Why Representation and Warranty Insurance is becoming increasingly popular in M&A transactions?

With more M&A deals happening globally the M&A process is also evolving and becoming more sophisticated and less cumbersome for both buyers and sellers.

One such innovation is the evolution of Warranty and Indemnification Insurance.

Escrow Provisions

Previously when the definitive agreement would be drafted between the buyer and seller more time would be spent on negotiating the representations and warranties with the subsequent protection to the buyer against the breaches of these reps with seller indemnifying the loss to the buyer.

This happens only in Private transaction and not on Public deals or where the target company is a Public company.The reason is the reps and warranty do not survive post closing because the buyer would not be able to indemnify his loss against public shareholders who are more in number.The public companies also maintain the information better due to the demands from regulators.

In the private transaction since there are few sellers and also the private companies are not bound to follow the reporting standards as demanded from the public companies these reps and Warranty have a survival period of atleast 2 years post closing though buyers negotiate for lesser time.

Generally a part of the purchase price which is about 10% is held by the buyer and maintained in an escrow account and when there is a breach of reps then the buyer can indemnify the seller from escrow.The escrow account is operative for 2 years post deal and post this period the buyer release the amount to the seller after indemnify him against any breach.

Generally seller limits his indemnity by introducing material and knowledge qualifiers in the reps and warranties on the disclosure schedule.These are generally in the form of deductible where only if the loss exceeds a certain minimum threshold the seller shall indemnify the buyer.Again not all reps are treated similarly. Fundamental reps like Standing of the organization, taxes, capital structure, stock and asset ownership have longer surviving period of atleast 5 years post closing and are indemnified dollar to dollar basis.What constitutes a fundamental and non fundamental reps would also be a negotiated between buyers and sellers.

Need for Representation and Warranty insurance

So these negotiations generally take a lot of time and to eliminate this either the buyer or seller take Representation and Warranty Insurance.

• The buyer or seller would be covered upto 10% of the purchase price and the premium for this policy is around 4% of the coverage amount.The buyer or seller would have a policy deductible where a certain amount needs to be borne by the buyer or seller when raising the claim.
• In addition there will be underwriter fees of around $150-400k to broaden the scope of the coverage for the deal which may differ from one deal to another.Hence the risk manager of the insurance company would independently do the sellers due diligence and come up with his report on his findings on risks in the deal which will further decide the premium amount of the policy.
• Generally the premium amount is borne by the seller but in some cases the premium amount is shared between the buyer and seller.The premium payment is one time and the coverage period varies from 3-5 years.
• This insurance only covers the loss till the coverage amount and any loss exceeding this, the buyer needs to recover from seller.This coverage does not include covenant breaches, purchase price adjustments and working capital reductions
• This policy comes with the indemnity strip and no survival clause where the seller liability for indemnity changes.In indemnity strip the policy deductible is generally shared between the buyer and seller but the remaining amount is covered by the insurer.In no survival clause the seller does not have any indemnity towards the buyer and the buyer approach the insurer directly for the claims.

Benefits of Representation and Warranty Insurance

• Since the seller does not have any liability for indemnification the deal happens faster
• If the buyer take this insurance then this can be a distinguishing point especially when there is an auction scenario.In addition the buyer can also negotiate on the purchase price with this policy in hand
• The cost to maintain escrow amount is reduced
• In most of the deals the seller continues to be with the entity.Hence any such claims on breaches of reps has the potential to spoil the relationship between the buyer and seller.With this policy the buyer can directly get the claim from insurer.
• Due to the demand for such insurance policies, the process for claim is made simple. The buyers find the claim recovery from insurance more easier than with the sellers

Limitations of Representation and Warranty insurance

One needs to keep in mind that this insurance policy is not a panacea for buyers and sellers

• The buyers still need to do a comprehensive due diligence on their end and the seller also needs to come up with comprehensive disclosure schedule
• This coverage does not indemnify on those breaches which the buyers had knowledge of during the due diligence.For instance if the buyer had prior knowledge of accrued tax that is payable by the seller then the buyer cannot indemnify the same from insurer.The same applies for environmental claims, employees misrepresentation and wage claims attributed on that, underfunded pensions to the employees by the seller
• When this policy is taken by the seller and if the buyer reports a breach and indemnify the seller, the seller should keep the insurer in loop before paying the buyer.The insurer needs to confirm if the seller has the breach covered under the scope of insurance before the payout is done.

Conclusion

• Representation and Warranty insurance is becoming increasing popular and more insurance companies are offering such products
• Due to the sophistication in M&A practices the buyer need not delay the deal with cumbersome negotiations with introduction of this insurance
• At the same time, the buyer need to conduct a comprehensive due diligence and seller has to prepare a disclosure schedule with relevant qualifier