Canada: Representation And Warranty Insurance: A Better Way To Get Deals Done?

Representations and warranties in a purchase agreement typically affirm key facts about the company or assets being purchased. How to deal with the possibility of a breach of a representation or warranty is therefore a central question in any transaction. Traditionally, the seller provides an indemnity, which in turn requires either the establishment of an escrow account or a holdback against purchase price for a defined period of time.

Recently, a new option—Representation and Warranty Insurance—has been gaining ground in the Canadian marketplace. Coverage can either supplement or replace the traditional indemnity approach and may be obtained either by the buyer or the seller. Representation and Warranty Insurance insures the buyer (or seller) against financial loss arising from the breach of a representation or warranty, while reducing or eliminating the seller’s post-closing exposure to potential liability. That it can do this without the need for an escrow or a waiting period is a distinct advantage that can potentially be the key to closing a transaction.

While the usefulness of Representation and Warranty Insurance depends on the circumstances of a given transaction, it deserves particularly close consideration where:

• Sellers are private equity investors (or other financial investors with a relatively passive ownership interest in the business) and are reluctant to provide an indemnity based on the founder’s or manager’s disclosure under the purchase agreement;
• Sellers require the proceeds of the sale immediately, e.g. to fund other businesses (or where seller is a fund approaching its final distribution and doesn’t want its assets tied up in an escrow or holdback);
• Sellers wish to be relieved of future risk, either for peace of mind or because they are estates or retiring individual founders;
• Buyer requires a significant escrow that seller cannot accept without an increase in the purchase price;
• Seller and buyer cannot agree on a time limit for survival of representations and warranties (in such a case, insurance could be used to bridge the gap);
• Seller and buyer cannot agree on the maximum amount of deal proceeds to be subject to the indemnity (in such a case, insurance could be used to bridge the gap);
• Buyer is concerned about collecting indemnification payments, e.g. because sellers are geographically dispersed or pose other forms of financial risk;
• Seller is a trustee in bankruptcy or a group of creditors managing or directing a financially-distressed company and will not provide an indemnity;
• Employee-managers of the business are to manage the business after closing (in the event of a breach of a representation or warranty, the buyer could then claim under its insurance, avoiding the awkwardness of potentially having to sue the continuing management team); or
• A potential buyer is in a competitive bidding situation (obtaining representation and warranty insurance may reduce or eliminate escrow and indemnity requirements, providing a strategic bidding advantage).

While Representation and Warranty Insurance may be taken out by buyer or seller, buyer-side policies are somewhat preferable because they leave the insurer with fewer defences. As well, in a buyer-side policy the seller is released from all liability to the extent of the policy, excepting only cases of fraud. In a seller-side policy, the loss must be determined under the purchase agreement before the insurer will pay the claim.

• Exclusions

Like other forms of insurance, Representation and Warranty Insurance will usually carve out exclusions, which typically include:

• Knowledge. The "knowledge" exclusion has traditionally applied (i) to defects or breaches and (ii) to facts and circumstances that could reasonably result in a breach, in either case where the insured (or in some cases, its "deal team") had actual knowledge of them. However, one insurer has recently revised its contract to exclude (ii);
• Defects/breaches disclosed in schedules or discovered in due diligence. The knowledge exclusion will also encompass matters disclosed in schedules to the purchase agreement or discovered in due diligence. These may therefore require a separate indemnity and escrow/holdback;
• Closing, balance sheet or post-closing purchase price adjustments;
• Projections;
• Breaches of conditions or covenants in the purchase agreement; and
• Multiples of damages. Where purchase price is calculated as a multiple of earnings (or some other multiple), there is typically an exclusion precluding the use of the multiplier in the calculation of damages.

• Coverage and term

Representation and Warranty Insurance can offer as much as $40 million in coverage for any one transaction. The duration of the policy differs between seller-side and buyer-side policies. In the former, the policy will be coterminous with the survival period of the representations and warranties. In contrast, a buyer-side policy may include coverage beyond the survival period, to a maximum of 6 years.

• Premiums

Generally, as the deductible gets significantly larger, the premium becomes smaller and the exclusions may be narrower. As you would expect, the insured pays the insurer’s legal fees, which are typically capped. Premiums are paid once, at the inception of the policy.

Insurers will also place emphasis on the form of purchase agreement (for example whether pro-buyer, pro-seller or neutral), the quality of the advisors involved in the transaction for the buyer and seller (lawyers, accountants, etc.) and the breadth, depth and quality of the due diligence investigations.

Once Representation and Warranty Insurance is in place, it is helpful to involve insurers’ counsel directly in the due diligence process as early as possible, as this may save them from having to engage in a more costly retrospective review of the process after it is completed.

• Insurer’s right of subrogation

Where a breach does occur, the insurer can subrogate against the insured, but only with respect to misrepresentations made fraudulently or with wilful intent to deceive.

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.