January 23, 2020
New Insurance Products: Warranty & Indemnity Insurance
The use of insurance in mergers and acquisitions is on the rise, according to a recent report by Aon. Since 2014, there has been a 35 percent increase in M&A deals where warranty and indemnity (W&I) insurance has been part of the transaction.
In a merger or acquisition, the seller makes certain representations and warranties. The buyer will find it favorable to have W&I insurance to protect against losses arising out of certain breaches to the acquisition agreement. But the insurance favors both buyers and sellers:
According to a recent article by attorneys Richard D. Harroch, David E. Weiss, and Richard V. Smith (quoted below), sellers benefit in several ways:
- It can reduce or eliminate the traditional seller’s indemnity for breach of representations and warranties.
- It can reduce or eliminate an escrow or holdback that would otherwise reduce the proceeds received by the seller’s shareholders at the closing of the acquisition.
- It can provide for a cleaner exit to the seller, with fewer contingent liabilities associated with the sale of the company.
- The seller (and seller’s counsel) may feel it can give the more extensive representations and warranties the buyer will want in the acquisition agreement, without as many “materiality” and “knowledge” qualifiers, leading to a quicker resolution of the form of acquisition agreement.
For buyers, the benefits of representations and warranties insurance include:
- Making the buyer’s bid look more attractive to a seller, since there would be no escrow or holdback required (as it’s provided by the insurance).
- A way to give the buyer additional time to discover problems with the acquired business (since representations and warranties are often valid only until the transaction is completed).
- Enhanced protection for the buyer, in amounts greater than the seller might otherwise agree to.
- Improving the buyer’s likelihood of prevailing on a claim under the policy, since the seller will likely give more extensive representations and warranties in the acquisition agreement.
For both parties, representations and warranties insurance usually simplifies and speeds up the negotiation of the acquisition agreement since the seller has less interest in negotiating the scope of its representations, since the insurance exists. Further, in a deal where there will be some limited post-closing indemnification by the seller’s stockholders, the seller has less interest in resisting materiality caveats where the insurance will cover all losses, and therefore this aspect of the deal negotiation also can be concluded relatively quickly.
The Limits and Exclusions in Representations and Warranties Insurance Coverage
Buyers and sellers need to understand that representations and warranties insurance is not a black-and-white alternative to the traditional post-closing indemnification, escrow/holdback and survival of representations and warranties structure of private-company M&A deals. Importantly, representations and warranties insurance policies typically contain the following exclusions and limits:
- The policy covers up to a certain dollar amount for losses, typically 10 percent of the M&A deal consideration. Therefore, the buyer can be at risk for extraordinary losses.
- The policy does not cover breaches of the seller’s covenants in the acquisition agreement.
- The policy does not cover purchase price adjustments (such as for working capital adjustments as of the closing date of the deal).
- The policy will exclude losses due to breach of representations and warranties of which the buyer had knowledge, typically defined as “actual knowledge” of certain identified deal team members. Given the extensive due diligence investigation buyers typically undertake (and insurers expect), this exclusion might result in non-coverage of material risks, such as the risk of patent infringement.
- The policy may exclude certain tax-related issues, including taxes accrued on the balance sheet for pre-closing periods, transfer taxes, taxes disclosed on the M&A Disclosure Schedule, and the availability to the buyer of net operating losses and R&D tax credits.
- The policy may include a carve out for liabilities associated with misclassification of employees/independent contractors and wage and hour laws.
- The policy may exclude forward-looking representations and warranties (such as revenue projections).
- The policy may exclude certain types of losses (such as consequential or multiple damages).
- If the buyer has specific concerns about the limits or exclusions (for example, as to intellectual property infringement), some insurers are willing to negotiate coverage under an “excess coverage” rider to the policy or otherwise modify the policy in consideration of the payment of special additional premiums.
The policy may exclude liabilities related to asbestos or other environmental issues.
Nevertheless, for strategic buyers, representations and warranties insurance may be an attractive alternative to traditional post-closing remedies.
The full article by Harroch, Weiss, and Smith may be accessed at AllBusiness.com.