Surprise Inheritance

Representations and Warranties (R&W) insurance – also known as Warranty and Indemnity insurance – provides coverage for losses arising from breaches of a seller’s representations and warranties within the context of a corporate merger or acquisition.

Often, during mergers and acquisitions (M&A) negotiations, there is a difference between the level of indemnification that will be offered by a seller and the level of indemnification sought by a buyer. Buyers generally require that sellers indemnify them for losses arising from sellers’ breaches of representations and warranties. However, sellers normally try to limit their post-closing obligations while buyers tend to push for higher indemnification rights. This can often lead to a deadlock between the parties and their advisors.

An R&W insurance policy can bridge that gap by transferring the risk of a post-closing breach to a third party.

Insurance coverage can be purchased by either the seller or the buyer. The cost can be borne by either party, or shared between the parties. The use and economics around the insurance coverage is like any other deal term – negotiated between the parties and often determined by the respective negotiating leverage the parties have in the transaction.

PROTECTING THE BUYER

In North America, R&W coverage has been available since the late 1990s but has only recently gained traction following the post-recession increase in deal activity. Based on anecdotal evidence, current estimates of utilization rates range from 7% to 12% of the overall North American M&A markets.

Terms can vary widely from deal to deal, and from industry to industry, but the general rule of thumb is the policy retention will be 1% of the deal value at a minimum, with the average being closer to 1.5 to 2%. Generally, the buyer will agree on a “basket,” which is a deductible on the seller’s indemnification. A seller will generally agree to an “escrow,” which is a holdback of part of the purchase price.

The retention in an R&W policy is typically satisfied by some combination of a buyer basket and seller escrow. The escrow is often reduced and supplemented with insurance to provide the buyer with protection.

In the majority of deals, primary rates tend to be between 3% and 4% of the limit purchased. Businesses with streamlined operations, fewer locations and employees, and simple products or services will fall on the lower end of the range, while those with more complex risks, such as regulated businesses or broad international companies, will be on the higher end.

UNKNOWN LIABILITIES

R&W insurance can be useful in any M&A transaction. On sell-side policies, companies can use the insurance to protect themselves against issues that were not known by the seller at the time of the transaction, but are discovered after the deal closes.

A seller could have a variety of liabilities that are unknown at the time of an M&A transaction. For example, the seller may have inadvertently filed its taxes incorrectly or made an error in failing to appropriately collect taxes from customers. Or, the buyer may have acquired a manufacturing operation that turns out to have environmental contamination issues of which the seller was unaware at the time the acquisition closed.

An error on the part of the seller – in administering an employee or contractor – could create an employment practice liability, for the buyer, after the merger or acquisition closes. The seller could represent to the buyer it has no undisclosed liabilities but then after the deal closes, one of the seller’s customers could file a lawsuit alleging breach of contract.

R&W coverage is also useful to sellers when they have agreed to a larger escrow or indemnity than they are comfortable providing, or to help provide certainty around transaction proceeds. Since it is currently a seller’s market, sell-side coverage is less common today than in the past. Sellers tend to drive deal terms more because there are many potential buyers sitting on excess cash, creating a more competitive environment in favour of sellers.

On buy-side coverage, as noted, sellers tend to ask – or even require – that buyers purchase coverage to replace a larger seller indemnity. In a competitive bidding process, which most mid-market M&A transactions tend to have, bidders are asked to use R&W insurance to make their bids more competitive.

Twelve to 18 months ago, forward-thinking private equity shops and law firms would use R&W insurance to make their bids stand out among the lot. Now it is common to see multiple bidders in a single auction asking carriers to provide insurance terms to include as part of their bids.

A typical process will take around two weeks from start to finish with an insurance carrier. Deal parties used to be concerned about insurers slowing the deal process and delaying the signing of a transaction. However, many of the brokers and underwriters in this space are former deal attorneys who are used to long hours and quick turn-arounds, and are capable of working in “deal time.”

For an insured considering R&W insurance, its broker will compile a submission that consists of a draft purchase agreement, audited financials and a confidential information memorandum or management presentation that outlines the company’s operations. The broker will send the submission to the carriers in the market and usually allow for three to four business days for each underwriter to turn around a non-binding indication letter, or non-binding quote, that generally outlines the retention, rate, duration of coverage and any exclusions based on the class of business.

Once the broker has had an opportunity to review options with his or her client, the client will select a single carrier to move into a more detailed underwriting process.

The carrier charges an underwriting fee to the client in order to help offset the carrier’s outside counsel fees. The carrier and its counsel will spend a few days looking through the insured’s diligence documents, including data room materials and third-party reports. These documents could include financial statements, tax returns, employee data (such as employment contracts and pay classifications), records on independent contractors and documents pertaining to environmental contamination of land owned or controlled by the seller.

The carrier and its counsel may also want to review documents pertaining to intellectual property, including patents, trademarks, licences and web domains. The insured, its outside advisors, the broker, carrier and its counsel will participate in a mandatory underwriting call to discuss the risks and close out any open issues from the diligence process.

Generally, the carrier will look for key risk areas in order to ensure it is not covering known risks that it should not be covering, and to ensure it is not taking on material risks it is not prepared to cover. For example, carriers will not cover the seller for issues that the seller knew about, but still failed to disclose.

In buyers’ policies, deliberate breaches (fraud) on the part of the seller might be covered, but in such cases, the insurer would generally have the right to subrogate against the seller.

Concurrent with the underwriting, the parties will negotiate the policy form, as every transaction requires a manuscript form. The underwriter will also communicate deal-specific exclusions, if any, through the broker and will be in a position to bind coverage at the time the transaction is signed.

A handful of carriers have been writing this insurance in Canada over the last few years, some for entirely domestic deals, and many on cross-border transactions. Some carriers in the United States have the ability to write in Canada, while a couple of U.S. carriers have staff in Canada developing the market domestically.

There are a number of brokers spending increasing amounts of their time on R&W insurance in Canada, including one with full-time resources for the Canadian market.

Anecdotally, it seems all of the major private equity firms in Canada have either used the product on recent transactions or have taken a serious look at the coverage during the bidding process. Similarly, a number of U.S. private equity firms looking at acquisition targets in Canada have used the product here, giving advisors and deal parties on the other side of the table exposure to the product.

Canada is poised to see significant growth in R&W insurance in the next year or two.