The Importance of Representations and Warranties Insurance in M&A

Those representations and warranties usually relate, among other things, to ownership of equity interests and assets, authority to transact, corporate organization, financial statements and liabilities, customers, contracts, intellectual property, compliance with laws, liens, litigation and claims, taxes, employees and benefits. In a typical deal structure, if those representations and warranties are inaccurate, sellers must then indemnify (make whole) buyers for any resulting losses buyers suffer (subject to customarily negotiated survival periods for claims, deductibles, caps and other limitations on recovery).

What Is RWI?

RWI is a form of transaction insurance that is usually purchased by a buyer, although sell-side policies are also available. RWI can be used either to supplement a traditional seller indemnity for breaches of its representations and warranties or to fully replace a seller indemnity. In such a “no seller indemnity” structure, which has become more prevalent in recent years on larger deals, a buyer looks only to the insurance, and not to the seller, to recover losses arising from breaches of a seller’s representations and warranties (unless the seller commits fraud).

RWI originated in the private equity market where, on the sell-side, PE firms wanted to distribute the proceeds from sales quickly to their limited partners and not retain long post-closing indemnity obligations. On the buy-side, PE firms did not want to be put in the position of having to bring indemnity claims against founder/management team sellers who remained with the acquired company post-closing. Despite its origins in the PE market, the use of RWI has become increasingly popular in the past 10 years across all types of buyers (PE and strategic), industries and transaction types, driven by what was, until very recently, an increasingly seller-friendly market. Often, sellers and their financial advisors will require buyers to agree to an RWI construct at the outset of a deal even to participate in an auction process. RWI has become the norm in deals over $50 million in value across all industries and is currently available in sales as low as $20 million in value.

The cost of RWI (currently about 3.5%-4% of the coverage amount for deals above $50 million in value, including the premium, underwriting fees and broker’s fees) is typically split by buyers and sellers. There will be an overall coverage limit (usually 10% of the transaction price, although insurers are sometimes willing to provide higher coverage levels), and claims brought under an RWI policy will be subject to a deductible (historically, about 1% of the transaction price).

What Are the Benefits of RWI to Sellers?

• Sellers have very limited post-closing exposure for breaches of their representations and warranties (typically, half of the RWI deductible; subject to agreed-upon caps, certain matters that are excluded from RWI coverage and losses in excess of the RWI coverage amount; and fraud). In a “no seller indemnity” structure, a seller can have no exposure for breaches of its representations and warranties, unless it relates to fraud.
• Sellers do not need to leave a meaningful portion of the sale proceeds in escrow for 12-24 months (escrow amounts are often limited to half of the RWI deductible).
• RWI makes negotiation of the purchase agreement easier. Sellers do not need to strenuously negotiate for “qualifiers” to their representations and warranties (such as “materiality” and “knowledge”) since buyers will primarily look to insurance for losses they incur.

What Are the Benefits of RWI to Buyers?

• Buyers can make more competitive offers due to reduced escrow amounts and reduced seller exposure for indemnification.
• Buyers do not have to make claims against or sue sellers who are continuing as members of the acquired company’s management team.
• Buyers can get coverage for greater amounts than sellers might agree to be liable without RWI and for longer time periods than sellers might agree to be liable without RWI.
• RWI makes negotiating representations and warranties in the purchase agreement easier since sellers, for the most part, will not have to stand behind them.

Availability of RWI on Smaller Deals

RWI is generally not available on deals under $20 million in value for several reasons:

• Underwriters’ reluctance to issue policies without certified financials or a quality of earnings report, which smaller businesses may not have.
• Minimum fees (approximately $150,000-$250,000 for insurance coverage, underwriting fees and broker’s fees) that can make RWI not cost-effective.
• Additional professional costs for buyers to prepare comprehensive legal, accounting, tax and insurance due diligence reports required by RWI insurers and respond to underwriting questions that arise.
• Buyers’ belief that in smaller deals sellers should have “skin in the game” and be responsible to stand behind an indemnity for buyers’ losses.

In today’s competitive M&A market, savvy dealmakers know the importance of using all available tools to get deals done. In transactions above $20 million in value, the benefits of RWI to both sides can justify its cost and help facilitate an amicable sale.

Paul Pincus, Esq. is a partner at the international law firm Ortoli | Rosenstadt LLP and head of the firm’s Mergers & Acquisitions practice. He can be reached at (212) 829- 8931 or php@orllp.legal.

Middle Market Growth is produced by the Association for Corporate Growth. To learn more about the organization and how to become a member, visit www.acg.org.