The global M&A boom has spurred an increase in the use of representation and warranty insurance (“RWI”), which is designed to protect the insured party against breaches of a sellers’ representations and warranties in a corporate acquisition or merger agreement. RWI is increasingly used by buyers to differentiate their bids in an ultracompetitive marketplace, as well as by sellers look to maximize returns and minimize post-closing risk. A purchase agreement that incorporates a RWI policy can influence a seller’s ultimate decision when selecting a buyer.
For private equity-backed portfolio companies, incorporating RWI in a deal allows sellers to pass profitable returns to the fund’s limited partners and can reduce or eliminate claw back distributions from the LPs when indemnification claims are subsequently made. RWI also gives sellers the full value of the sale without tying proceeds up in escrows, holdbacks, and can reduce or eliminate entirely future indemnification claims.
For buyers, a RWI policy helps to eliminate the need to decide whether to make claims against “friendly” indemnitors (e.g., management), and can often result in a buyer-favorable purchase agreement in a seller-favorable climate. RWI can provide additional indemnification limits above the terms of the purchase and an extended period of time to recover for any breaches beyond the survival period.
Yet at each stage of the acquisition, buyers regularly fail to maximize the value that the RWI policy can provide. By utilizing the RWI policy at each stage of an acquisition, a buyer can add value to its acquisition.
How to Maximize the Value of the RWI Policy
1. Consider the Details of RWI in Your Letter of Intent
Although the procurement of RWI is now routine during the negotiation of the letter-of-intent, the parties often limit their focus on the RWI policy to the mere requirement that the buyer will obtain a policy, without negotiation of the specifics of how the coverage will apply, much as buyers routinely obtain but do not negotiate D&O tail policies. Occasionally the parties negotiate the desired size of the retention insofar as it relates to the size of an escrow. However, buyers regularly fail to consider simple but important concepts that can increase their risk and limit their rewards:
- Is the RWI policy the sole measure of recourse (other than the escrow)?
- Who bears the risk of policy exclusions?
- Who pays for the policy?
Considering these questions during the LOI phase gives buyers increased certainty regarding the overall indemnification package and takes these items off of the table as future negotiating chits.
2. Use the RWI Policy to Push During Diligence
RWI underwriters rely on the due diligence performed by the buyer. If the use of RWI is a facet of the deal, the due diligence by the buyer must be adequate and the seller must be ready to provide greater access to data in order to facilitate the required due diligence. The nature of the target’s operations will drive the depth of the diligence. For example:
- Is a Phase I Environmental Report needed to avoid an exclusion based on environmental liabilities?
- How much of the target’s business relies on key contracts, customers or suppliers?
- What are the target’s billing practices, particularly billings to federal, state or local government agencies?
- Is the target susceptible to wage and hour claims?
The non-binding letters of intention received from the RWI underwriters will highlight the particular area of concern, based on the underwriter’s review of the initial purchase agreement and LOI. If the RWI is the sole recourse, the buyer must be vigilant that the due diligence conducted will be sufficient to address the underwriter’s concerns. Likewise, to the extent that the seller remains on the hook for any excluded representations or warranties, providing access to this information is vital to reducing the chances of a deal-specific exclusion.
Moreover, in the current competitive deal landscape where sellers seek to pressure buyers into expediting their diligence and thereby limit the scope of diligence, a smart buyer will leverage the RWI underwriter’s need for in-depth diligence to obtain a level of diligence satisfactory to the buyer and the RWI underwriter.
3. Use the RWI Policy to Negotiate the Purchase Agreement
A well-negotiated RWI policy can provide greater protections to buyers (and sellers) than they might otherwise get without engaging a RWI carrier. Buyers can negotiate a more fulsome representations and warranties package from the sellers since the vast majority of the risk of a breach is on a third-party insurance carrier. This typically means lower materiality thresholds and longer look-back periods.
For sellers, the RWI policy can afford a shorter escrow period, lower escrow limits and provide the sole recourse for any indemnification obligations beyond any escrow. Because there is another source for the indemnification obligations, sellers should be willing to open up the representations and warranties.
4. Address Exclusions
When armed with the proper diligence, buyers can successfully negotiate with RWI underwriters to reduce or eliminate deal-specific exclusions. Where a buyer has conducted sufficient due diligence, buyers and their counsel should be unwilling to accept exclusions related to unknown risks, and should push back against such exclusions. A buyer that has conducted in-depth diligence has the leverage to successfully push back against exclusions related to areas of a company where there may be increased potential for risk (e.g., risks related to a high customer concentration) but where there are no identified reasons for concern. In addition, the use of schedules to identify the known risks often reduces the need for broad and open exclusions.
As private M&A continues to skyrocket at a record pace, buyers and sellers increasingly use representations and warranties insurance to transfer risk to third party insurance carriers. Yet in many cases buyers fail to realize the full value of the policy. Deal lawyers and their clients should be leveraging RWI at each stage of a transaction to better mitigate post-closing risks and to maximize the RWI policy’s overall value.