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By Richard D. Harroch, David E. Weiss, and Richard V. Smith
There is a significant emerging trend in the use of M&A representations and warranties insurance in mergers and acquisitions of privately held companies. Both strategic acquirers and private equity buyers have gotten increasingly comfortable in using such insurance for their acquisitions, providing meaningful benefits to both the buyer and seller in an acquisition.
As a prelude, representations and warranties by a seller are key components of an acquisition agreement and are often heavily negotiated by the parties. In a traditional M&A transaction, the seller (or its shareholders) agree to indemnify the buyer (subject to caps, exclusions, and time limits) for breaches of the seller’s representations and warranties. Often, the indemnity has been backed by an escrow of a portion of the proceeds otherwise payable at the closing (typically 10% to 15% for one to two years). The emerging use of representations and warranties insurance is modifying or eliminating this traditional structure.
This article provides a comprehensive overview of representations and warranties insurance, its benefits, the scope of coverage and exclusions, and other key issues.
What Is Representations and Warranties Insurance?
Representations and warranties insurance is an insurance policy used in mergers and acquisitions to protect against losses arising due to the seller’s breach of certain of its representations in the acquisition agreement.
The key points of such insurance policies are as follows:
- The insurer will charge a fee (the “premium”) for issuing the policy, typically 2% to 3% of the coverage limits. For example, if the coverage amount of the policy is $20 million, the premium could be $400,000 to $600,000. Insurers typically charge a minimum premium of $150,000 to $200,000. The premium for such policies has been decreasing as more competitors have jumped into the market. The insurer will also charge an underwriting fee, which could be as high as $50,000 for deals over $50 million. In addition, premium taxes will need to be paid to the state of domicile of the buyer. There also might be an insurance broker fee in some situations.
- The policy coverage is typically a dollar amount equal to 10% of the M&A purchase price.
- There will be a deductible amount under the policy that is excluded from coverage (the “retention”), typically a minimum of 1% of the M&A purchase price.
- There are “standard” exclusions to coverage; for example, the insurance does not cover covenant breaches by the seller or purchase price adjustments, and there may be specifically tailored exclusions based on the results of the insurance company’s due diligence/underwriting.
- Not all representations and warranties of the seller are covered (see “The Limits and Exclusions of Coverage” below).
- The buyer or the seller can be the insured party, but 90% of the time the insured is the buyer.
- The premium payment is typically a onetime fee paid up front.
- The policy term is typically for 3 to 6 years, to be negotiated with the insurer.
The Typical Process for Obtaining Representations and Warranties Insurance
The process for obtaining a policy usually starts with the buyer or seller approaching an insurance broker to solicit quotes from insurers. An application for insurance must be completed.
The following are the key information and documents the insurer will want to review:
- The parties involved
- The coverage amount sought
- The form of acquisition agreement, especially the nature and scope of the seller’s representations and warranties
- The seller’s online data room
- The buyer’s due diligence reports on the seller
- The seller’s Disclosure Schedule connected with the acquisition agreement
The process is usually in two parts: (i) an initial non-binding indication of interest which costs nothing and then (ii) an underwriting/due diligence process that requires payment of an upfront underwriting or due diligence fee (typically $15,000 to $50,000).
After the insurer’s due diligence, the insured will then negotiate the specific terms of the policy, such as the scope of losses included within coverage and excluded from coverage.
The Benefits of Representations and Warranties Insurance
There are multiple benefits of representations and warranties insurance to the parties to an M&A deal.
For sellers, the benefits of such insurance can include:
- It can allow for the reduction or elimination of the traditional seller’s indemnity for breach of representations and warranties.
- It can allow for the reduction or elimination of an escrow or holdback that would otherwise reduce the proceeds received by the seller’s shareholders at the closing of the acquisition.
- It can provide for a cleaner exit to the seller, with fewer contingent liabilities associated with the sale of the company.
- The seller (and seller’s counsel) may feel it can give the more extensive representations and warranties the buyer will want in the acquisition agreement, without as many “materiality” and “knowledge” qualifiers, leading to a quicker resolution of the form of acquisition agreement.
For buyers, the benefits of representations and warranties insurance include:
- The buyer’s bid can look much more attractive to a seller if there is no (or limited) escrow or holdback required, since the buyer will rely on the insurance for indemnification protection.
- It can extend the time for duration of the representations and warranties, giving the buyer additional time to discover problems with the acquired business.
- It can enhance or increase the amount of protection to the buyer, in amounts greater than the seller might otherwise agree to.
- Since the seller will likely be willing to give more extensive representations and warranties in the acquisition agreement, this improves the buyer’s likelihood of prevailing on a claim under the policy.
And, for both parties, the anticipated use of representations and warranties insurance usually simplifies and speeds up the negotiation of the acquisition agreement since the seller has less interest in negotiating the scope of its representations, especially if they do not survive closing. Further, in a deal where there will be some limited post-closing indemnification by the seller’s stockholders, the seller has less interest in resisting materiality caveats where the insurance will cover all losses, and therefore this aspect of the deal negotiation also can be concluded relatively quickly.
What a Typical Representations and Warranties Insurance Policy Looks Like
A typical policy will set forth the following:
- Name and address of insured party
- The limit of liability
- The deductible amount
- The specific representations and warranties contained in the acquisition agreement to be covered by the policy
- The scope of coverage (claims, defense costs, losses, etc.)
- The policy period
- Exclusions from coverage
- Conditions applicable to the policy (e.g., truthful information provided by insured, payment of premium, reasonable cooperation)
- Dispute resolution (typically through binding arbitration)
Here is a sample buyer-side policy form.
Prospective insureds and their counsel will want to carefully review the form of policy, and potentially negotiate to eliminate any gaps in desired coverage.
Which Insurers Issue Representations and Warranties Insurance?
In the United States, many of the policies of representations and warranties are issued by the following insurers:
- AXA XL
- Everest Insurance
- The Hartford
Insurance brokers who arrange for obtaining such insurance include:
- Woodruff Sawyer
The Limits and Exclusions from Representations and Warranties Insurance Coverage
Buyers and sellers need to understand that representations and warranties insurance is not a black-and-white alternative to the traditional post-closing indemnification, escrow/holdback and survival of representations and warranties structure of private-company M&A deals. Importantly, representations and warranties insurance policies typically contain the following exclusions and limits:
- The policy covers up to a certain dollar amount for losses, typically 10% of the M&A deal consideration. Therefore, the buyer can be at risk for extraordinary losses.
- The policy does not cover breaches of the seller’s covenants in the acquisition agreement.
- The policy does not cover purchase price adjustments (such as for working capital adjustments as of the closing date of the deal).
- The policy will exclude losses due to breach of representations and warranties of which the buyer had knowledge, typically defined as “actual knowledge” of certain identified deal team members. Given the extensive due diligence investigation buyers typically undertake (and insurers expect), this exclusion might result in non-coverage of material risks, such as the risk of patent infringement.
- The policy may exclude certain tax-related issues, including taxes accrued on the balance sheet for pre-closing periods, transfer taxes, taxes disclosed on the M&A Disclosure Schedule, and the availability to the buyer of net operating losses and R&D tax credits.
- The policy may include a carve out for liabilities associated with misclassification of employees/independent contractors and wage and hour laws.
- The policy may exclude liabilities related to asbestos or other environmental issues.
- The policy may exclude forward-looking representations and warranties (such as revenue projections).
- The policy may exclude certain types of losses (such as consequential or multiple damages).
If the buyer has specific concerns about the limits or exclusions (for example, as to intellectual property infringement), some insurers are willing to negotiate coverage under an “excess coverage” rider to the policy or otherwise modify the policy in consideration of the payment of special additional premiums.
Nevertheless, for strategic buyers, representations and warranties insurance may not be an attractive alternative to traditional post-closing remedies.
The Key Issues Negotiated Between the Seller and Buyer
When representations and warranties insurance is used in M&A deals, here are the key related issues that typically get negotiated between the buyer and seller:
- Who pays for the insurance?
- Is there a sharing of the retention/deductible amount under the policy? (The 1% typical retention is often split 50-50 among the buyer and seller.)
- If the buyer will be exclusively relying on the insurance policy, do the seller’s representations and warranties expire on the closing of the M&A deal?
- Does the seller retain some liability for breach of fundamental representations and warranties, such as due organization or capitalization of the seller?
- Will the seller be liable for certain extraordinary losses in excess of the insurance policy limit?
- Will the seller be liable for “gaps” in coverage?
- Will the buyer insist on a separate indemnity for losses disclosed by the seller and not covered by the policy (such as potential pre-closing sales tax liabilities)?
- Is there potential continued exposure of the seller for “fraud” or “actual fraud” and how are those terms defined?
Acquisition Letter of Intent/Term Sheets Language Incorporating the Use of Representations and Warranties Insurance
Buyers are now frequently including references to the use of representations and warranties insurance into their Letters of Intent or Term Sheets. The following is sample pro-seller language:
Buyer will, at its sole expense, pursue obtaining an M&A representations and warranties insurance policy covering all of Company’s representations and warranties under the definitive acquisition agreement (the “Policy”), with the intention of minimizing post-transaction risk to the Company’s shareholders and maximizing their immediate proceeds from the proposed transaction. There will be no escrow or holdback, as Buyer will look solely to the Policy for breaches of the Company’s representations and warranties in the definitive acquisition agreement. The Company’s representations and warranties shall terminate as of the closing of transaction.
In Letters of Intent or Term Sheets, buyers who agree to obtain M&A representations and warranties insurance may seek to include clauses requiring the seller or its stockholders to bear some portion (usually one half) of the cost of obtaining the insurance policy and the cost of the retention.
Claims Under Representations and Warranties Insurance
In its 2018 report analyzing claims under its representations and warranties insurance, AIG stated that it had experienced a 19.4% claims frequency under its policies. This is similar to other publicly reported figures. AIG commented that its 2018 analysis “demonstrates that claims, both large and small, are likely to be a constant feature in M&A deals going forward.” AIG further reported an average payout of $19M but that the largest claims were quite material.
The frequency of claims under representations and warranties insurance is bound to increase given the enhanced popularity of the policy. The most common claims to date have revolved around the representations and warranties related to:
- Accuracy and completeness of financial statements
- Disclosure of material contracts
- Compliance with laws
As with any other type of insurance policy, a carrier may deny a claim presented by the insured. The beneficiary of the policy may then need to resort to litigation or arbitration to recover its losses. This requires a specific type of legal expert who has had experience in dealing with insurers on such claims.
The typical reasons for denial by an insurer on a claim under a representations and warranties insurance can include:
- The insured’s application for coverage was false or incomplete
- The claim does not fall within a definition within the policy of a covered “loss”
- The problem was known by the insured prior to the closing of the M&A transaction
- The claim involves a covenant of the buyer, and not a representation or warranty
- The deductible must first be applied before any recovery is available
- The language of the particular representation or warranty has not been breached
- The claim is within the type carved out by the policy (such as asbestos or wage and hour claims)
Since most representations and warranties insurance policies are subject to mandatory arbitration provisions, there is little published legal authority in this area. Cases pursued in arbitration may also be subject to confidentiality agreements that prohibit the parties from disclosing substantive information about the proceedings. Accordingly, we may not see much development in the law with respect to this type of insurance, as opposed to other areas of insurance law where there has been extensive public litigation and numerous published appellate decisions.
One published decision involving representations and warranties insurance is Ratajczak v. Beazley Solutions Limited, 870 F. 3d 650 (7th Cir. 2017). That case involved a seller-side representations and warranties policy. The sellers were accused of failing to disclose that their corporation had been adulterating a whey protein concentrate product the company sold as part of its business. They settled with the buyer for $10 million.
The sellers purchased a representations and warranties policy providing indemnity protection for losses caused by breaches of warranties made to the buyer. The acquisition agreement provided indemnification for breaches of “fundamental representations” and breaches of other representations. For non-fundamental breaches, the sellers’ liability was capped at $1.5 million, which happened to be the amount of the policy deductible. The sellers argued that the claims against them were for fundamental breaches, and therefore the liability cap did not apply and the insurance company should cover their $10 million settlement with the buyer.
The Court of Appeals disagreed and ruled for the insurance company, finding there was no coverage under the policy for the settlement, as the false representations at issue were not among the specified fundamental representations. The Court also addressed the sellers’ rhetorical question as to why they would have settled for $10 million if their contractual liability was capped at $1.5 million. The Court answered by pointing out that there was no cap on liability under the contract for fraud, but, unfortunately for the sellers, the policy excluded fraud.
In addition to the above, and even more significant, the Court ruled there was no coverage because the insurance company did not approve the settlement before it was entered into by the sellers. Indeed, the insurance company was not even notified of the claim until the settlement talks were almost concluded. The sellers argued that the insurer could not prove prejudice, but the Court ruled there was no prejudice requirement in the policy— the insurance company approval requirement was “absolute.”
This case presents a cautionary tale for policyholders when dealing with a potential claim situation. Policyholders should provide prompt notice to their insurer and keep the insurer apprised of any settlement discussions or other material developments with respect to the claim. While some jurisdictions may require the insurance company to establish prejudice in order to avoid coverage for alleged violations of notice and cooperation policy provisions, policyholders should not assume they will be able to win such arguments. The better practice is to involve insurers early in the process to avoid giving them an easy way out of paying valid claims.
Copyright © by Richard D. Harroch. All Rights Reserved.
About the Authors
Richard D. Harroch is a Managing Director and Global Head of M&A at VantagePoint Capital Partners, a large venture capital fund in the San Francisco area. His focus is on Internet, digital media, and software companies, and he was the founder of several Internet companies. His articles have appeared online in Forbes, Fortune, MSN, Yahoo, FoxBusiness, and AllBusiness.com. Richard is the author of several books on startups and entrepreneurship as well as the co-author of Poker for Dummies and a Wall Street Journal-bestselling book on small business. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He was also a corporate and M&A partner at the law firm of Orrick, Herrington & Sutcliffe, with experience in startups, mergers and acquisitions, and venture capital. He has been involved in over 200 M&A transactions and 250 startup financings. He can be reached through LinkedIn.
David E. Weiss is a partner at Reed Smith, LLP, in its insurance recovery litigation practice group. For over 28 years David has represented corporate policyholders in disputes with their insurance carriers. David also advises companies on issues regarding insurance policy procurement and provides insurance advice regarding corporate transactions, including M&A transactions. David has helped recover billions of dollars in insurance proceeds for his clients and has been listed for several years as one of the The Best Lawyers in America© in insurance law, among other honors. David regularly writes and speaks on topics related to insurance law and litigation. He can be reached through LinkedIn.
Richard V. Smith is a partner in the Silicon Valley and San Francisco offices of Orrick, Herrington & Sutcliffe LLP, and a member of its Global Mergers & Acquisitions and Private Equity Group. Richard has advised on more than 500 M&A transactions and has represented clients in all aspects of mergers and acquisitions transactions involving public and private companies, corporate governance, and activist defense. He is the co-author of the recently published 1,500-page book by Bloomberg, Mergers and Acquisitions of Privately Held Companies: Analysis, Forms and Agreements. He can be reached through LinkedIn.
January 23, 2019 at 11:40AM
Forbes – Entrepreneurs