Representations & Warranties Insurance: An Emerging M&A Tool

Representations and Warranties (“R&W”) form the crux of the architecture of any M&A agreement. Breaches of such R&W allow the buyer to claim their share of losses or sometimes even walk away from the deal. Traditionally – and even in a lot of deals today – and especially where the consideration is just cash, it is the seller who indemnifies the buyer for any losses suffered for breach of seller warranties. However, many recent deals (especially involving private companies) have seen the inclusion of R&W insurance (“RWI”), a new and emerging product that fully or partially replaces seller indemnity. While this was historically not the first resort for parties, buyers have gradually become more comfortable with this policy. In fact, data reflects that it has been used in approximately seventy-five percent of the private equity transactions and sixty-four of larger strategic acquisitions in the M&A market.

What is RWI?

RWI is an insurance policy designed to expressly provide coverage for breach of R&W in an acquisition agreement, acting as an addition to or replacement for a contractual indemnity. It is typically used in deals sized between $20 million and $2 billion, with a majority of the transactions that use RWI falling between $100-$500 million in size. RWI coverage is typically around ten percent of the deal size and the market premium is around three to four percent of the coverage limits.

An Edge Over Contractual Indemnity

The advent of RWI has definitely made buyer protection more advanced and seamless. On the other hand, sellers also benefit from RWI as it relieves them from having to provide seller indemnity and deal with certain stressful post-closing litigation claims. For the buyer, RWI could help enhance its bid in an auction process, provide comfort in the event of a distressed seller, and even limit potential variation in valuation estimates. Using RWI typically enhances survival periods for R&W, giving the buyers more time to claim for their losses – three years for business R&W and six years for fundamental and tax R&W, whereas for the seller, it primarily limits post-closing liability for a breach of its R&W and provides purchase price certainty.

Is It Really Worth It?

The use of RWI in the USA in increasing gradually and market data suggests that it is a product that is here to stay, especially in private deals. Public deals usually do not have post-closing indemnity, and RWI may therefore not prove as useful for such deals as the cost is not set off against the risk. Further, while RWI has proven to be a useful tool in large M&A deals, it is typically unfavorable for deals below $20 million as its fixed premiums and related costs make it more effective in larger deals.

A typical RWI excludes certain matters from coverage: losses for fraud, known breaches, fines and penalties, purchase price adjustments and forward-looking items. This is in contrast to traditional seller indemnity, which usually includes these items subject to what is negotiated contractually. A typical indemnity provision might also indemnify the buyer for specific liabilities such as outstanding litigation, environmental or tax related risks, which are clearly excluded from RWI. Further, RWI policies are usually subject to standard deductibles in the form of retention between 0.75-1.25 percent of the enterprise value. Traditional seller indemnity in a pro-buyer acquisition is generally not subject to such blanket deductibles and can recover losses from the very first dollar.

RWI may not be all that glorious for a buyer. Premium is an additional transaction cost and underwriting may delay the transaction timetable. While it does save the buyer from dealing with the seller post-closing in the event of losses, claiming the RWI from the issuer can also be a cumbersome process. Further, a lot of the claims are settled or resolved within the policy retention itself, resulting in the insurer not having to shell out any money at all in an indemnity event.

Conclusion

The RWI market has continued to evolve and has gained significant traction in the last few years. The issuers have become extremely competitive in order to remain relevant. Premiums are being priced even lower than three percent of the coverage amount, in order to foster competition and attract parties to an acquisition. RWI has its upside, but evidence of this has so far been limited to transactions of a considerably large value. Parties to smaller acquisitions must evaluate the cost-to-risk ratio to determine whether buying an RWI policy would be an appropriate protection. Further, due to the deductibles and exclusions, on a standalone basis it may not even be the best solution for larger deals. It could be advisable to have a part-seller indemnity, part-RWI deal to offset the downside of RWI deductions and exclusions. If used strategically, RWI could really prove to be a catalyst, offloading the buyer and seller’s burden with respect to losses for breach of R&W. The terms of an RWI policy must be negotiated to fit the particular transaction and ensure that the policy provides the desired coverage. Like any other M&A tool, the parties should have the expertise to tweak and negotiate the RWI policy in order to use it to their full advantage.

Anushka Shah is an LL.M. (Corporation Law) candidate at NYU School of Law and serves as a Graduate Editor of the NYU Journal of Law & Business. Prior to attending NYU School of Law, Anushka worked for two years as an Associate in the General Corporate (M&A and private equity) team at Shardul Amarchand Mangaldas & Co (one of India’s largest and leading law firms) at their Mumbai office. At Shardul Amarchand Mangaldas & Co, her practice largely focused on advising clients on a wide range of public and private cross-border M&A and private equity transactions dealing with industry-specific, foreign exchange and securities laws. Her role involved conducting due diligence, drafting and negotiating transaction documents, particularly in the pharmaceutical, healthcare, electric vehicles, digital and telecom sectors.