Reps and Warranties insurance has been available for several years now, but there is no doubt that more recently there has been an increase in the product uptake. Indeed, according to an April 29, 2015 article from George Wang of the Haynes and Boone law firm (here), reps and warranties insurance “has gained popularity as a tool to decrease transaction liability exposure in M&A transactions” and more recently there has been a “dramatic increase” in the use of reps and warranties insurance products.
As I have detailed in prior posts (for example, here), reps and warranties policies can preserve deal value by shifting potential liability for breaches of transaction representations and warranties discovered after deal closing. In exchange for an upfront payment, the policy may reduce or eliminate the need for seller escrows or holdbacks for contingent liabilities – an arrangement that could be particularly attractive in the current low interest rate environment. Although the policies are available either for the buyer or the seller, most policies are buyer-side policies.
According to the law firm memo’s author, there are a number of reasons why these insurance products have become more popular. The most basic reason involves simple economics – “the cost to obtain coverage today is significantly lower than the premiums charged even five years ago.” At the same time, the market for reps and warranties has “expanded greatly” (and is growing larger all the time).
In addition to these economic considerations, there are several other reasons why the product has become more popular: first, there has been an increase in what the author describes as “middle-market deals” (that is, deals ranging from between $25 million and $2 billion), as opposed to “mega public deals.”
Second, private equity sellers increasingly are trying to limit their indemnity exposure and limit escrow and holdback obligations. In addition, these private equity sellers may want to be able to close out their funds and fully distribute sales proceeds to their investors.
Third, in a consideration that I have seen becoming increasingly important, buyers in a competitive auction process are trying to use the inclusion of a reps and warranties policy (which would reduce the need for seller escrows and holdbacks) in a competitive auction process, as a way to enhance their bid relative to competitors.
Fourth, in what is also an increasingly important consideration, where a transaction involves a seller that the buyer considers a high-risk indemnitor or a foreign seller, the buyer may want to implement the reps and warranties insurance to avert a possible collection risk (such as when a seller based in a jurisdiction that my not offer reassuring means of recourse if a breach occurs). The law firm memo’s author notes that reps and warranties policies “can be particularly useful in the context of cross-border transactions … to facilitate middle-market transactions involving foreign buyers or sellers of domestic U.S.-based businesses.”
Fifth, reps and warranties insurance “may be attractive in situations involving multiple sellers who may have different levels of indemnity obligations to a prospective buyer (i.e., several versus joint and several liability) or in the case of an equity rollover transaction or partial management buyout situation in which a majority buyer may not want to seek post-closing claims against a continuing management team that comprises the selling group.” The insurance product avoids the possibility that the buyer might have to assert a claim against, and thus demotivating, the post-deal management team.
Another reason for the increased uptake of the product is that a recurring past concern about the insurance product can now be addressed through policy wording (at least when the product is properly put together). As I noted in prior posts (here and here), the have been recurring questions whether the product would provide appropriate protection for multiple-based damages – for example, where the damages are expressed as a multiple of a negotiated EBITDA. It is now possible in the marketplace for a buyer to obtain a policy allowing the recovery of damages based upon a multiple of earning, “but the parties must take care in negotiating the specific terms of the [insurance] and waiver of consequential, special, and indirect damage provisions, lost profits and diminution of earnings provisions in the underlying acquisition agreement to obtain the intended deal consequences.”
There are two more practical reasons why the product is increasingly popular. First, the process for obtaining a reps and warranties binder has been streamlined, and, second, there is now more of a track record of the insurers actually paying claims. The law firm memo’s author notes that “while claim history information is anecdotal, it is generally understood that claims are asserted in about 20 percent of issued policies and that most claims fall within the self-retention loss of the issued policies (1-2 percent of the enterprise value).” At the same time, “insurers recognize the necessity to pay, and to maintain their reputation for responding to, legitimate claims.”
M&A Transactions: Important Run-Off Insurance Issues: There are other important insurance issues involved when companies enter an M&A transaction. Care must be taken to ensure that the acquired entity is properly incorporated into the acquiring company’s D&O and E&O insurance. In addition, the acquired company’s D&O insurance and E&O insurance programs must be restructured into a run-off, or “tail” policies, so that liabilities relating to the acquired company’s operations prior to its acquisition are properly insured.
In an interesting May 1, 2015 memo (here), Thomas S. Novak of the Sills, Cummis & Gross law firm takes a look at the issues that can arise in connection with the selling company’s liability insurance program. The memo is interesting and addresses the key considerations that arise in connection with the selling company’s run-off insurance. The article also discusses related issues, such as the question of whether the insured should give a notice of circumstances that could give rise to a claim prior to the deal date. Novak is correct when he states at the conclusion of his memo that “careful consideration of your existing insurance program, risk profile and future business strategy is essential to avoid unexpected gaps in coverage.”
While I recommend Novak’s memo, I do disagree with him on one issue that is a point of emphasis in his memo. Indeed, in memo’s title, he asserts that “delegating M&A insurance issues to a broker is risky business.” He adds, to underscore how supposedly risky it is to rely on an insurance broker, that “the bottom line is that an insurance broker does not know corporate law or your business as well as you do.”
With all due respect to Novak, I think his emphasis on the danger of relying on an insurance broker is off the mark. It has been my privilege as an insurance broker to work with many outside counsel while they represented many different companies, and in many cases these lawyers are quite knowledgeable about insurance issues. By and large, however, these lawyers generally lack day-to-day knowledge of the insurance marketplace. Even lawyers that have very detailed knowledge about the insurance issues and other legal considerations have limited knowledge about the mechanics of the D&O insurance procurement process; of the various carriers in the marketplace and of their peculiarities of their expectations and practices; and of the range of likely possibilities available from any given carrier in any given circumstances. Only a knowledgeable and experienced insurance broker can address these and the many other practical factors involved in any insurance transaction.
Novak would have been providing better advice if, rather than trying to scare company officials about how dangerous it is for them to rely on their insurance brokers, he had communicated that the best approach is for companies to ensure that their brokers and their outside counsel work together collaboratively.
The most important consideration when it comes to insurance brokers is for companies to make sure that they have knowledgeable and experienced brokers involved in their insurance placement. Indeed, if companies have appropriately knowledgeable and experienced brokers involved, there usually is no need for the companies to incur the additional expense of involving outside counsel – as in fact is the case for many of our clients and the clients of other knowledgeable and experienced brokers.
Ten FCPA Facts You Need to Know: Here at The D&O Diary, we are big fans of the FCPA Professor Blog (here), which is written by Southern Illinois University Law School Professor Mike Koehler. We recommend the blog as one of the best resources available on all things relating to the FCPA. In addition, Professor Koehler has also published an interesting May 1, 2015 paper entitled “Ten Seldom Discussed Foreign Corrupt Practices Act Facts that You Need to Know” (here). His paper provides a number of interesting observations about the FCPA, including its limitations and its differences from similar anti-corruption laws in other jurisdictions, and what he characterizes as the SEC’s and DoJ’s questionable track record in enforcing the statute. The article is worth a read.