United States: Representation and Warranty Insurance Can Break the Log Jam

What do you do when negotiations stall because a seller and a buyer cannot agree to indemnification terms for breaches of representations and warranties? "Representation and warranty" insurance, which has emerged for use in M&A transactions, may be a possible solution to deal with unknown risks that could otherwise make the parties walk away from a proposed transaction.

Representation and warranty insurance supplements and sometimes replaces the seller’s contractual liability to the buyer for certain of the seller’s representations, warranties and indemnities under an acquisition agreement. This insurance can be useful in many circumstances, including these:

• when a seller wants limited or no exposure to unknown risks that could give rise to post-closing claims for indemnification;
• as an alternative to an escrow arrangement, when a buyer is concerned that a seller has inadequate creditworthiness to honour its indemnification commitment;
• when a buyer may not want to pursue an indemnification claim against a seller for business reasons (such as when the buyer is to employ the seller).

Either the buyer or the seller can obtain representation and warranty insurance and, depending on the circumstances, may do so without the other’s knowledge.

For a buyer’s policy, key aspects of the underwriting process and policy terms include the following:

• Coverage. When this insurance is used to supplement the seller’s liability for representations and warranties by covering claims that may exceed its indemnification cap, the insurance will generally piggyback on the package of representations and warranties given by the seller. In this case, the policy will indemnify the buyer for losses from any breach of the seller’s representation and warranty package, to the extent that the losses exceed a negotiated level. This level will typically equal (but may be lower than) the seller’s indemnification cap, such that the policy would indemnify the buyer for losses above the seller’s indemnification cap. Exceptions may be required for specialized areas that can be separately insured, such as environmental risks. The term of the insurance will generally match the survival period for representations and warranties in the acquisition agreement, but it can be longer. An experienced insurance broker can advise on market terms and conditions in this developing area.
• Exclusions. Representation and warranty policies do not cover disclosed or known risks. As mentioned above, this type of insurance is intended only for unknown risks.
• Due Diligence. The insurer will seek to piggyback on the buyer’s due diligence and will require copies of due diligence reports prepared by the buyer and its advisers. The insurer should be permitted to use this information only to satisfy itself about the adequacy of the buyer’s due diligence process and as evidence of known risks. The insurer should not be permitted to rely on the accuracy or completeness of the buyer’s due diligence because this would defeat the purpose of having the insurance. In some cases, the insurer will insist on conducting direct due diligence (such as participating in a question-and-answer session with management).
• Cost. The premium is a one-time payment generally in the range of 3% to 7% of the face value of the policy. Factors influencing the amount of the premium include the transaction size, the claims level at which the insurance kicks in, the insurer’s comfort with the diligence process and market conditions. Insurers will generally require payment of a work fee if the buyer decides not to purchase the insurance.

The underwriting process and policy terms for representation and warranty insurance purchased by a seller will be different in some respects from the buyer’s policy. For example, a seller’s policy is likely to stipulate a higher level of losses above which claims under the policy can be made, and fraud by the seller will be excluded.

Insurers will work to the transaction timetable with the goal of binding the insurance concurrently with the signing of the acquisition agreement. Parties to the deal and their advisers should ensure that they have sufficient staff available to satisfy the insurer’s diligence requirements and to negotiate the insurance policy concurrently with the negotiation of the acquisition agreement. Insurers generally seek to facilitate matters by deploying experienced M&A specialists to lead their underwriting teams and to ensure a smooth process.