Essential to a buyer’s and seller’s evaluation of the purchase and sale of
a company is the allocation of exposure between them for unknown risks and
liabilities associated with the breach of representations and warranties in
the purchase agreement, such as inventory reporting or products liability
exposures. Less than two decades ago, very few considered purchasing
Representations and Warranties Insurance (“RWI”), a product designed for
the express purpose of providing insurance for the breach of a
representation (“rep”) or warranty contained in the purchase or merger
agreement. Recently, however, these policies have emerged as an important
tool to allocate risk to an insurer. RWI has also been recognized as an
enhancement to the value of the deal, as well as critical to closing deals
that might not otherwise get done.
RWI allows the early termination of the escrow for the seller while
providing a longer survival period for the indemnification of breaches of
reps and warranties for the buyer. RWI policy periods typically provide six
years of coverage for breaches of fundamental and tax reps (where not
specifically excluded) and three years of coverage for non-fundamental
reps. The buyer can also purchase policy limits that exceed the cap on the
seller’s indemnification obligations.
RWI policies can be either “buy-side” or “sell-side”. Buy-side policies can
reduce – or for certain deals, eliminate – the need for a seller’s escrow
because the insurer, as opposed to the Seller, is indemnifying the Buyer
for covered losses. With sell-side policies, Sellers are insured, but they
remain liable to the Buyer for breaches, with the RWI compensating them for
their losses. Buy-side policies are the dominant form of RWI currently
being used because they satisfy both the desire of Sellers, on the one
hand, to achieve a “clean exit” and an end to potential liability, and that
of Buyers, on the other hand, to obtain a longer indemnification period.
The use of RWI, however, can potentially impact deal dynamics in
non-economic ways. Sellers’ reps and warranties are key to risk allocation
and due diligence. Without RWI, the Buyer will use reps and warranties to
allocate to the Seller as much of the risk as possible for material
information and potential unknown liabilities, whereas the Seller will seek
to avoid as much of the risk as possible. Parties to the transaction should
never view the option of RWI as a means to limit the scope of a necessary
and thorough diligence of key risks and operational factors.
The use of RWI in mergers to transfer risks has become near standard
practice. Inclusion of RWI in the bids themselves is becoming more common –
either as an enhancement for the bid or as a requirement from the Seller.
Buyers need to recognize, however, that RWI will not cover all risks
arising from a proposed acquisition. The policies will include
deal-specific exclusions, which will be based almost entirely on the scope
and results of the Buyer’s due diligence. The policies also include
standard exclusions, such as known issues, i.e., issues discovered during
due diligence or described in disclosure schedules. They also do not cover
purchase price, net worth or similar adjustment provisions contained in the
parties’ agreement. Because the due diligence results are often not clear
at the bidding stage, Buyers should be wary of using RWI as the sole
recourse for indemnification.
Potential buyers who want to add RWI as a sole recourse in their bids need
to have a deep knowledge of the target’s operations, including the target’s
compliance with laws across a broad spectrum. Early, pre-bid retention of a
reputable insurance broker and counsel with an understanding of the RWI
market are essential to understanding the risks that may be left to the
Buyer as a result of policy exclusion.