M&A Problems: Using ‘Reps and Warranties’ Insurance Policies to Seal the Deal
By Lynda A. Bennett and Andrew S. Zimmerman, Lowenstein Sandler LLP
When selling a company or business, reaching a set of representations and warranties mutually acceptable to the buyer and seller is often the tail that wags the dog: while a deal may be ostensibly acceptable in terms of the purchase price and form in which it is paid, buyers will often seek contractual assurances, backed by an escrow fund, regarding the business they are purchasing.
However, the escrow approach is frequently problematic for both buyers and sellers. For sellers, escrow requirements often lock up (and even imperil) a substantial portion of the sale’s proceeds for an extended period of time, and yet, for buyers, escrows offer only limited and imperfect protection against the risk that the seller’s representations and warranties are false or inaccurate, as accessing the funds can be difficult and may require litigation; and the funds may be insufficient.
For many transactions, a representations and warranties insurance policy can mitigate or eliminate these problems. R&W policies insure buyers and sellers against the risk of inaccuracy, falsity, or a breach of the representations and warranties contained in a purchase and sale agreement (or similar type of agreement). When structured correctly and underwritten with the careful input of the parties’ professionals – in particular, their coverage counsel and insurance brokers – R&W policies allow the parties to reallocate some or all of this risk to an insurer.
R&W policies allow buyers to accept significantly smaller escrows, and, in turn, to offer more lenient escrow terms than would typically be customary; lengthen the period during which a buyer may detect and assert a claim for an R&W breach; reduce the seller’s risks of contingent and/or long-tail liability relating to R&W claims; and allow sellers to access a larger portion of the sale’s proceeds immediately.
As with any insurance policy, the devil is in the details. R&W insurance policies are highly customized for each deal. Policyholders must familiarize themselves with the “default” terms and conditions of these policies and then negotiate changes with the insurer to obtain the best and broadest possible protection. Small changes in key provisions can result in significant improvements to the overall level of risk transferred to the insurer. Accordingly, it is critical that the prospective policyholder engage sophisticated coverage counsel and a sophisticated broker to assist with the policy negotiation process.
R&W insurance is issued on a claims-made basis only, which requires that an alleged R&W breach (or a claim relating to a breach) must occur during the policy period. Prospective policyholders must therefore be particularly sensitive to late notice issues in the event of a claim. Policies may be purchased which are oriented towards buyers or sellers. In addition, policies are available that can be “shared” by buyers and sellers. R&W policies do not cover breaches actually known to exist prior to the inception of the policy, although buyer-side policies should cover undisclosed breaches known by the seller. In buyer-side policies, the policy structure is similar to other forms of claims-made first-party insurance coverage in that the policy is intended to reimburse a buyer for losses attributable to a false or inaccurate representation or warranty made by a seller. In seller-side policies, the structure is similar to other forms of claims made liability insurance, in that the policy protects against the risk of a claim for a breach of the representations and warranties made by the seller.
Scope of R&W Coverage
R&W policies can be structured to cover specific representations and warranties, or they can provide “blanket” coverage for all representations and warranties within a purchase and sale agreement, or within a designated section of such an agreement. Again, the devil is in the details: prospective policyholders and their professionals must pay close attention to the identification of the representations and warranties to which the policy applies in order to ensure they have actually transferred the intended risks to the insurer.
As noted above, R&W policies generally exclude coverage for breaches of representations and warranties known prior to the inception of the policy. However, these exclusions generally apply only where a member of the “deal team” is aware of the breach. Accordingly, prospective policyholders and their professionals should ensure that the term “deal team” is defined narrowly – in fact, the best practice is to define the term by referencing specifically-identified individuals. In this way, the policyholder can “quarantine” the potential for a person’s knowledge of an inaccuracy to result in the forfeiture of coverage.
More generally, R&W policies rarely offer coverage for several categories of risks inherent to the sales of companies and businesses. For example, R&W policies rarely apply to a party’s covenants. Also, contingent indemnification promises – like a promise to indemnify a buyer against potential environmental claims – are almost never covered. Finally, R&W policies, like any number of other kinds of policies, generally exclude coverage for any liability relating to traditional long-tail tort claims, like asbestos, regardless of whether a representation or warranty is breached with respect to such risks. Buyers and sellers often have other, more traditional insurance coverage to manage such risks.
Nuts and Bolts
The insuring agreements for representations and warranties coverage depend primarily on the terms “Breach” and “Loss.” For example, a policy may contain the following coverage grant:
the Insurer shall indemnify the Insureds for, or pay on their behalf, any Loss in excess of the Retention that is reported by the Named Insured to the Insurer during the Policy Period.
The definition of “Loss” varies depending on whether the policy is buyer-oriented or seller-oriented. In seller-side policies, “Loss” typically means: (i) the amount the Insureds are obligated to pay in respect of a Breach; and (ii) Defense Costs. In buyer-side policies, the term typically means damages or losses resulting from a Breach or a third-party claim that relates to a breach. For both buyer- and seller-side policies, the term “Breach” typically means any breach of, or inaccuracy in, the representations and warranties set forth in the covered acquisition agreement, or a specific section thereof. However, some insurers’ “standard” forms insert the word “actual” to modify the terms “breach of, or inaccuracy in, the representations and warranties.”
As these terms indicate, in order to recover under either a buyer- or seller-side R&W policy, the policyholder must establish that one or more representations and warranties within a purchase-and-sale agreement has been breached, and that the policyholder has suffered a loss proximately related to the breach.
However, in a buyer-side policy, a third-party claim alleging facts that would amount to a breach is also sufficient. Again, the prospective policyholder’s professionals must exercise great care to ensure that the coverage desired is actually obtained. In particular, use of the term “actual” to modify “breach” should be excised if possible.
Under no circumstances should seller-side policies require proof of an actual misstatement, omission or inaccuracy; an alleged rep/warranty breach should be sufficient to establish a coverage obligation.
Additional Important Terms
Arbitration and Choice of Law: Most R&W policies include arbitration and choice of law terms in their policies. The chosen law is invariably that of a jurisdiction known to be favorable to insurers. However, insurers have proven flexible on these terms. Accordingly, a prospective policyholder and its professionals should seek the removal of the arbitration clause, and should seek the designation of a favorable jurisdiction’s law, or, at a minimum, the law of a jurisdiction logically connected to the transaction.
Policy Period: Most R&W policies default to a policy period between three and six years. However, the policy period is negotiable and, therefore, should be calibrated to the relevant time periods defined in the transaction agreement.
Exclusions based on the policyholder’s knowledge: While coverage may be reasonably excluded if a key member of the deal team is aware of a breach prior to policy’s inception, prospective policyholders should insist that such exclusions require a final adjudication that the policyholder (a) actually possessed and withheld relevant knowledge, and (b) that the loss is proximately related to the non-disclosure.
Premiums, Limits, Deductibles: Most R&W insurers target transactions valued between $25 million and $1 billion to sell R&W insurance. Limits vary depending on the size and scope of the transaction but limits as great as $50 million are readily available. Premiums also vary depending on the size of the deal but most insurers are looking for a minimum premium in the $50,000-$125,000 range. Retentions are generally substantial, but policyholders can “purchase” smaller retentions.
Procuring Coverage: The insurers offering R&W insurance have underwriting units dedicated to R&W coverage that are capable of providing a basic “coverage indication” – i.e., an interest in insuring the deal or not, swiftly. However, the time required to bind coverage can span several weeks. Accordingly, considering R&W insurance as an option for the deal at a relatively early point can potentially reduce the need to respond to an insurer’s extensive due diligence demands at the last minute; and doing so can allow the parties to structure the deal’s price terms to account for the reduced escrow needs.
If an insurer’s basic coverage indication is favorable, then the insurer will move forward with more substantive underwriting. This often involves the engagement of outside counsel and, accordingly, the insurers often charge a significant and non-refundable “underwriting fee” in the range of $20,000-$40,000. It is critical that the policyholder – and its professionals – ensure that a full and careful disclosure of known representations and warranties risks is made during the underwriting process. Incomplete disclosures during the underwriting process may spawn an unwelcome and expensive coverage litigation later where forfeiture of the R&W insurance hangs in the balance. To avoid these issues, policyholders should follow the best practice of fully disclosing any and all information within its control while negotiating the scope of coverage available for “potential” as opposed to known claims.
As with any sophisticated insurance product, R&W insurance policies must be scrutinized, parsed, and revised, and then scrutinized again to ensure that the prospective policyholder’s expectations for coverage are captured in the final product. When that occurs, R&W insurance policies can be a highly effective tool that allows a buyer and seller to bridge the gap that will facilitate closing a deal.
Ms. Bennett is a Member of Lowenstein Sandler LLP and Chair of the Firm’s Insurance Coverage Practice Group. She routinely represents policyholders in insurance coverage disputes. Questions or comments concerning this article should be sent to Ms. Bennett at firstname.lastname@example.org. Mr. Zimmerman is Counsel at Lowenstein Sandler LLP and a member of the Firm’s Insurance Coverage Practice Group. He may be contacted at email@example.com. The opinions expressed in this article represent only those of the authors, not their clients.
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