Trends in Corporate Law: Rep and Warranty Insurance
By Stefan dePozsgay
Sellers and buyers in private control transactions negotiate a host of issues when documenting the change in ownership of a target business. While the general economics of private company merger and acquisition deals tend to make their way into the news media, risk allocation issues are often left to the fine print of transaction documentation, despite their importance to both sellers and buyers.
Understandably, sellers usually have substantially more familiarity with a target business than potential acquirers, resulting in an information disparity that is difficult to overcome through due diligence alone. Realizing the impracticality and costliness of a prolonged and invasive due diligence process, sellers and buyers historically have addressed this “information gap” by supplementing due diligence efforts with a package of representations and warranties about the target company made by sellers for the benefit of buyers. Representations and warranties in acquisition agreements are usually accompanied by indemnification mechanics to ensure that buyers are protected against losses arising from inaccuracies. Indemnification provisions can be complicated: sellers and buyers must negotiate whether known and unknown risks will be covered, whether indemnification will be “capped” at some percentage of the transaction consideration, whether there is some threshold or deductible of losses that a buyer must sustain before a seller becomes liable, and whether a buyer’s prior knowledge of breaches will absolve sellers of liability, among other things.
Unfortunately, no matter how heavily negotiated or well designed they are, representations, warranties, and indemnification provisions are only valuable to a buyer if they can be enforced against the seller. Without a creditworthy seller providing indemnification (and often even with such a seller), buyers will typically demand that a portion of the transaction consideration be deposited with a third-party escrow agent (or held back by the buyer) for the potential satisfaction of future indemnification claims. The customary requirement for a “backstop” of indemnification obligations transforms a “legal issue” into a “money issue,” since buyers and sellers are forced to quantify risk. Over the past several years, the insurance industry has emerged to address risk allocation and quantification in private company M&A transactions through a new product, representation and warranty insurance.
Rep and warranty insurance protects the insured (buyer or seller) from certain losses it may incur as a result of a breach of covered representations and warranties, or other matters that may be insured under the policy. Insurance can be structured to cover specific representations and warranties or to cover the entire package of representations and warranties given by the sellers under the acquisition documents. A standard rep and warranty insurance policy can act as either security (backstopping or extending the coverage of a seller’s indemnification obligations for breaches of representations and warranties) or as the primary source of coverage (replacing the indemnity entirely).
More and more frequently, our clients are considering the use of rep and warranty insurance policies to bridge the gap on risk allocation between sellers and buyers. For sellers, these policies can maximize their closing date payouts by reducing or eliminating the need for escrows or holdbacks. This is particularly advantageous for private investment funds that are trying to maximize their internal rates of return or other performance metrics to improve their track records. If the sellers are a consortium, an insurance policy can alleviate complications associated with joint and several liability for breach, which is often required by buyers but may be onerous for sellers with varying levels of knowledge of the target business’s operations and contingent liabilities.
There are also benefits to buyers. Because these policies may be attractive to sellers, a buyer’s willingness to use insurance may be enough to distinguish its bid in a competitive sale process. In our experience, sellers are also often willing to provide a more comprehensive representation and warranty package when a policy is in place, since much of the risk has been transferred to the insurer. Furthermore, the coverage period for rep and warranty insurance typically exceeds the survival period for representations and warranties set forth in the acquisition agreement, thereby providing additional protection for the buyer.
However, using a rep and warranty insurance policy does raise some additional issues for the parties to consider. First, they must decide who pays for the policy. Premiums usually fall within the range of 1 percent to 6 percent of the amount of coverage. Insurers also typically require that one or more parties (customarily the seller) retain some risk on representations and warranties in the form of a deductible, which is often set at 2 percent to 3 percent of the total transaction value but may vary from deal to deal. The party paying the premium does not necessarily have to be the insured. However, the insured’s actual knowledge of a breach is typically excluded from the coverage, and since sellers usually have more knowledge about the target business than buyers, buy-side insurance (where the buyer is the insured) is generally considered to be more comprehensive and is, accordingly, more expensive. The treatment of seller fraud is another significant distinction between sell-side and buy-side policies. Sell-side policies exclude fraudulent misstatements by the sellers from the coverage, whereas buy-side policies typically do not. This is largely because buyers are not in a position to know which of the sellers’ statements are fraudulent.
The parties must also decide the breadth and scope of insurance coverage. The specifics of a particular deal are material in determining the scope of the coverage. Rep and warranty insurance usually covers breaches of reps and warranties but customarily does not cover breach of post-signing covenants, since compliance with covenants is generally under the control of the sellers. However, rep and warranty insurance can cover specific contingent liabilities (for example, outstanding litigation) and other general indemnities (for example, indemnification for pre-closing taxes). On the other hand, circumstances may dictate that certain representations be excluded from the coverage, typically when the potential exposure is high. An example of this would be coverage of a representation on environmental matters where such issues are a disproportionately material risk of the target business.
The benefits of rep and warranty insurance have been documented extensively by practitioners, and the market has moved dramatically in recent times toward widespread adoption. We would strongly recommend that our clients, whether on the buy side or the sell side, consider the use of rep and warranty insurance in their acquisition strategies.
Stefan dePozsgay is a partner in the corporate group at Boies, Schiller & Flexner in New York.