Expanding Opportunities for Coverage of M&A Transactions in Representation and Warranty Insurance

Traditionally, Mergers & Acquisitions (“M&A”) have imposed burdens directly on sellers of companies to cover the buyer’s risk stemming from any faulty representations and warranties (“R&W”) made in the course of the deal. Under the typical arrangement, a seller company would place some proportion of the proceeds of the sale into an escrow account for a predetermined period of time, and such funds would be forfeited to the buyer in the event of a misrepresentation.

More recently, however, insurers have stepped in to facilitate M&A by offering Representations and Warranties Insurance (“RWI”). This type of policy benefits both the buyer and the seller, since not only is the seller shielded from significant liability, but the buyer can rest easy knowing that the seller’s insolvency will not bar recovery.

The prevalence of RWI may lead corporations and their coverage counsel to ask whether it makes sense for them. How big must a deal be to make such a policy worthwhile? What opportunities exist—where can a policy be found, and what limits are available? Are there any pitfalls?

RWI Is Available for Ever-Smaller Transactions

In the past, insurers were unlikely to offer RWI for deals with a total value of under $50 million. As the benefits of policies have become better-known and demand has increased, the threshold value has steadily declined to below the $20 million mark, and even under $15 million. The popularity of RWI and the success of larger insurers at the $50 million level and above have prompted less-established insurers to enter the market and drive the low end of the spectrum downward.

Recognizing the prevalence of M&A at smaller scales, insurers have also begun marketing a policy that is analogous in many ways to pure RWI: Transaction Liability Private Enterprise (TLPE) insurance. This offering is designed for deals with a total value between $250,000 and $10 million. Unlike typical RWI, which is available to sellers but is mainly purchased by buyers, TLPE is available only to sellers. It is also available to a more limited number of industries.

Sellers and Buyers Find Opportunities to Benefit from RWI

Because of the bilateral benefits of RWI, policies are often sold to both buyers and sellers in M&A transactions. Since the buyer is generally the party that bears a greater risk from a seller’s misrepresentation, buyer policies are more common. Sellers also may prefer buyer-side RWI, because it allows them greater access to the proceeds of a deal—rather than being on the hook for a deductible (called a “retention” in RWI) should a claim arise. Still, because the deal itself often places liability on the seller to pay damages in the event of a breach of R&W, sellers may mitigate that risk by purchasing the policy.

The benefits of such a policy include the fact that it will generally provide coverage over a long time period. Sellers are likely to want to avoid such a long commitment of indemnity for a variety of reasons. Either they must lose access to their proceeds for the time that the funds are in escrow, or they must risk liability that they cannot afford. In either case, the seller is not able to close and exit the deal without worry.

The premium for a RWI policy tends to be 2-4% of the policy’s limit. The retention risk may be shouldered by either party, and is frequently split by the parties under the terms of the deal. The retention is typically  1-2% of the total value of the transaction.

Pitfalls and Risks of RWI

Despite its advantages, RWI comes with certain dangers to both buyers and sellers. Notably, RWI does not eliminate all types of financial liability stemming from a breach of R&W. It is also conceivable that it may adversely affect the deal process itself, by diminishing the care and diligence with which the parties might otherwise have conducted the deal process.

RWI coverage often only applies to “innocent” breaches of representations and warranties; that is, a seller cannot have knowingly made a misrepresentation. Because of this, it is a miscalculation for a seller to rely too heavily on the availability of RWI. A buyer who knowingly makes a misrepresentation should still be directly liable to the seller, and the buyer should still do its due diligence to ensure that a breaching seller is in a position to pay damages for the breach. RWI also does not cover breaches of covenants or other terms of the M&A agreement, so parties must be careful to clearly delineate R&W in their drafting of the contract.

Additionally, a buyer’s temptation to weaken its due diligence efforts where RWI applies can be a bad long-term strategy, particularly for repeat buyers. As with other types of insurance, higher risks create higher premiums and a lower likelihood that insurance will be available in the future. Likewise, a seller might feel a false sense of security and soften its negotiations of R&W. Where it would normally be incentivized to draw the narrowest possible R&W, the seller might fail to scrutinize those provisions and create a fundamentally less stable deal.

Even when a breach is covered economically, the lower stability of the deals that may result from overly liberal R&W on the seller’s part—or insufficiently careful research on the buyer’s part—is likely to degrade the parties’ leverage both in future deals and in securing RWI as the market corrects to the change in behavior.

There is also the issue of the insurer itself. Because RWI is a relatively new and growing product, it is difficult for many insurers to accurately calculate the risk of claims, particularly in light of the parties’ potential to change behavior. Less-established insurers may be overextended in their risk portfolios. It is therefore highly advisable not only to deal with experienced insurers, but also with experienced insurance coverage counsel that can help navigate the market.

Conclusion

For buyers looking to minimize the risk of a corporate acquisition and sellers looking to make a clean exit, Representations & Warranties insurance offers several advantages. Such coverage may, however, present drawbacks, which may be mitigated through artful construction of both the policy and the deal itself. With the help of skilled coverage counsel, companies are likely to find new and beneficial ways to facilitate their deals through this increasingly popular insurance product.

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