Note: This is the first in a series of posts that will discuss the use of RWI in Mergers & Acquisitions.
Essential to a buyer’s and seller’s evaluation of the purchase and sale of a company is the allocation of exposure between them for unknown risks and liabilities associated with the breach of representations and warranties in the purchase agreement, such as inventory reporting or products liability exposures. Less than two decades ago, very few considered purchasing Representations and Warranties Insurance (“RWI”), a product designed for the express purpose of providing insurance for the breach of a representation (“rep”) or warranty contained in the purchase or merger agreement. Recently, however, these policies have emerged as an important tool to allocate risk to an insurer. RWI has also been recognized as an enhancement to the value of the deal, as well as critical to closing deals that might not otherwise get done.
RWI allows the early termination of the escrow for the seller while providing a longer survival period for the indemnification of breaches of reps and warranties for the buyer. RWI policy periods typically provide six years of coverage for breaches of fundamental and tax reps (where not specifically excluded) and three years of coverage for non-fundamental reps. The buyer can also purchase policy limits that exceed the cap on the seller’s indemnification obligations.
RWI policies can be either “buy-side” or “sell-side”. Buy-side policies can reduce – or for certain deals, eliminate – the need for a seller’s escrow because the insurer, as opposed to the Seller, is indemnifying the Buyer for covered losses. With sell-side policies, Sellers are insured, but they remain liable to the Buyer for breaches, with the RWI compensating them for their losses. Buy-side policies are the dominant form of RWI currently being used because they satisfy both the desire of Sellers, on the one hand, to achieve a “clean exit” and an end to potential liability, and that of Buyers, on the other hand, to obtain a longer indemnification period.
The use of RWI, however, can potentially impact deal dynamics in non-economic ways. Sellers’ reps and warranties are key to risk allocation and due diligence. Without RWI, the Buyer will use reps and warranties to allocate to the Seller as much of the risk as possible for material information and potential unknown liabilities, whereas the Seller will seek to avoid as much of the risk as possible. Parties to the transaction should never view the option of RWI as a means to limit the scope of a necessary and thorough diligence of key risks and operational factors.
The use of RWI in mergers to transfer risks has become near standard practice. Inclusion of RWI in the bids themselves is becoming more common – either as an enhancement for the bid or as a requirement from the Seller. Buyers need to recognize, however, that RWI will not cover all risks arising from a proposed acquisition. The policies will include deal-specific exclusions, which will be based almost entirely on the scope and results of the Buyer’s due diligence. The policies also include standard exclusions, such as known issues, i.e., issues discovered during due diligence or described in disclosure schedules. They also do not cover purchase price, net worth or similar adjustment provisions contained in the parties’ agreement. Because the due diligence results are often not clear at the bidding stage, Buyers should be wary of using RWI as the sole recourse for indemnification.
Potential buyers who want to add RWI as a sole recourse in their bids need to have a deep knowledge of the target’s operations, including the target’s compliance with laws across a broad spectrum. Early, pre-bid retention of a reputable insurance broker and counsel with an understanding of the RWI market are essential to understanding the risks that may be left to the Buyer as a result of policy exclusion.