Closing with Confidence: Representations and Warranties Insurance in M&A

Representations and warranties insurance (RWI) has become an increasingly common feature in mergers and acquisitions (M&A) transactions, serving as a risk management tool for both buyers and sellers. RWI facilitates deal-making by offering protection against financial losses arising from breaches or inaccuracies of the representations and warranties made by the seller in the transaction documents, which are often a contentiously negotiated aspect of a purchase agreement. This insight explores the types of RWI policies, what they generally cover and exclude, how they benefit parties in M&A deals, and the typical costs associated with these policies.

Types of Representations and Warranties Insurance Policies: Buy-Side vs. Sell-Side

RWI policies can be categorized into two main types: buy-side and sell-side. A buy-side policy, the most common type of RWI policy, is purchased by the buyer to cover losses arising from breaches of the seller’s representations and warranties. A buy-side policy allows the buyer to recover losses directly from the insurer rather than pursuing the seller post-closing. This is particularly beneficial in situations where the seller is not financially strong or when the buyer wishes to maintain a good relationship with the seller post-closing, such as when the seller remains involved in the acquired business after the transaction (e.g., when a seller is rolling over equity and/or will be a key employee after the closing).

A sell-side policy, on the other hand, is less common and is purchased by the seller to protect against claims made against the seller by the buyer for breaches of representations and warranties. This type of policy can be useful in situations where the seller is concerned about being pursued by the buyer post-closing. Sell-side policies can also be beneficial by providing peace of mind to sellers who want to distribute sale proceeds without setting aside significant escrow or holdback amounts or being overly concerned with potential post-closing exposure for indemnification claims.

Coverage and Exclusions in RWI Policies

RWI policies generally cover financial losses arising from breaches or inaccuracies of the seller’s representations and warranties in the purchase agreement. This can include, among other things, inaccuracies in financial statements, undisclosed liabilities, issues with ownership of assets, tax matters, intellectual property claims, and claims relating to material contracts (including, for example, undisclosed pre-closing breaches or defaults under a material contract).

However, like most insurance policies, RWI policies generally contain exclusions. These exclusions typically relate to issues known by the buyer, forward-looking statements (like financial forecasts), seller fraud, covenants (like purchase price adjustments, non-competes, etc.), and closing conditions. Ultimately, the extent of coverage and the specific exclusions are essential aspects of RWI that must be scrutinized by the insured and their legal counsel and insurance broker.

Benefits of RWI for Buyers and Sellers

RWI policies provide several benefits for both buyers and sellers, particularly concerning survival periods, baskets (i.e., the threshold amount of damages that must be met before indemnification claims can be made against the seller), and indemnity caps (i.e., the limits set on the amount of indemnification a buyer can claim from the seller for breaches of representations and warranties) in the purchase agreement.

Typically, representations and warranties in a purchase agreement are subject to survival periods, which dictate the time frame within which a claim can be made under the purchase agreement. However, RWI can extend the effective survival period by the nature of the terms of the policy, thereby allowing buyers to make claims against the policy for a longer period than might otherwise be negotiated with the seller under the purchase agreement. Specifically, the policy will contain coverage periods, which refer to the duration for which the policy will be in effect with respect to types of covered claims. Often, the policy will contain varying coverage periods based on the type of representations, such as general representations versus fundamental representations.

Additionally, RWI can provide a mechanism for the parties to negotiate and agree to reductions of baskets and indemnity caps. In turn, by reducing the baskets and the caps, RWI often will allow for a lower indemnification holdback or escrow amount (which is often closely tied to the indemnity cap).

Baskets are often aligned with retention of the RWI policy and, for deals involving RWI, the retention typically ranges from 0.5% to 1.5% of the transaction value. This amount is often split between buyer and seller equally through the basket so that buyer covers the first half of the retention, and the seller covers the second half before coverage under the policy kicks in. In M&A transactions, baskets and caps play a crucial role in determining how much risk each party is willing to bear before insurance coverage kicks in. When RWI is in place, these caps and baskets are often structured differently to reflect the insurance policy’s retention, providing greater clarity and security for both buyers and sellers.

In summary, RWI often provides buyers with extended coverage periods that provide longer protection, while allowing sellers the ability to negotiate shorter survival periods in the purchase agreement to align with their risk tolerance and financial considerations. Further, RWI often helps streamline the process of determining baskets and caps, making it easier for both parties to agree on terms that protect their interests while facilitating the smooth completion of the transaction.

Economic Features Associated with RWI: Premiums, Underwriting, Retentions, and Coverage

The economic features of RWI are an important consideration in M&A transactions. They typically include premiums, underwriting costs, retentions (similar to deductibles), and coverage limits.

• Premiums: RWI premiums generally range from 2% to 4% of the total coverage amount. For example, a $10 million policy might cost between $200,000 and $400,000.

• Underwriting costs: These costs cover the insurer’s due diligence and can range from $20,000 to $50,000 (or more), depending on the complexity of the transaction.

• Retention: Retentions in RWI policies typically range from 0.5% to 1.5% of the transaction value. Retention acts as the deductible, meaning the insured (either the buyer or seller, depending on the type of policy) must bear initial losses up to this amount before the insurance kicks in. As discussed above, the retention is often closely aligned to the basket in the purchase agreement.
• Coverage amounts: These can vary widely but are typically between 10% and 30% of the transaction value. This means that for a $100 million deal, the coverage might range from $10 million to $30 million.

While negotiated among the parties, the premium and underwriting costs are often split equally between buyer and seller, but, in some transactions, these costs may be paid solely by one of the parties.

Conclusion

Representations and warranties insurance is a valuable tool in M&A transactions, offering protection and peace of mind to both buyers and sellers. By understanding the different types of policies, what they often cover and exclude, and the associated costs, parties can better navigate the complexities of M&A deals and structure transactions that are beneficial for all involved.

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