If the seller has insufficient assets or becomes insolvent after closing, the buyer cannot recover. A traditional alternative to protect against a seller’s financial weakness is to tie up a portion of the purchase price in an escrow to cover indemnity claims for a set time period. However, sellers would rather receive their full purchase price sooner rather than later. RWI provides financial backing for seller indemnities and allows the parties to eliminate or reduce reliance on the seller’s financial wherewithal or escrows.
How does RWI work?
RWI is highly specialised and tailored specifically for each M&A deal. The policy language tracks the terminology in the underlying transaction, matching coverage to indemnity protections for representations and warranties in the deal agreement. Typically, RWI covers financial statement warranties, inventory levels, vendor contracts, environmental law compliance and undisclosed litigation or tax liabilities. The time period of coverage is also longer than traditional indemnity plus escrow mechanisms – three to six years as opposed to 12 to 18 months. RWI also helps protect key relationships by reducing or eliminating the potential for a buyer to pursue claims against the seller following closing.
‘Buy-side’ RWI protects the buyer because it is first-party coverage. Buyers can recover directly from an insurer for losses arising from breaches of the seller’s representations and warranties and leave any litigation to the insurer through its subrogation rights. This essentially shifts the risk from the seller to an insurer without diminishing the buyer’s protection, and it allows the buyer to recover its loss without the expense and time cost of litigation. Buy-side RWI is particularly useful if the seller will be dissolved post-transaction, or has a large number of shareholders – anything that could make an indemnity claim burdensome.
‘Sell-side’ RWI provides third-party liability coverage, so the seller can tender a claim made by the buyer alleging a breach of its representations or warranties made at closing to its insurer. It provides coverage for defence and damages, including judgments and settlements. Sell-side RWI permits sellers to distribute more of the purchase price to its investors or retain the proceeds for other uses.
RWI has important limitations. It does not cover disclosed breaches, and it is not designed to replace thorough disclosure or due diligence. RWI underwriters review due diligence reports carefully and add exclusions for significant risks uncovered in the diligence process. RWI is commonly limited to 10 percent of the value of the total deal, leaving the buyer and seller to allocate the risk of losses above the RWI limits. RWI does not cover covenant breaches, purchase price adjustments, or other payment obligations unrelated to representations and warranties arising under the acquisition agreement.
RWI may exclude consequential and punitive damages, forward-looking statements or projections, closing letter misrepresentations, pension underfunding and any exceptions to representations and warranties listed on disclosure schedules. While RWI covers tax representations in the acquisition agreement and some policies include a standalone pre-closing tax indemnity provided by the seller, pre-closing tax coverage under the typical RWI policy is limited to taxes of which the buyer is unaware when the policy is bound. Other typical exclusions include asbestos and polychlorinated biphenyls and liabilities related to employee misclassification, and compliance with wage-and-hour laws. Many M&A agreements have boilerplate language providing that liability for breach of RWI is limited to amounts in excess of any collectible insurance. This is, in effect, an anti-subrogation provision when RWI is involved, and should be removed or eliminated, although some sellers will insist that it remain in effect for traditional insurance that existed as of the closing date.
Negotiating the RWI policy
Experienced insurance coverage counsel can add significant value in working with a broker to negotiate an RWI policy. There is significant variation among policy forms provided by RWI insurers, and counsel familiar with the purposes, structure and competing forms can help maximise the coverage an RWI policy provides. Some critical provisions include: (i) having a high standard for ‘knowledge’ of a misrepresentation during due diligence (for example, actual conscious awareness of misrepresentation and that it constitutes a breach); (ii) limiting any obligation of the buyer to chase the seller or third-parties before collecting on a buy-side policy; (iii) placing limits on an insurer’s time for investigation before accepting or denying a claim; and (iv) having the policy apply without regard to materiality or indemnity qualifiers in the deal agreement.
Here are some good guidelines for negotiating RWI policies. First, make sure you have non-disclosure agreements with insurers before providing any information. Second, legal counsel (both for the M&A and insurance counsel) and the broker should review all terms and conditions. Third, make sure the coverage structure is the best structure for your M&A. Fourth, negotiate policy language and ensure it tracks the M&A’s language. Fifth, keep your insurer in the loop as deal negotiations progress – the policy may need alteration. Sixth, identify potential coverage gaps and determine how best to cover these. Some ideas include: (i) sharing the risk with the seller by agreeing to an upfront deduction to the purchase price; (ii) having the seller provide a special indemnity backed by escrow for the identified liability (for example, asbestos); and (iii) covering gaps with other types of insurance with the RWI policy providing excess limits. A buyer may be able to obtain the primary insurance policy from the RWI insurer. If this is the case, the buyer should try to obtain a discount on one or both of the policies.
Carolyn Rosenberg and Courtney Horrigan are partners and Adrienne Kitchen is an associate at Reed Smith. Ms Rosenberg can be contacted on +1 (312) 207 6472 or by email: email@example.com. Ms Horrigan can be contacted on +1 (412) 288 4246 or by email: firstname.lastname@example.org. Ms Kitchen can be contacted on +1 (312) 207 2445 or by email: email@example.com. The authors thank John S. Vishneski and Frederick Egler for their invaluable assistance in connection with this article.
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Carolyn Rosenberg, Courtney Horrigan and Adrienne Kitchen