Facilitating the Transaction

Representations and Warranties (R&W) insurance has undergone a dramatic evolution in execution and perception over the last few years and is now being actively used as an integrated transaction solution on various types and sizes of mergers and acquisitions (M&A) in Canada.

Once regarded as expensive, slow and too intrusive of an underwriting process to be a value-added M&A risk transfer solution, awareness around the potential uses, benefits and features of R&W insurance is increasing.

After a brief slowdown in Canadian M&A activity in the first part of 2013, enthusiasm for Canadian M&A activity, especially in the private middle market segment, has been renewed by continued uncertainty in the global economy and the perceived recovery and resurgence of the debt markets. But many transactions face challenges en route to closing, whether the issue is a specific transaction-related risk attribute or a value consideration, and some will fail where others succeed.

In this tight M&A market, buyers and sellers have a diminished appetite for risk, which is driving an increased appetite for creative risk-transfer and deal-facilitation solutions such as R&W insurance. The current state of the Canadian R&W insurance market — with competitive premiums and improving awareness levels among corporate lawyers, private equity and specialty insurance professionals — has a similar feel to when private company director and officers (D&O) liability insurance began taking off.

EVOLVING PRODUCT

The key drivers for R&W insurance in 2013 will be economic conditions with distressed sellers who have weak financial covenants, a diminished appetite for risk by cautious buyers, corporate refocusing leading to sales of non-core assets, continued appetite of foreign strategic buyers and foreign private equity for Canadian assets, and a desire by Canadian corporations and funds for international diversification.

Although available in the Canadian market for more than a decade, R&W insurance here remains a relatively under-utilized solution on M&A transactions. Since R&W insurance started being actively utilized in the late 1990s, the majority of this business being in the United Kingdom, the specialized insurance product has undergone an evolution.

Having evolved from its sell-side liability risk transfer roots to an integrated deal facilitation solution, the insurance is commonly used (and is sometimes automatically built into the sale and purchase process) in jurisdictions such as Europe, the United States, Australia and now Asia.

It is estimated that approximately 5% of international corporate or strategic M&A transactions, and approximately 75% of private equity transactions, use R&W insurance.

It is anticipated the adoption and utilization of a local, “Canadian” underwriting approach to this insurance segment will continue to improve the solutions, service, process and perceived value within this marketplace.

BUILDING PROTECTION

R&W insurance can protect either the seller or the buyer for financial losses resulting from breaches of representations and warranties made by the seller in the sale and purchase agreement (SPA). Such policies cover the unknown, but can be specifically tailored for a trans- action where there are identified issues, including tax or outstanding litigation.

Regardless of the structure of an M&A transaction, all SPAs have two important sections that are heavily focused areas of negotiation: R&W and indemnification. As net liabilities are identified during the due diligence process and the buyer tries to determine the scope of the exposure, understandings are reached between the buyer(s) and seller(s) as to whether — and to what extent — each party is responsible for the liability.

Often, the SPA calls for the seller to indemnify the buyer for some or all of the liability; sometimes, the seller is asked to post a sum of money in escrow to provide security for its agreement to indemnify. These SPA provisions are called “representations and warranties.” If either the scope or duration of the indemnity, or the amount of security provided in connection with the indemnity, becomes a point of contention, this can delay, or even derail, a transaction.

Although not a substitute for proper disclosure by the seller or proper due diligence by the buyer, R&W insurance is available in connection with exposures associated with many transactions, including but not limited to, cross-border deals, fund exits and strategic purchases.

As R&W insurance policies are customized to each deal, they will often mirror time limits and de minimis values in the SPA, and can be written so that either a buyer or seller of the M&A transaction is the insured. The most obvious utilization of an R&W policy occurs when a seller is unable to provide adequate levels of indemnification, or where the buyer feels the seller has a weak financial covenant. Insurance can offer easier access and a better financial covenant than some protection offered by sellers.

Under a seller-side R&W policy — which offers third-party liability protection, such as defence costs and damages, to the seller — the insured is the seller and coverage is triggered once the buyer submits a claim against the seller for a breach. Seller policies provide protection to sellers for unknown breaches and can ensure severability from other warrantors (even in the event of fraud) and be a strategic consideration in eliminating transaction obstacles, expediting the sale, reducing contingent liabilities and potentially increasing the return.

Under a buyer-side R&W insurance policy, which offers first-party protection to the buyer for loss resulting from a breach of warranty, the insured is the buyer and submits claims for a seller’s breach directly to the insurer to obtain coverage. Buyer-side policies offer such benefits as protection against seller fraud, enhanced warranty protection, extended warranty duration and/or easement of indemnity collection concerns, especially in transactions with multiple sellers potentially located in multiple locations.

There is sometimes an assumption made that a D&O insurance policy will cover a client for the contractual risks of selling the business (i.e., representations and warranties given in a SPA). However, an R&W insurance policy is specifically tailored to the risks of selling a business, and is designed to protect buyers or sellers for the full survival period of those obligations (as long as seven years).

Transaction parties usually wish to settle their disputes privately, without the attention of the media or their shareholders or competitors. As such, few proceed as far as the courts, with most settling privately. Those that reach the courts are often high profile and may involve actual or alleged fraud.

CLAIMS MATTERS

Premiums for R&W insurance policies — calculated as a percentage of the policy limit, usually a small proportion of sale proceeds — generally range from 1% to 4%, depending on the size of the insurance policy limit compared to the size of the transaction. In most cases, this can be an accretive proposition in comparison to a large indemnity and associated holdback or escrow with an extended survival period.

To illustrate, a $100-million transaction with a 25% indemnity cap provision ($25 million) and a 10% escrow requirement ($10 million) may purchase a R&W policy of $25 million, which may have a premium of approximately $500,000 (2% of policy limit, but only 0.5% of the transaction value). The R&W insurance policy deductible will generally be equal to 1% to 3% of the value of the transaction or purchase price (or approximately $1 million in this example).

In many cases, the insurer will charge an upfront underwriting fee ($10,000 to as high as $3
5,000) since considerable due diligence is required in the underwriting process. Some insurers may be willing to refund the underwriting fee off the premium should the policy be eventually purchased; however, this is not always the case and may be dependent on the transaction and the insurer.

In addition, most insurers are willing to offer a non-binding indication on a prospective transaction so the client can make a more educated decision with regard to whether or not to pay the underwriting fee and move forward with the formal underwriting process.

The uncertain economic conditions have led to an arduous M&A market as of late, which has driven buyers and sellers to employ new facilitation tools that will continue to evolve. Over the long term, R&W insurance is expected to help improve efficiency and flexibility in the sale and purchase process.

Although not a solution for every transaction, where transactions contain a party who wishes to transfer liability or the parties involved encounter an insurmountable obstacle prior to closing, R&W insurance can be the very solution to aid in removal of these obstacles and to help facilitate the transaction.