August 18, 2020 Update: Please see our most recent blog, Representation and Warranty Insurance 2020 Update, for a summary of two recent market reports that provide helpful information to buyers are using representation and warranty insurance.
The M&A field has begun to find a lot of upside in use of representation and warranty insurance (RWI) – sometimes referred to as transaction insurance – to get a deal to closing. In the past five years the RWI market has matured greatly and has served as a valuable tool in a number of transaction situations. Whether aiming to improve indemnity protection or survival of representations and warranties, improving a bid in a competitive auction process, or being forced into a RWI policy when no vendor indemnity is possible, there are various ways RWI can give comfort to both vendors and purchasers.
Fundamentally, RWI protects against unanticipated and unknown breaches of representations and warranties. In its most basic form, RWI can take the place of or supplement indemnity provisions and survival periods in a transaction. Coverage is available for both fundamental and non-fundamental representations and warranties and can be provided for specific representations and warranties when appropriate. This occurs in a situation where there is a mismatch in the comfort level or risk tolerance between the vendor and purchaser on a particular representation. The parties can then use RWI to backstop that representation and warranty and get the deal to closing.
In certain instances, such as purchasing distressed assets, there may be no possibility for recourse against the vendor so RWI can in such instances intervene to protect against that risk. A similar use of RWI would be in the context of a public company target where limited representations and warranties will be given but comfort on liability is sought.
There can be strategy in the application of RWI. When a purchaser uses RWI to take indemnity provisions and survival periods off the negotiating table in an auction process, it improves the bid. All things being equal, a vendor will accept a bid with limited or no indemnity and survival over one requiring negotiation.
Further to the bid strategy, RWI can be used at any time to ease negotiating terms and break deadlock. By moving risk away from the party creating the barrier, that party may be more likely to be amenable to a higher indemnity and longer survival periods and moving forward with the deal.
RWI also eases collection concerns relating to a breach of representations and warranties. As many RWI insurers are AAA rated institutions, RWI can step in to provide protection where the vendor is a high credit risk or a maturing fund selling assets to close out.
Even if there is comfort the vendor will be able to pay claims, purchasers may want to protect their relationship within newly acquired management teams. Suing management teams, for example, for claims while at the same time trying to grow the business is not ideal. Moving claims to insurers keeps management happy and focused while still providing comfort on any claim that could arise.
Planning to have RWI in place instead of due diligence or fulsome negotiation will not work. Representation and warranty insurers demand comprehensive due diligence to assess the risks being insured. The same applies to negotiating the underlying agreement and particularly the representations and warranties the insurance will be covering. RWI is not intended to fix sloppy work which is why insurers take great efforts to determine that everything has been due diligenced, negotiated and documented properly.
RWI policies are bespoke and customizable based on numerous factors requiring a lot of care and attention. The definition of damages is critical to ensure that the needs to be covered are included. This can be a challenge considering the numerous exclusions insurers typically include in their policies. Besides damages and exclusions, additional issues for negotiation include coverage amounts, term, deductible, premium and fees and cost allocation between the parties. The final result should be a policy which fulfills both risk and cost requirements of the parties. A distinct issue to be aware of is that coverage is typically effective at closing. Any risks that are realized in interim periods between signing and closing will not be covered unless it is expressly contemplated in the policy language.