Representations and Warranties Insurance (“R&W Insurance”) is becoming increasingly more prevalent in private M&A transactions, particularly in middle market deals. As a potential seller of a business, you might wonder whether such a policy could be useful during a competitive bid process. As a buyer of a business, you might wonder what you actually get out of such a policy. Learning more about what R&W Insurance can do for you will help you determine whether it is a strategic tool you should rely on to close your transaction.
There are two types of R&W Insurance policies: buyer-side policies and seller-side policies. A buyer-side policy, which is purchased by or on behalf of the buyer with the buyer as the insured party, is the most popular. This policy is designed to cover a buyer’s losses resulting from unknown breaches of the seller’s representations and warranties in the purchase agreement. It can be a useful tool to supplement or even replace a seller’s indemnification obligation. Conversely, a seller-side policy will insure the seller and provide a backstop to its indemnification or escrow obligations. A seller policy is typically only purchased when a buyer is unwilling or unable to purchase a buyer policy. Because of this, buyer-side policies are the focus of this article.
A standard R&W Insurance policy provides a buyer with coverage for breaches of the seller’s representations and warranties in a purchase agreement that are not otherwise known to be untrue by the buyer’s deal team prior to binding the policy. In a typical M&A transaction, the seller agrees to indemnify the buyer for breaches of representations and warranties (subject to certain limitations, such as baskets, caps and survival periods). In the absence of insurance, to provide the buyer with some assurances of collectability, the parties might agree to hold back or escrow a portion of the purchase price to cover the seller’s indemnification obligations. There is a built-in tension between buyers and sellers, with buyers seeking to have a dedicated source of proceeds from which to collect for the greatest period of time and sellers seeking to have as few dollars tied up for the shortest period of time possible. R&W Insurance is an excellent product to help bridge this gap. By replacing escrowed funds with a policy of R&W Insurance, a buyer can often assure itself of a creditworthy source of repayment that is greater than what it could obtain from the seller, and the seller is able to retain a greater portion of the sale proceeds than would otherwise be possible.
Although R&W Insurance provides buyers with an alternative source of payment for breaches of representations and warranties, it is not likely to cover all possible losses. Policies will be company specific, and there will be some exclusions for coverage. These exclusions will depend on the business at issue and the specific underwriter but are likely to include known matters, certain specialized representations and losses relating to fines and penalties. The parties will need to negotiate coverage from the seller for gaps in the R&W Insurance coverage.
- Engage an experienced broker as early in the process as you can. The broker will obtain proposals from several underwriters. The underwriter selected by the buyer will need to conduct its own due diligence, which can take up to two weeks. A well-organized data room can help expedite review.
- If the nature of the transaction requires certain specialized representations (e.g., healthcare, data breaches, etc.), the parties should engage in discussions with an experienced broker that is familiar with the market for insuring such matters.
- Determine who will pay for the policy and who will bear uninsured portions of loss. There will be underwriting fees associated with the policy, but there will also be a “retention amount” for the policy that will act as a deductible. Parties often heavily negotiate how and in what proportions these amounts are borne by the parties.
- Consider binding the policy at signing as opposed to closing or structuring the transaction as a simultaneous signing and closing.
- Consider an R&W Insurance policy if the transaction has roll-over equity so that the buyer engages with a third party regarding indemnification claims rather than its new partners.
- Engage counsel who is familiar with the R&W Insurance process and can advise you on market terms.