Transactions are inherently risky, giving rise to contentious negotiations over representations and warranties and related indemnification provisions. The rise of R&W insurance is smoothing the way to faster and less contentious closings.
By Dave Thayer.
Buyers and sellers come to the transaction table wanting the best price at the lowest risk, and ready to do battle over both. The most contentious provisions between parties in an acquisition generally revolves around the seller’s representations and warranties and related indemnification provision.
The two parties start from positions that are far apart. Buyers want an expansive representation, warranty and indemnification package that reduces risk in business operations, customers, financial statements, legal and regulatory matters, employee relations and other relevant business matters. Buyers also want to protect against breaches of the sellers’ representations and warranties and business risks related to post-closing losses. Indemnification provisions are often secured by a holdback and escrow of a portion of the sales proceeds, earn-outs or other safeguards.
Sellers want a limited representation, warranty and indemnification package, one that allows them to sell their businesses and walk away with their bargained for sale price without risk of having to give back a portion of the sale proceeds.
One way to bridge the buyer-seller divide is with Representation &Warranty (R&W) insurance.
Generally purchased in merger and acquisition transactions, a R&W insurance policy insures the monetary indemnification obligations for breaches of many of the representations and warranties made by sellers in the transaction agreements. For reasons beyond the scope of this article, R&W Insurance is uncommon in connection with acquisitions of public companies.
What is R&W Insurance?
Buyers and sellers may obtain R&W insurance to shift a substantial portion of the business risks of an acquisition to an insurance company in exchange for payment of the policy premium. A policy provides coverage for indemnification claims a buyer may have for losses resulting from breaches of a seller’s representations and warranties in the acquisition agreement. Seller-side coverage insures the seller’s liability for claims of breach of a representation or warranty. Buyer-side policies directly compensate the buyer for breaches by the seller and make up a significant majority of R&W insurance market.
Although around for a couple decades, the use of R&W policies has increased in recent years, primarily due to:
R&W insurance has been best suited for deals with transaction values between $50 million and $10 billion. Recent reports indicate transactions valued as low as $30 million are now benefiting from these policies, which typically cover 10% of the acquisition purchase price (or higher) and extend three to six years. This term is a significant benefit since the R&W survival period is 12 to 24 months when R&W insurance is not used. A policy includes a deductible, called the retention, whereby losses are not covered under the policy until such losses exceed the retention amount.
Standard exclusions may include breaches known by the seller, underfunded pension liabilities, asbestos and other environmental problems, and covenant breaches by the seller. Policies do not cover pre- or post-closing purchase price adjustments or deal-specific exclusions based on the insurance company’s due diligence and underwriting efforts, such as misclassification of employees versus independent contractors and violations of wage laws and environmental matters in connection with transactions involving natural resource companies.
Key Transaction Issues
While this insurance can smooth negotiations, several issues remain when using R&W insurance:
R&W insurance can expedite a sale and potentially increase the purchase price for a seller by providing a mechanism to resolve scoping of representations and warranties and indemnity obligations. It also reduces the risk of liability for breaches of representations and warranties by lowering or eliminating the seller’s indemnity obligations in connection with such breaches, except for fraud and fundamental representations and warranties. Sellers can determine return on investment sooner and more cleanly exit the business earlier, freeing up funds from escrow or other holdback arrangements to be distributed at closing. Early distribution is especially attractive for sellers who are owned in part or whole by private equity firms or similar investors. It also protects passive investors who have an ownership interest in sellers from the risk of liability for unintentional breaches of representations and warranties.
R&W insurance benefits the buyer by supplementing or replacing the indemnification provided by the seller when the seller has the leverage to negotiate a limited indemnification package. A policy also extends the survival period for certain representations and warranties, allowing the buyer more time to detect and recover losses. A potential buyer’s bid can be distinguished in a competitive auction by reducing the indemnification requirements of the seller. A policy may contain a collection alternative for losses by a seller or sellers who may be difficult to collect from post-closing; and, protect continuing business relationships when seller management or equity interest is part of the purchase price.
The retention ranges from 1% to 2% of the transaction value, with some market variability and negotiable step-downs that decrease the retention over time. The insured and insurer may also negotiate the amounts counted towards the retention. Insurers may want to exclude amounts recovered from other sources (such as other insurance or third parties) or amounts that would count towards the indemnification basket or threshold in the acquisition agreement.
Who bears the cost?
The cost of R&W insurance, including the premium, may be borne by the buyer, the seller or shared. The underwriting fee associated with the purchase of R&W insurance may be between $25,000 to $50,000. Add to that insurance premiums, which can range from 2% to 4% of the coverage amount based on perceived risks by the insurer.
The costs are often paid by the party who benefits the most from R&W insurance. If the policy is obtained so the buyer can have a competitive advantage in an auction, the buyer may bear the cost of the insurance. If the policy is obtained as a concession by the seller in lieu of providing a better indemnification package, the seller may bear the cost of the insurance. Often the seller will bear at least half of the cost since the policy generally provides the seller the ability to “walk-away” from many traditional indemnification responsibilities.
An insurance broker may be used to compile general information and draft transaction documents for marketing to one or more insurance companies, who then provide non-binding indications of premium estimates and terms of coverage before completing due diligence and negotiating the scope of the policy. An insurer generally retains subrogation rights for claims against third parties in the event of loss but does not allow the insurer to assert claims against the buyer or seller (except in cases of fraud), or owners, officers and employees of the acquired business. By reducing risk and the need for escrow, R&W insurance smooths the way to faster and less contentious closings.
David A. Thayer, Esq., is a corporate and transaction attorney, and former CPA, that focuses on being a deal maker, not a deal breaker, as he helps clients achieve their business dreams. He can be reached at firstname.lastname@example.org.
THIS INFORMATION IS NOT INTENDED AS LEGAL ADVICE. SEEK SPECIFIC LEGAL ADVICE BEFORE ACTING.