Feb 02, 2021

The Basics of Representations and Warranties Insurance for M&A

Fundamental Representations and Warranties

Fundamental Representations and Warranties (R&W) insurance, once reserved for public company and higher-market mergers and acquisitions, is becoming more prevalent in lower middle-market private company M&A transactions.

Recent trends show that Representations and Warranties Insurance, which provides liability coverage for breaches of representations and warranties made by a seller in an M&A deal, is now being used in an estimated 25% of private deals. In this article, we provide an overview of R&W insurance and the potential benefits and risks to both buyers and sellers.

What Does R&W Insurance Cover and What is Excluded?

R&W policies cover certain types of losses or damages incurred by the insured (usually the buyer) arising from a seller’s breach of representations and warranties in the definitive purchase agreement. The policies cover losses above a deductible amount (typically equal to 1.0% of the transaction value) up to the amount of the policy limit (typically equal to 10% of the transaction value).

However, R&W policies do not cover all losses or damages arising from breaches of representations and warranties Standard coverage exceptions include losses or damages arising from, among other things,

(1) known liabilities (such as a known lawsuit or known failure to pay taxes),

(2) purchase price adjustments,

(3) consequential, punitive or exemplary damages,

(4) agreements based on projections or forward-looking statements (i.e., failure to achieve some post-transaction sales or earnout metric), and

(5) breaches of certain “fundamental” representations and warranties (a select category of representations and warranties in every acquisition agreement that are considered so basic or “fundamental” to the deal that a buyer would not do the deal were it known that a fundamental representation and warranty was untrue).

Common examples of fundamental representations include the power of sellers to legally consummate the deal, good standing of the seller entity under the state law of its incorporation, seller’s good title to assets, tax matters, etc.). Other deal-specific issues identified during due diligence could result in additional exclusions from coverage under a R&W policy.

Although sellers will customarily remain responsible for losses not covered by an R&W policy based on the terms of the definitive purchase agreement, buyers may balk at R&W insurance if too many known or unknown material risks are excluded from coverage.

Benefits of R&W Policies to Buyers and Sellers

While the buyer is the policy holder in M&A transactions around 90% the time, both sides can benefit from a R&W insurance policy. Closing “holdback” or “escrow” arrangements can be reduced or eliminated altogether, which means buyers can make more attractive offers to sellers and sellers can receive more of the purchase price at closing (as opposed to sales proceeds otherwise being tied up in escrow or being treated as seller-carry financing for a lengthy post-closing period).

Sellers may also be more willing to make broader representations and warranties with fewer qualifiers (such as materiality and knowledge qualifiers), which could reduce the time spent negotiating and drafting the R&W terms and the related indemnification provisions in the purchase agreement.

Buyers may be able to realize greater coverage and a longer timeframe in which to make claims under an R&W policy than based on traditional seller indemnification obligations (which may be much more limited under the definitive purchase agreement than is afforded by the terms of the R&W policy).

Overall, buyers and sellers alike may be able reduce their legal exposure, allowing the parties to focus less on risk allocation (which is inevitably a time consuming and gritty component of any M&A deal where a R&W policy is not utilized), and to instead focus more on the nuts-and-bolts financial and accounting elements of the deal.

Costs of R&W Warranties Insurance

Premiums for R&W insurance run between 2 and 3% of the policy limit (i.e., the coverage amount). Providers also charge underwriting (due diligence) fees, which can be as high as $50,000. 

To illustrate the costs and coverage of a standard R&W policy, consider an M&A deal with a $100 million sale. Assuming the retention (deductible) equals 1.0% of the purchase price and the coverage limit equals 10% of the purchase price, the buyer is covered for losses that exceed $1.0 million up to a cap of $10 million.

The premium would cost between $200,000 and $300,000. A common arrangement involves the seller paying the deductible and the buyer paying for the premium, although the parties can negotiate other ways to split the costs of the policy, such as splitting the premiums and fees and/or splitting the deductible (in any proportions that are agreeable to the parties).

Steps to Purchase an R&W Policy

Buyers usually approach insurance brokers to obtain a quote for R&W coverage. Several well-known major insurers and brokers, including AIG, Chubb, the Hartford, AON, Lockton and Marsh, currently offer R&W insurance policies. The underwriter will receive a fee for its due diligence process.

In this phase, the insurance provider will likely request detailed information regarding the buyer, the seller, and the transaction. Expect for the insurer and its underwriter to be involved in the due diligence process, and to also be involved in the review of the seller’s disclosure schedules to the definitive purchase agreement. 

Let Us Guide You to a Favorable Outcome

Representations and warranties insurance can provide numerous benefits to the parties, but not every M&A deal is a good fit for an R&W policy. Bear in mind that R&W insurance does not solely benefit buyers in a high-stakes business acquisition; sellers should also pay attention to these policies and weigh the applicable advantages and impacts on ongoing liability following the sale.

Linden Law Partners has been lead counsel on countless M&A deals, yet we recognize how unique each one is. Reach out to discuss how we can provide value to your next transaction.  

 © 2021 Linden Law Partners, LLC. All rights reserved.

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