For most M&A transactions, one of the primary concerns for the buyer is understanding the risks and liabilities that it will be inheriting through the purchase of certain assets and/or shares and reflecting such risk in the purchase price. Buyers will inevitably engage in varying levels of due diligence, with the understanding that some liabilities and risks cannot be easily identified. Thorough due diligence is prudent and vital to a successful transaction but it is by no means a guarantee that every stone has been turned, every question has been answered accurately or honestly and therefore every liability discovered. To minimize this unknown risk, buyers will employ various measures including the imposition of holdback and escrow mechanisms in the purchase agreement, and requiring the sellers to maintain certain liability and indemnity obligations for an extended period past the close of the transaction. Sellers will naturally want to receive the full purchase price at close and will want to minimize their liability once the transaction has been completed. These contrary motivations often result in either significant delays, unattractive shifts in the allocation of the purchase price or the outright cancellation of the deal.
Representation and Warranty insurance
Fortunately, certain insurance companies have created insurance solutions that enable buyers and sellers to insure against the risk of unknown, contingent liabilities arising after the completion of a transaction and the Canadian legal and business community are increasingly relying upon such insurance to close their deals. There is a vibrant international market of specialist, expert M&A insurance underwriters, with vast deal experience. M&A insurance can be a valuable deal tool and does not yet have the widespread knowledge, within Canada, of its uses and benefits.
Representation and Warranty (R&W) insurance refers to insurance that covers losses arising from breaches of representations and warranties which are commonly provided for within a purchase agreement. The R&W insurance policy can be set up to insure either party, depending upon how the parties' contractual relationship is established and the objectives they wish to achieve. Coverage will be tailored to the needs and risks of a specific deal and can accommodate a variety of corporate transactions. For example, in a typical M&A transaction, R&W insurance can be purchased to replace or supplement the indemnification package provided by the seller in favour of the buyer and because the buyer's risk is mitigated by R&W insurance, the buyer is more amenable to eliminating or minimizing any escrow or holdback arrangement. R&W insurance can remove the cost of escrow and may enable the seller to achieve a greater purchase price. The party requiring protection should arrange the R&W insurance; a buyer should not rely upon a seller's R&W policy but rely upon its own cover (to have contractual access to the policy and to obtain seller fraud protection).
R&W insurance is commonly used in many parts of the world as a closing tool for a broad range of corporate transactions and is increasingly being relied upon in Canada as an accepted tool for the reallocation of risk in sophisticated M&A transactions. With certain global insurers now investing in specialized M&A underwriters for the Canadian marketplace, we anticipate that the use of R&W insurance will continue to accelerate. For instance, Ironshore, the largest R&W insurance provider in Canada and the only insurer with an M&A underwriter in Canada, expects that the number of R&W insurance policies it will issue in 2014 will be a 100 percent increase from the previous year.
When would R&W insurance be used?
As a bespoke solution, R&W insurance can be used in many corporation transactions, customizable to the unique nuances of each deal. The following examples illustrate a few typical situations in which it is has been relied upon in Canada to benefit both sides of an M&A transaction:
- Remove contingent liabilities and distribute proceeds. In a situation where a seller, whether a private equity firm or corporate strategic, would like to limit its exposure to indemnification risk as a result of contingent liabilities that may arise post-closing, a seller-side policy can be purchased to shift the risk to the insurer. Coverage under a seller-side policy would provide comfort to the seller with respect to risk allocation when negotiating its position vis-ŕ-vis the buyer, remove exposure to liabilities from its balance sheet but most importantly allow the seller to freely distribute sale proceeds to shareholders without the risk of being required to repay part of the purchase price due to the occurrence of a future liability. Being able to freely distribute proceeds is enormously advantageous for a private equity firm, allowing them to quickly distribute to their investors or reallocate such proceeds to a new investment. The buyer, in turn, would obtain its desired indemnification package from the seller (insured by the insurer) without losing the deal or having to settle for less protection and can effectively replace, supplement or enhance the indemnification package. Insurance is also often used by individuals, retiring and wanting to be free of the long-tail obligations and legal expense risks of R&Ws and to be able to distribute sale proceeds.
- Distinguish and enhance bids. In a competitive auction process a buyer can use R&W insurance to tender deal terms that are appealing to the seller and superior to the other bidders. If a buyer obtains a traditional indemnification package from an insurer, it is able to offer the seller (i) a reduced or eliminated escrow/holdback; (ii) a lower liability cap for indemnity claims; (iii) shorter survival periods for the representations, warranties and indemnities requested from the seller, thereby providing less warranty recourse against the seller; and (iv) the likelihood of a faster closing and reduced legal fees due to less negotiating of R&Ws resulting from the shift of warranty risk from the business parties to the insurer. The ability of the buyer to claim directly against a regulated insurer would alleviate the credit risk of the seller and in some cases provide a superior indemnification package to what would have otherwise been negotiated. Moreover, it would help the buyer reduce the risk of losing a critical deal and possibly even offset the cost of the R&W insurance policy by achieving a lower purchase price. The seller, on the other hand, would obtain a better offer in terms of the amount of indemnification provided to the buyer and it would be able to make use of the sale proceeds immediately after closing. It should be noted that R&W insurance is not a replacement for disclosure, proper negotiation or due diligence. R&W insurance can be invaluable when acquiring distressed or insolvent targets and sellers, particularly where it will be difficult to obtain meaningful indemnification from the parties involved. An insurer has strong financial ratings and, on top of the contractual provisions of the contract, offers an added layer of regulatory protection.
- Multiple sellers/multiple jurisdictions. Astute buyers understand that a strongly worded indemnity is relatively meaningless if the probability of collecting on such indemnity is low. This is of particular concern when a buyer is purchasing assets from one or more sellers in multiple jurisdictions. In a situation where a buyer is concerned about its ability to collect from numerous sellers in multiple jurisdictions it may be useful to purchase a buyer-side policy to reallocate the risk to the insurer. This might be done even where the buyer is satisfied with the indemnification package in the purchase and sale agreement. The insurance would also help address situations where (a) the buyer's concerns are exacerbated in the instance where the sellers liability is not on a joint and several basis, or (b) some of the sellers who are providing the indemnity are remaining with the company as management and the buyer does not want to have to bring an indemnity claim against its own management. By purchasing a buyer-side policy, the buyer is able to offer the seller better deal terms such as (x) short survival periods for representations and warranties; (y) a lower liability cap; and (z) reduced or eliminated escrow/holdbacks on the purchase price thereby enabling the sellers to utilize the sales proceeds immediately after closing. The protection of a buyer-side policy allows the sellers, who are now part of the buyer management team to focus on operating the business without the fear of an indemnity claim from the buyer. In addition to alleviating the credit risk of the sellers and obtaining a satisfactory level of warranty recourse, the buyer would gain the advantage of consolidating liability into a known and regulated insurer located in a familiar jurisdiction. The buyer would also be able to protect its relationship with the management retained from the seller by being able to access its insurance policy rather than claiming against the sellers.
How is R&W insurance obtained?
The process of obtaining R&W insurance is managed by an insurance broker in conjunction with the insurance company and often requires the assistance of the corporate lawyers leading the transaction. Though insurers are often contacted directly by the party interested in purchasing M&A insurance, a broker must be engaged to act on behalf of the insured. It is worth understanding the distinct roles of the broker and the insurer: the insurer underwrites the risk, pays the losses and provides the product/solution; the broker is the adviser to the client and helps the client select the insurer and the solution offered. With complex areas of insurance such as R&W, there is often merit to have a meeting or call to discuss the M&A issues, exchange information and establish what role the insurance is to play in that transaction. Information flow is important and it is wise to contemplate insurance as early as possible so that its feasibility can be decided at the appropriate decision making point. For example, if the seller wishes to propose the use of R&W insurance to buyers in an auction process, it will be beneficial for the seller to establish the scope and cost of insurance at the bid stage or before.
It is ideal to engage the insurer early in the negotiation process; however the insurer can be brought into the transaction at any point of time. Information is critical to insurers and the best outcome is often achieved where time is factored in and not left to the final days of the transaction. For typical transactions, the insurer is able to complete the underwriting process in 5 to 10 days and be in a position to issue an insurance policy at the end of such period. This is due to the fact that insurance companies have developed sophisticated internal M&A teams, consisting of experienced corporate and tax specialists, enabling the insurer to efficiently quote and underwrite a transaction quickly. That being said, the timing will vary depending on the circumstances and the complexity of the transaction.
A summary of the transaction will need to be supplied to the insurer, including the draft purchase and sale agreement and related materials as part of a request for a non-binding quote. Typically the lawyer will be best situated to know the type of information required for the policy as well as have experience working with the insurer, so his or her assistance will speed up the process considerably.
Who pays for the insurance?
It is not uncommon for the seller to purchase the insurance policy for the buyer in order to bridge any gaps between the parties with respect to the indemnification provisions, but the cost of the insurance can be structured into the deal to be paid by either party or split between them. The fact that one party pays should not affect the insurers pricing or risk assessment of the transaction. Often the cost of the insurance is deducted from the purchase price and the benefit of the insurance will likely be a multiple of the premium cost.
What is the underwriting process?
The underwriting process is akin to an audit of the underlying due diligence process, and does not duplicate the due diligence performed by the buyer. The underwriting process will not require the amendment or addition of the terms and conditions contained in the purchase and sale agreement, but does rely on proper disclosure by the seller, proper due diligence by the buyer and proper negotiation between the parties. Working together with the insured's legal team or broker, the insurer will generally be able to determine whether to underwrite a transaction and issue a preliminary indication fairly early on in the process. Factors that may prolong the determination include the sector of the target business, the size of the deal and the choice of law governing the purchase and sale agreement. It is will be useful to the insurer to see draft due diligence reports, where available, to quickly get up to speed on the business and potential risks and this will reduce the execution risk. The insurance process does not get in the way or slow down the deal, if done properly with specialist M&A insurers and brokers. Some clients like the additional comfort of an insurer reviewing and accepting their risk, as such specialist insurers review hundreds of M&A transactions per year and across a broad spectrum of sectors.
Typical claims process
The extent of coverage permitted under a policy varies depending on whether it is a buyer-side or seller-side policy. For both types of policies, the insured must establish that one or more of the representations or warranties contained in the purchase and sale agreement has been breached and that it suffered a loss giving rise to liability. Important to any seller is that a seller-side policy will cover defence costs associated with an alleged breach provided that the breach is in respect of a representation and warranty covered under the policy. Though timing of payment under a policy varies depending on the breach and type of policy, it is in the best interests of the insurer to make payment as efficiently and fair as possible. The typical claims process is set out in the chart below:
- Parties who lack experience with R&W insurance or are located in jurisdictions where such insurance is not commonly used are sometimes hesitant to obtain R&W insurance with the concern that there will be issues with collecting under the insurance policy in the event of a claim. This concern arises not only with respect to the ultimate recovery but also with respect to the envisaged difficulty experienced in the process to obtain recovery. Firstly, based on our experience and after reaching out to our colleagues and contacts who have experience with such policies, we would encourage parties that want to obtain R&W insurance to do so from a reputable insurer with experience in this niche area as such insurers are likely not able to incur the reputational risk of not properly fulfilling their commitments under a policy. Secondly, it is also important for the insured to understand what would cause an insurer to refuse to pay out under an issued policy. The insurer will be primarily concerned with what the parties actually knew when they entered into the policy. A R&W insurance policy will not cover any losses arising from a breach of a representation and warranty of which the parties had actual knowledge of at the time the policy was issued. Buyer-side policies can be structured to include coverage for seller fraud, but there is no parallel in a seller-side policy. That said, a seller-side policy will permit severability amongst the sellers protecting the innocent warrantors, even in the event of fraud by other sellers. While the insurer will maintain its right of subrogation, it will typically not exercise this unless there has been an egregious act or omission. Such concerns can often be allayed through having a kick-off meeting with insurers to discuss the deal and the possible insurance options.
- Parties may also be concerned with the cost of the insurance policy. Based on our experience, parties have been willing to incur the cost of the insurance premium in return for among other things (i) reduced or eliminated escrow/holdback; (ii) lower on-going liability; (iii) ability to submit more competitive bids; (iv) ability to quickly reinvest or distribute sale proceeds; and (v) greater chance of closing. In many cases analysis will show that the benefits and efficiencies of using R&W insurance exceed the premium cost.
- Parties are sometimes worried that involving an insurer would delay the closing process and result in the insurer amending the deal documentation. Again, our experience has been that the underwriting process does not slow the process down and conversely, in many cases, accelerates it as parties are able to move past certain sensitive deal points once some of the liability connected to such deal points are transferred to the insurer. The insurer is not looking to amend the deal documentation as the insurer is reviewing the transaction as a third party and insuring the deal as it has been negotiated between the parties.
R&W insurance is ubiquitous in certain parts of the world and with the entry of certain specialty insurers such as Ironshore into the Canadian market, is increasingly being used by the Canadian business and legal market. We believe that as more people understand the benefits of R&W insurance, it will not be long before it is commonly relied upon in structuring M&A transactions and showing up as a standard closing deliverable.
Lawyers and business advisors would be well served to understand the contexts in which R&W insurance could strengthen their clients' positions and when best to introduce it into negotiations. Much can be learned from the widespread use of these M&A products in Europe, where the same advanced solutions can be utilized in Canada.
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