While representation and warranty insurance
(RWI) has been available in the Canadian and U.S.
insurance marketplaces since the 1990s, it has only more recently
gained traction as a risk-allocation tool in negotiated M&A
transactions.1 Together with other related insurance
policies such as tax liability and contingent liability insurance,
RWI has become a mainstream transactional consideration in a broad
range of M&A and capital markets transactions in Canada, with
several such policies having been issued in the context of Canadian
deals in 2013 alone. As a general rule, RWI is most effective for
transactions where the purchase price is between $20 million and$2
billion (due to the limits that may be purchased and the pricing of
While a number of factors are driving this growth, three in particular stand out:
- Increased efficiency of available RWI products, where binding coverage can be put in place within a week;
- Greater awareness of the tactical value of RWI as a catalyst of transactional success; and
- Heightened sensitivity to risk-profile issues in a period of increased economic uncertainty.
This article provides an update on the current state of RWI in Canada and an overview of its application in particular situations, with a particular focus on the three factors noted above, and specifically on the value of RWI as a tactical tool to both buyers (who may purchase "buy-side" coverage) and sellers (who may purchase "sell-side" coverage).
1 | Value of RWI in the Negotiation Process
In any negotiated M&A transaction, there will be tension between the buyer and the seller with respect to risk allocation (for both known and unknown risks), with each party generally desiring the other party to bear as much of the risk as possible. The result can often be incompatible with respect to the demands on traditional risk-management mechanisms such as representations and warranties, covenants, conditions, indemnities, due diligence, escrows, holdbacks and purchase price adjustments. Negotiations typically play out as follows:
- The buyerwill generally consider the protection of its investment to be paramount. Thus, the buyer will tend to conduct more due diligence on the target, seek more and broader representations and warranties, request more comprehensive indemnities and longer indemnity periods, require larger escrows and holdbacks, and demand reductions in purchase price or earn-outs and other purchase price adjustment mechanisms.
- The seller will generally seek to reduce its exposure under the transaction indemnity profile and to make as clean and certain a break as possible. Accordingly, the seller will tend to seek fewer and narrower representations and warranties (with shorter survival periods), to request more specific or limited indemnities and smaller (or no) escrows and holdbacks, and to demand high deductibles and low caps on its indemnity obligations.
The first important function of RWI is therefore to provide parties with additional flexibility when negotiations over these traditional means of risk allocation have reached an impasse and are threatening to derail the transaction.
A second significant function of RWI is as a "tactical tool". In a controlled auction, for example, a bidder will typically struggle to find the perfect balance between (i) making its bid as attractive to the seller as possible, and (ii) maintaining what from its own point of view is an acceptable risk allocation profile. RWI can help the bidder to minimize its revisions to the seller's proposed purchase and sale agreement as part of its overall binding proposal (e.g. by reducing or eliminating the need for an escrow or holdback, or even having the buyer agree to look to the RWI to take the place of the indemnities from the seller(s)). From the bidder's perspective, this has the advantage of allowing it to distinguish its bid while at the same time maintaining an acceptable risk allocation profile. On the flip side, a seller wishing to cap its liability in such a transaction can do so by obtaining RWI and offering it as an alternative means of recourse to buyers.
Broadly speaking, RWI can act as a catalyst in the negotiation process by allowing the respective parties to quantify the risk not otherwise addressed in the purchase and sale agreement (i.e. as the cost of the policy plus the amount of the deductible) and deal with that risk without creating additional liability risks for either side.
2 | Key Aspects of an RWI Policy
Generally speaking, RWI can cover buyers or sellers2 and can either replace or supplement the indemnification package contained in the negotiated purchase and sale agreement. The most basic function of RWI is to protect the insured, whether the buyer or the seller, against losses suffered as a result of breaches of the representations and warranties contained in a purchase and sale agreement. RWI accomplishes this by reallocating some or all of the risk of such losses from the insured to an insurer willing to issue a policy to underwrite that risk. In order to recover, the insured must establish that a representation or warranty contained in the purchase and sale agreement has been breached and that the insured consequently suffered a loss that creates a liability under the purchase and sale agreement.
Key aspects of RWI include:
- Coverage. RWI policies are customized to each particular transaction and, as noted, can be purchased by either buyers or sellers.3 While an RWI policy can be limited to specific representations and warranties, it is more common for such policies to provide blanket coverage for breaches of any and all of the seller's representations and warranties in a purchase and sale agreement.4 The coverage can replace or supplement any negotiated escrow or holdback arrangement in the purchase and sale agreement.
- Exclusions. As with the issue of coverage, the devil will be in the details when it comes to the issue of exclusions. Exclusions will depend on the negotiation of the particular policy.Generally, RWI policies do not offer protection for known issues and will not cover any breach of a representation or warranty of which any member of the "deal team"5 has actual knowledge at the time the policy's coverage begins. Policies may also have exclusions specific to the transaction where the insurer cannot get comfortable enough to insure particular elements of an underlying risk in the transaction.
- Retention/Deductible. RWI policies will typically contain a self-insured retention or deductible which will vary from transaction to transaction based on the insurer's assessment of the particular risk involved. This typically results in a retention in the RWI policy of between 1% and 3% of the total value of the transaction. Often the retention in a RWI policy will be tied in some manner to the indemnification deductible or threshold in the purchase and sale agreement (or the indemnity cap in the case of supplemental buyer-side coverage). Whether the retention in the RWI policy is inclusive or exclusive of the deductible or threshold in the purchase and sale agreement will be a negotiated point. Insurers generally require the insured to have some real dollars at risk before a claim can be made under the RWI policy.
- Duration of Coverage. While the duration of coverage is negotiable, it will generally match the survival period of the representations and warranties in the purchase and sale agreement. Coverage may be extended beyond the negotiated survival period in order to provide the insured with extended coverage beyond that offered in the purchase and sale agreement.
- Coverage Limits. Coverage limits of up to $50 million are generally available from certain leading RWI insurers, but available limits will depend on each particular transaction.6 The coverage limit can be set having regard to the negotiated escrow amount (if any) or indemnification limit under the purchase and sale agreement if the desire is to backstop or replace the negotiated indemnification package. Alternatively, it may be set at a higher amount if the desire is for extended coverage beyond what has been negotiated in the purchase and sale agreement.
- Pricing. The cost of an RWI policy will depend on a range of factors, including the nature of the insured risks, the amount of the retention and the length of the coverage and coverage limit. Premiums generally range between 2% and 4% of the coverage limit in North America, although pricing in Canada to date has generally been slightly less than in the United States. In addition, in most instances the insurer will require the payment of a non-refundable underwriting fee in order to fund its retention of outside counsel to assist it through the underwriting (including due diligence) and policy negotiation process.
3 | Sell-Side Applications
Circumstances in which a seller may wish to consider purchasing sell-side coverage include:
- Distribute Proceeds. Private equity or venture capital sellers, whether at the end of the life of the fund or otherwise, wanting to cap their indemnification exposure in order to allow for the free distribution of proceeds to securityholders without the risk of repayment.
- Backstop Comfort. Where the negotiated indemnification package in the purchase and sale agreement imposes potential indemnity liability on the seller which is greater than what the risk profile that the seller is comfortable with. (In such a scenario, the seller can regain some comfort by purchasing RWI coverage to backstop this additional exposure and to align it more closely with an acceptable level of exposure to the seller.)
- Removing Contingent Liabilities. A seller disposing of assets or a division and wanting to remove contingent liabilities for indemnification from its balance sheet, whether to return capital to its shareholders or otherwise.
- Value Creation. A seller wanting to add value to the transaction by negotiating a higher purchase price in exchange for giving enhanced representations, warranties and indemnities in the purchase and sale agreement. (In such a scenario, RWI would give the seller the comfort that it can give the enhanced representations, warranties and indemnities knowing some or all of the additional risk will have been shifted to the insurer, while the cost of the RWI policy would be more than offset by the increase in the purchase price.)
4 | Buy-Side Applications
Circumstances in which a buyer may wish to consider purchasing buy-side include:
- Enhancing and Distinguishing Bids. As noted above, a buyer wanting to enhance or distinguish its bid in an auction scenario can accept smaller (or no) escrow or holdback, lower caps on indemnification and shorter survival periods for representations and warranties, all contingent on the buyer's knowledge that it can turn to the RWI policy to bridge the gap in risk that is created by such transaction terms as compared to more traditional buyer-side approaches with respect to those contractual provisions dealing with risk allocation between the parties.
- Distressed M&A. In a distressed M&A transaction, the buyer may obtain an RWI policy in order to offset the credit risk of collecting on indemnity obligations from the seller in such circumstances.
- Multiple or Fragmented Sellers. In transactions involving multiple sellers, a buyer may obtain a RWI policy where it is not possible to obtain joint and several indemnification, especially with sophisticated or financial sellers, or where the collectability of indemnification payments otherwise may be more onerous than it would be in a single-seller transaction.
- Management Sellers. In transactions involving a management buy-out or buy-in, a buyer may obtain an RWI policy as an alternative to claiming against existing management under the purchase and sale agreement. Similarly, RWI may be useful in transactions where an equity sponsor teams up with management on a MBO where the transaction is structured on an "as is, where is" basis due to the sale to insiders.
- Adding Value. A buyer may be able to add value to the transaction by negotiating a lower purchase price in exchange for accepting diminished representations, warranties and indemnities in the purchase and sale agreement. In such a scenario, RWI would give the buyer the comfort that it can accept the diminished representations, warranties and indemnities recognizing some or all of the additional risk will have been shifted to the insurer, and the cost of the RWI policy would be more than offset by the decrease in the purchase price.
- Bridging the Gap. Where the negotiated indemnification package in the purchase and sale imposes a risk profile that the buyer is uncomfortable with, whether due to survival periods being too short or indemnification caps being too low, the buyer can regain some comfort by purchasing RWI coverage to supplement and offset these limitations and align the overall risk profile more closely with an acceptable level of exposure to the buyer.
5 | Putting an RWI Policy in Place in Canada
As discussed above, there is ample evidence that RWI is now very much established as part of the Canadian M&A marketplace and a viable option in a range of negotiated M&A and capital markets transactions. One of the key improvements in recent years with respect to placing a RWI policy has been timing: the timeline for issuance of a policy is now typically between one and two weeks from the time that first contact is made with the insurer, although it is possible to have a policy in place in as little as five business days depending on the circumstances.
One of the ways that insurers have accomplished this is by developing sophisticated M&A groups and processes that deal exclusively with RWI. These groups are often directed by experienced M&A lawyers and M&A and private equity specialists who are very familiar with purchase and sale transactions generally, and who can quickly and efficiently get up to speed with respect to potential risks associated with a particular transaction. The following is an outline of some key steps in putting an RWI policy in place in Canada:
- NDA and Submission of Materials to the Insurer. Typically, the process of placing RWI begins with the execution of a non-disclosure agreement and the potential insured submitting the purchase and sale agreement and related materials to the insurer as part of a submission for a preliminary price and coverage quote. During the submission phase, or when diligence begins, the potential insured may also request that the insurer execute non-reliance letters prior to being provided with diligence reports from the potential insured's legal or other transaction advisors.
- Insurer Issues Preliminary Indication. The insurer, having reviewed and assessed the representations and warranties in the purchase and sale agreement, will typically provide a preliminary indication with respect to price and coverage within two or three business days.
- Substantive Underwriting Process Begins. If this indication is positive and the parties elect to proceed, the insurer would then undertake a more substantive underwriting process. Before continuing the underwriting process, the insurer will often require the payment of a non-refundable underwriting fee (typically between $15,000 and $30,000) to retain outside legal counsel to assist it in conducting its own due diligence and thereafter with the negotiation of a policy. Often this underwriting fee will be credited against the cost of policy when issued.
- Discussions with the Insurer. The underwriting process, which will involve the insurer and its counsel reviewing the due diligence or disclosure process (depending on the party seeking the insurance) and any legal, financial or tax diligence reports that may have been prepared, usually culminates in all parties convening one or more meetings or calls to discuss the due diligence conducted and any questions that the insurer may have as a result. The insurer's level of comfort and confidence in the diligence and disclosure process undertaken by the parties to the purchase and sale agreement will be important factors.
- Completion of the Underwriting Process. While the length of time it takes to complete the underwriting process will depend on the transaction, typically an insurer and its counsel can complete the underwriting process in 3 to 10 days.The speed at which the underwriting process can be completed is due, at least in part, to the fact that the insurer will typically piggyback on the diligence review already conducted rather than starting from scratch and reinventing the wheel in such regard. As noted above, the use of non-reliance letters executed by the RWI insurer often assists with abridging the timetable for completion of the diligence review by the insurer and its counsel.
- Negotiation of the Policy. The final stage in the process – which will often proceed concurrently with the underwriting process – is the negotiation of the RWI insurance policy by the parties involved. As each transaction is different, so too will each policy be different. Key issues in negotiating will include defining the scope of insured losses and exclusions, the coverage term, subrogation rights and the effect of knowledge. Some insurers have previously negotiated policy forms with law firms and insurance brokers; having these precedential documents can speed up policy negotiations.
6 | Claims
No discussion of RWI would be complete without a greater understanding of the ability of an insured to claim for losses under a RWI policy. In respect of claims made by insureds against RWI issuers for covered losses, AIG has, for example, published claims studies that show that claims are made on more than 20% of all policies that AIG has issued in the U.S. and Canada. In addition, while the exact amount of such losses has not been publicly disclosed, leading insurers, including AIG, have confirmed the payment of millions of dollars in losses on RWI policies in North America to date.
7 | Conclusion
Over the past year, Canada's RWI marketplace has continued its rapid development, maturing to the point that RWI is becoming a fundamental component of M&A transactions in Canada. One of the primary reasons for this growth has been a major advance in the speed and efficiency with which RWI can be obtained, thanks largely to the efforts of insurers who have recognized the value of policies that deal cost-effectively with risk allocation issues that historically had to be addressed in the purchase and sale agreement itself. RWI provides added flexibility that can be used as an effective tactical tool by both buyers and sellers in negotiated M&A transactions, especially in robust auction scenarios. While many Canadian transactions will not require RWI, strategic use of this type of insurance in appropriate circumstances can be the difference between success and failure in closing a deal.
1 AIG, one of the largest RWI providers, issued more than twice as many RWI policies in the United States and Canada in 2013 as compared to 2011. Marsh, one of the leading RWI brokers, placed 86% more transactional insurance, by limit of liability, in 2012 over 2011.
2 Currently in North America, buyer coverage accounts for a majority of RWI policies.
3 In some scenarios, a seller may wish to purchase buy-side coverage on behalf of the buyer as a means to bridging any gap between the parties in negotiating the indemnification provisions in the purchase and sale agreement. For example, RWI could eliminate the need for an escrow or other holdback arrangement.
4 As noted, it is also possible to obtain alternative transactional insurance protection such as tax liability insurance and contingent liability insurance. While beyond the scope of this article, these other policies have been used in the Canadian marketplace this year in connection with negotiated purchase and sale and capital markets transactions.
5 The RWI policy will include a list of named individuals from the insured, and any breach in any representation or warranty of which any such deal team member had actual knowledge at the time of the policy will be excluded from coverage.
6 Additionally, it is possible to obtain RWI from multiple insurers if additional total coverage is being sought. For a single transaction, RWI insurers can collectively provide aggregate insurance limits up to $300 million.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.