The natural tension between buyers and sellers in merger and acquisition ("M&A") transactions has led to countless hours being spent allocating risk and consequences of various elements of that risk. Typically viewed as a "zero-sum game," the way in which risks, whether known or unknown, are allocated between buyers and sellers often becomes a significant point of contention for all involved with an M&A transaction. But it doesn't need to be that way. Rather, many risks and many of the elements of those risks can be insured with transaction insurance, often referred to as representation and warranty insurance ("R&W Insurance").
With the global economy, including Canada,1 experiencing a record number of M&A transactions in 2021 and this upward trend expected to continue into 2022 and beyond,2 R&W Insurance should be considered an important tool for buyers and sellers, among others, to consider for any M&A transaction.
What Is R&W Insurance?
Representations and warranties ("R&Ws") are used in a majority of commercial contracts to allocate risk between the parties. R&Ws are assertions of fact given by one party to another to induce the other party to enter into the contract and, in certain types of contracts such as purchase agreements typically seen in M&A transactions, to disclose information about the parties to the contract. R&Ws are generally coupled with indemnities, which provide the indemnified party with a contractual mechanism to seek recourse against the indemnifying party in the event of a loss based on a breach of, among other things, an R&W. An untrue R&W is a breach of the contract and the non-breaching party may receive compensation from the breaching party applying the mechanics, and subject to the limitations, of the negotiated indemnities in the contract. In a typical M&A transaction, there is commonly an escrow or holdback amount taken from the purchase price which is used to provide security for payment to the non-breaching party in an event of such a breach.
R&W Insurance changes this dynamic and provides that, subject to certain exclusions and the terms and conditions of the applicable policy, the losses and damages associated with a breach of R&Ws associated with a particular M&A transaction are insured by a third-party insurer. Although minimum dollar thresholds for M&A transactions seeking R&W Insurance are not typically identified, in our experience, R&W Insurance was only commonly available for larger dollar value transactions (e.g. in excess of C$25 million). With many M&A transactions in Canada having a dollar value below that "larger dollar threshold" and seeing a gap in the market, there is at least one streamlined R&W Insurance product available in Canada for M&A transactions (referred to as transaction liability private enterprise) designed for the small and micro M&A market with a dollar value of less than C$10 million.
Benefits of R&W Insurance
For buyers, the benefits of R&W Insurance can include:
- Additional R&W Coverage – As described below, the survival period for many R&Ws can be longer and the scope of the R&Ws can be more comprehensive – in both cases adding protection for the buyer in the event of a breach of an R&W by the seller.
- Availability of Funds for Payment – Non-individual sellers can disburse all funds post-closing; sellers can become insolvent or otherwise be unable to pay a buyer who suffers losses or damages as a result of a breach of an R&W. Although a claims process will need to be completed by an R&W insurer, such insurer is likely to have funds available for payment under an R&W Insurance policy.
- Competitive Advantage – For potential buyers, particularly those in an auction process, securing an R&W Insurance policy can allow that buyer to provide a more competitive offer by, among other things, reducing the need for an escrow or holdback amount for R&Ws, while still securing protection for itself.
For sellers, the benefits of R&W Insurance can include:
- Decreased Financial Risk – R&W Insurance typically allows for the seller to decrease or completely remove an escrow or holdback amount, thereby decreasing the financial risk for the seller of not ultimately receiving those escrow or holdback funds. It also limits or removes the financial risk facing the seller in the event of an indemnity claim for a breach of an R&W, thereby reducing post-closing indemnity obligations and reducing contingent liabilities of the seller.
- Less Adversarial Deal Dynamics – Knowing that the potential liabilities of the seller will at least be reduced, a seller could agree to a more robust R&W package, thereby reducing deal tension over the content of R&Ws and, for sellers who will remain part of the "management team" post-closing, allowing them to avoid negotiating with their new employer over R&Ws.
- Protection of Minority Sellers – Many M&A transactions include minority shareholders as sellers, which can often lead to divergent interests and add an additional layer of complication to the negotiation of an M&A transaction. These complications can include a desire for those minority shareholders to be treated in a way that is inconsistent with the majority shareholders, particularly in terms of the indemnity provisions. By limiting the post-closing indemnity obligations of the sellers, R&W Insurance can be used to reduce or eliminate many minority shareholder M&A transaction complications.
Key Elements of R&W Insurance
R&W Insurance policies have a number of key elements, including coverage, exclusions, policy limits, retention/deductible, and survival.
Generally speaking, R&W Insurance policies will provide coverage for all, or at least the majority, of the R&Ws in an M&A transaction, other than with respect to tax matters and environmental matters. Separate policies for tax matters and environmental matters can often be purchased, but those R&Ws would generally be covered by their own insurance policies. Other types of insurance may also be purchased as part of an M&A transaction, such as title insurance for M&A transactions that are principally driven by real estate considerations.
Exclusions from an R&W Insurance policy can be characterized as either general exclusions, meaning that they are customarily excluded from R&W Insurance policies, or deal-specific exclusions, meaning that they are excluded from a particular R&W Insurance policy based on a deal-specific point. An example of a general exclusion would be excluding any losses or damages arising out of any present asbestos or out of matters where the buyer or its advisers had actual knowledge of a breach of R&W. An example of deal-specific points could be excluding any losses or damages arising out of particular risks identified through the diligence review by the buyer or the insurer's counsel on matters such as foreign subsidiaries or a pre-closing reorganization.
The average coverage limit for an R&W Insurance policy is typically between 10 to 20% of the enterprise value or purchase price of the deal and in certain mandates, a full coverage limit is also available.3
Retention or Deductible
Like other types of insurance policies, R&W Insurance policies have a deductible, commonly referred to as a retention. The amount of the retention or deductible can depend on the deal size, but for many Canadian M&A transactions, the retention will be 0.5% to 1%. Whether the cost of the deductible is to be borne by the buyer or the seller, and whether any amount of the deductible will be placed into escrow, are deal-specific terms to be negotiated by the buyer and seller.
The survival period for "non-fundamental" R&Ws in an M&A transaction is usually 12 to 24 months, while the R&W Insurance market standard is three years of coverage for "non-fundamental" R&Ws, with such coverage lasting for up to six years of R&W Insurance coverage for "fundamental" R&Ws.
The Process of Getting R&W Insurance4
Implementing an R&W insurance policy in an M&A transaction tends to involve two steps: (1) soliciting Non-Binding Indication Letters ("NBILs") from R&W Insurance carriers, and (2) the underwriting process.
Step 1 – NBILs
This first step normally takes between three to five business days and involves acquiring a quote from R&W Insurance providers, which is generally facilitated through a broker. Using a buy-side policy as an example, the buyer will confidentially provide the R&W Insurance providers with drafts of key transaction documents, as well as detailed information regarding the target company, including financials and assets being acquired.
Step 2 – Underwriting Process
An insurer will begin the underwriting process at the time when due diligence in the M&A transaction by the buyer has been substantially completed, and a draft of the principal transaction documents, including the schedules thereto, has been prepared.
The insurer underwriting the transaction and the buyer will then execute the NBIL. At this time, the underwriter and its counsel will be given access to the virtual data room relevant to the transaction, which contains all of the diligence materials that the diligence reports drafted by the buyer's counsel on the seller and the target business is based on. This review will inform further conversations between the insurer and the respective parties.
After reviewing the draft transaction documents, due diligence reports, and disclosure schedules, there will be an underwriting call between the underwriter, its counsel, and the buyer and its advisors, where the underwriter and its counsel will ask the buyer and its various advisors – including legal, financial and other specialized advisors – questions about the diligence process and findings and general questions about the transaction, which will inform the drafting of the R&W Insurance policy.
With the conclusion of the underwriting call, the insurer will provide a draft R&W Insurance policy, including proposed exclusions and various additional close-out diligence questions. The language of the policy, including the contemplated exclusions, is then reviewed by the buyer and its counsel. The buyer and its advisors will have an opportunity to provide comments on the R&W Insurance policy itself and to remove any exclusions from the policy by completing additional due diligence or to narrow the scope of the exclusions. Once the final terms and conditions of the R&W Insurance policy are agreed upon, the policy is eventually bound and issued on or prior to closing.
Although M&A transactions that include R&W Insurance as part of the transaction still have points of negotiation, such as which party bears the cost of the policy, the deductible and risks associated with other elements of the transaction, R&W Insurance should be considered an important tool for buyers and sellers in Canadian M&A transactions.
The Capital Markets Group at Aird & Berlis will continue to monitor developments in M&A transactions generally, as well as developments with R&W Insurance in the Canadian market and beyond. Please contact Jeffrey Merk, Gary Volman, Christian Nianiaris, or any other member of our Capital Markets Group if you have questions or require assistance with any matter related to securities legislation, M&A transactions and how R&W Insurance may be effectively implemented in your deal.
1. PwC Canada, 2022 Canadian M&A industry and market trends
2. KPMG, 2021 was a blowout year for M&A
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.