As I have previously noted (most recently here), Reps and Warranties Insurance is an increasingly indispensable part of M&A deals. While this observation has been true for some time now, a competitive marketplace for Reps and Warranties Insurance has increased the relevance and significance of the insurance as part of corporate deal-making. An interesting December 11, 2017 Harvard Law School Forum on Corporate Governance and Financial Regulation article entitled “Representations and Warranties Insurance in M&A Transactions” (here) takes a look at the current state of play for Reps & Warranties Insurance in the M&A arena and examines the benefits the insurance affords for M&A transaction parties. The article also examines the insurance’s limitations as well as possible ways to address these constraints.
The State of the Marketplace
Reps and Warranties Insurance affords a means by which an M&A transaction buyer can recover directly from an insurer for losses arising out from breaches of the seller’s representations and warranties in the deal documents. This kind of insurance has “gained market acceptance over the last few years,” but as a result of increased competition due to the significant number of new insurers, improved terms are now available. For example, the premiums charged and the retention amounts have steadily decreased.
Perhaps even more importantly, “buyers have become more comfortable with the RWI claims process,” as marketplace participants have seen that the insurers “have routinely paid valid claims.” (For more detail about the claims paying experience for this type of insurance, refer here.) As a result buyers have “become comfortable relying primarily or exclusively on RWI, which has allowed them to limit or even eliminate the traditional seller indemnity.
Using Reps and Warranties Insurance to Support “No-Survival” Deals
In order to show how the use of this type of insurance can allow buyers to limit or even eliminate the traditional seller indemnity, the article compares a situation in which the seller has retained liability for a portion of the post-closing indemnity amount (what the article calls the “seller’s strip”) to a situation in which the buyer has agreed to eliminate the seller’s liability for certain breach of the reps and warranties (what the article calls a “No-Survival Deal”).
Importantly for consideration of these issues, many insurers are now willing to offer the same coverage limit, initial retention, drop-down retention, and scope of coverage in a deal without a seller indemnity, albeit at a modest premium increase compared to a deal in which the seller retains liability for a portion of the indemnity amount.
The Reps and Warranties Insurance can of course be important even in those transactions in which a seller has retained liability for a portion of the indemnity amounts. But the use of Reps and Warranties Insurance can be particularly helpful in the context of No-Survival deals. Limiting or eliminating the seller’s indemnity can “meaningfully shorten the negotiating timeline” by simplifying negotiations.
A No-Survival deal will help preserve important relationships after the closing, as for example where a management group from the seller remains part of the combine companies post-closing. If there is no seller strip, but buyer can avoid the potentially unpleasant circumstance of having to sue the management team to recover losses after the closing.
A No-Survival deal may be less burdensome for the buyer as well, if Reps and Warranties Insurance is in place. In the event of a claim, the buyer can work with the “a stable, creditworthy insurer to process the claim,” rather than having to seek a small recovery from the seller as it would have to do if there were a Seller Strip.
In addition, in a No-Survival Deal, most Reps and Warranties policies will routinely include two types of coverage enhancements. First, they will include a “full materiality scrape,” meaning that they will “read out” materiality qualifiers in the reps and warranties for purposes of determining whether the reps and warranties have been breached. Second, the will not impose a “damages exclusion” on the buyer’s recovery, allowing coverage for a range of losses (including consequential damages, and those based on multipliers of earning and lost profits).
These coverage enhancements will only be available when the seller has retained liability for a portion of the indemnity amount if deal documents include a full materiality scrape and does not include a damages exclusion. In other words, “while the insurer is generally willing to offer coverage enhancements, if the seller is providing an indemnity, the insurer generally is only willing to offer such coverage enhancements to the extent the seller also does so.”
The Limitations of Reps and Warranties Insurance
Despite its advantages, Reps and Warranties Insurance is “no panacea.” For example, its coverage does not extend to covenant breaches, purchase price adjustments, and other payment obligations. In addition, the limit of liability of the insurance is typically only a portion of the overall deal value, meaning that losses could arise that exceed the amount of the insurance.
In addition, the most policies contain certain exclusions. For example, most policies will preclude coverage for liabilities the buyer knew about when coverage was bound. This exclusion creates a due diligence Catch-22 for the buyer, as the more comprehensive the buyer’s due diligence is, the likelier it may be that the buyer will be deprived of coverage for any liabilities it uncovers. A buyer can, of course, deal with these discovered liabilities in other ways, for example through a reduction in the deal price or by the provision of a special or dedicated seller indemnity.
Most policies also carve out coverage for certain types of liabilities, such as asbestos and PCB liabilities; certain types of accrued or deferred tax liabilities; unfunded pension liabilities; and liabilities associated with employee misclassification and wage and hour law compliance. Some insurers are willing are at least willing to provide coverage for these amounts in excess of the buyer’s primary insurance policies applicable to these losses.
There are a number of other reasons why the use of Reps and Warranties Insurance is increasingly prevalent. First of all, the application and underwriting process has been significantly streamlined compared to the product’s early days. Second, and perhaps more important, prospective buyers have discovered that in a competitive deal environment, the inclusion of proposed Reps and Warranties insurance as part of a deal bid can help distinguish the buyer’s bid. From the buyer’s perspective, the inclusion of Reps and Warranties insurance as part of the bid can encourage the seller to be more willing to expand its representations and to reduce the use of knowledge qualifiers.
But even more fundamentally, take up of the Reps and Warranties Insurance has increased because the cost of the insurance has come down while at the same time the carriers have established a credible track record of paying claims. Simply put, we are now to the point where Reps and Warranties Insurance should be considered in connection with all but the smallest M&A transactions.
It should be noted that the insurance product itself is complex, as is the role it plays in the M&A transaction. For that reason, it is indispensable for buyers considering purchasing this product to include in the deal planning process an insurance advisor that is knowledgeable about and experienced in working with this product.