United States: Representations And Warranties Insurance In M&A Transactions

Last Updated: April 8 2015
Article by Olga Sandler

Historically, negotiations over representations and warranties (R&W) and the related indemnification in M&A transactions have often been difficult, time-consuming and costly, even where the parties had fully agreed upon the purchase price.

Once the relevant terms and numbers were finalized, parties frequently resorted to escrows and holdbacks to secure sellers' indemnity obligations. Although such arrangements have provided some level of security, they have always had limitations: (i) sellers assumed the risk that they will not be able to receive the remainder of the purchase price or will only receive funds after a significant delay; (ii) buyers assumed the risk that escrowed funds or funds held back would be insufficient to cover all indemnity claims and that funds would be released prior to discovery of a breach; (iii) both sellers and buyers carried an additional risk that the other may hold up the release of escrowed funds and that funds may not be released until a court order is issued after prolonged litigation; and (iv) the party that would ultimately be entitled to the escrow or holdback amount gave up opportunity costs by keeping funds in low-interest bearing escrow accounts or only received low interest on the holdback amount.

Over the last few years the availability of more reasonably priced representations and warranties insurance (RWI), the improved process of obtaining RWI (where coverage can be secured in a few days) and better terms and conditions of RWI (with higher limits on liability, longer policy periods and narrower exclusions) have permitted both sellers and buyers to shift a significant portion of the risk associated with breaches of sellers' R&W in sale and purchase agreements (as well as certain other types of agreements) to the insurer, to address some of the shortfalls of the escrow and holdback arrangements and achieve other benefits described below.

Types of insurance

Generally two types of RWI policies are available: seller-side and buyer-side.

Seller-side policies protect a seller against risk of claims against the seller for breach of R&W made by the seller. The policy periods generally match the survival periods in the sale and purchase agreement and sometimes provide for an additional short period of time in order for the insured to make a claim. Policy limits generally match the indemnity cap under the sale and purchase agreement plus an additional amount for defense costs.

Buyer-side policies are the more frequently used and are intended to reimburse a buyer directly for losses arising out of a breach of R&W by the seller. Policy periods in buyer-side policies may extend beyond the survival period of R&W in the sale and purchase agreement (two to four years for general R&W and sometimes even five to seven years for the so-called "fundamental representations," environmental and tax R&W). Buyer-side policies frequently provide coverage in excess of the indemnity cap under the sale and purchase agreement.

Benefits of RWI

For both sellers and buyers, RWI now allows parties to be more flexible on the scope of R&W and indemnities, including deductibles, caps and survival periods, therefore taking issues off the table in a much more expedited fashion.

RWI now allows the seller to:

  • Reduce potential contingent and long-term liability, and negotiate lower deductibles and caps and shorter survival periods in sale and purchase agreements
  • Exit "cleaner and faster" from a transaction by reducing or eliminating the amount of funds locked up in escrow or as a holdback, thus enabling a faster distribution of a larger portion of sale proceeds to the seller (and in case of private equity funds, their investors)
  • Insist, in an auction context, that buyers rely mainly or entirely on the RWI policy for recourse
  • Attract buyers with buyer-side insurance who otherwise would not consider a transaction with a seller of lesser creditworthiness
  • Protect itself from liability for breaches of R&W in sale and purchase agreements where the seller has not been actively involved in the management of the target business or in the relevant negotiations
  • Expedite the sale process and potentially increase the purchase price by eliminating obstacles to closing, such as indemnity negotiations

RWI now allows the buyer to:

  • Supplement indemnification protection offered in the sale and purchase agreement through coverage that may be in excess of the indemnity caps set forth in the sale and purchase agreement, which has become even more important in recent years as the indemnity caps have been sliding from 40–50 percent to 10–15 percent of the purchase price1
  • Obtain additional time to detect and report problems when policies provide coverage for claims made after the expiration of the survival period in the sale and purchase agreement
  • Provide for an effective indemnity in public deals where it is not possible to recover from public shareholders
  • Distinguish its bid in an auction by offering lower deductibles, caps, smaller escrows or no escrow, and in some cases offering that RWI be the sole recourse for breaches of sellers' R&W
  • Ease its concern about the ability to collect on seller's indemnification due to poor creditworthiness of the seller (including in case of bankruptcy, where escrow arrangements are extremely rare) or from numerous sellers who may be geographically dispersed or otherwise difficult to locate
  • Mitigate jurisdiction-specific risk on cross-border transactions, and explore transactions in jurisdictions with which the buyer is not familiar
  • Obtain from the sellers additional R&W as long as the buyer's main or sole recourse is the RWI
  • Preserve relationships with sellers who may become joint venture or other commercial business partners of the buyer after the closing

Premiums, deductibles and limits

The major insurers offering RWI today include AIG and Chubb. Today, typical premiums in the US range between two percent and four percent of the amount of insurance purchased (compared with five percent to six percent in the early 2000s). Deductibles range typically between one percent and three percent of the transaction value, based, inter alia, on the type of business and the nature and the scope of the R&W. Deductibles (in buyer-side policies) often line up with the indemnity cap or size of the escrow in the transaction.

Generally insurers insure up to US$50 million individually, though higher amounts are possible, and parties have also reached higher limits by combining policies from several insurance companies.

Increase in use of RWI

As a result, the use of RWI has become more accepted, especially in middle market deals valued between US$20 million and US$1 billion.

According to Marsh, in the US and Canada the amount of buyer-side RWI used in acquisitions in 2014 increased by 225 percent compared with 2013.2

Claims notifications and payouts have also increased in line with market growth.3

Limitations and pitfalls

RWI, however, is not an answer to all problems associated with risk allocation in M&A transactions. Parties to M&A transactions should be aware of the limitations and pitfalls of such policies. Some of these include:

  • RWI is issued on a claims-made basis only (i.e., claims with respect to a breach must be asserted during the policy period or any reporting period in order to be valid)
  • RWI deals with coverage of breaches of R&W; sometimes specific indemnities may be also covered, but such policies rarely apply to breaches of covenants or to postclosing adjustments to the purchase price
  • RWI can be structured as a "blanket" coverage for all R&W or only for certain ones; furthermore, the terms of the RWI may not completely mirror the terms of R&W in the sale and purchase agreement, so parties should pay close attention to gaps in coverage
  • Although buyer-side policies can essentially provide an extension of the survival periods set forth in the sale and purchase agreement for many representations, in the case of the so-called "fundamental representations" where the survival period is indefinite, the RWI policy will not cover the entire survival period
  • Similarly, while RWI policy limits are generally higher than the indemnity cap for breaches of certain R&W under the sale and purchase agreement, "fundamental representations" may not be covered in their entirety since indemnification for breaches of such R&W is generally uncapped

Not all types of risk are covered, and alternative means of protecting against the downside may have to be sought.

For example:

Environmental issues: Generally RWI covers costs of the cleanup of unknown pre-existing conditions, including associated permitting, but does not cover new conditions. Consequential losses, such as third-party bodily injury, or long-tail tort claims, such as asbestos, may not be covered. Coverage for non-owned disposal sites and divested properties is also not guaranteed. Coverage may not be available for companies in high-risk industries, such as chemicals. In such cases, the pollution legal liability insurance may be used in tandem with the RWI.

Tax representations: Although the scope of tax representations that insurers now cover has increased dramatically, insurers still tend not to insure certain tax risks, such as taxes in certain foreign jurisdictions.

Foreign Corrupt Practices Act violations: Many insurers tend to exclude such violations from coverage, but it is becoming possible to obtain such coverage in cases where one can demonstrate strong internal compliance programs and control.

Fraud: Sellers may not be able to insure their own fraud, but buyers may obtain coverage against sellers' fraud.

Policies typically exclude claims in respect of matters of which the insured had knowledge prior to the effective date of the policy, though knowledge by the seller would not normally result in an exclusion under the buyer-side policy. One key consideration is to insist that the exclusion be limited to "actual knowledge" and be defined to refer to several specific individuals on the "deal team." Any coverage for known items would have be to specifically negotiated.

Finally, standard forms of some insurers define "loss" by reference to "actual breach of, or inaccuracy of representation or warranty." References to "actual" should be resisted by the insured, whether in the case of a buyerside policy or a seller-side policy. In the case of a buyer-side policy, it may be important for the buyer to ensure that a third-party claim alleging facts which are later proven incorrect would nonetheless cover litigation or other expenses related to pursuing the claim. In the case of a seller-side policy, it may be important that the seller will be able to recover costs of defense even if the seller is ultimately vindicated.

Conclusion

RWI offers a valuable tool for structuring M&A transactions more efficiently. While RWI does not negate the importance of negotiating robust R&W in sale and purchase agreements, or eliminate the use of other traditional means of addressing exposure to contingent liabilities in M&A transactions (such as escrows, holdbacks and other types of insurance), RWI does offer greater flexibility in structuring M&A transactions. Furthermore, even though claims and payouts are increasing as the RWI market grows, the expanding use of RWI in M&A transactions is a relatively new phenomenon and the claims-paying history is still in the developing stage.

Footnotes

1. M&A Market Trends Subcommittee, Mergers & Acquisition Committee of the American Bar Association, Business Law Section, Private Target Mergers & Acquisitions Deal Point Study, 2014.

2. Marsh, "Competition for Deals Fuels Rapid Adoption of Transaction Risk Insurance Among Global Deal Community: Marsh", November 19, 2014.

3. Id.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Events from this Firm
6 Dec 2017, Webinar, New York, United States

Join Dentons for a complimentary webinar focused on the ongoing challenge of integrating new technologies into existing information governance policies and risk management frameworks.

24 Jan 2018, Seminar, San Francisco, United States

Dentons will host our Fourth Annual Courageous Counsel Leadership Institute in January, centered on the theme "Cultivating Innovation."

 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Emails

From time to time Mondaq may send you emails promoting Mondaq services including new services. You may opt out of receiving such emails by clicking below.

*** If you do not wish to receive any future announcements of services offered by Mondaq you may opt out by clicking here .

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.