Mind the Gap: The Space Between a Post-Closing PPA and R&W Insurance

Use of Representations and Warranties Insurance (“RWI”) in M&A deals has risen over the last several years. RWI transfers the risk of losses arising out of breaches of covered representations and warranties from the deal parties to an insurer. RWI, however, does not typically cover losses arising out of a post-closing purchase price adjustment (a “PPA”). A PPA is a provision in the M&A agreement that allows the deal’s purchase price to be adjusted post-closing based on financial metrics calculated as of the closing date.

For a variety of reasons, parties sometimes exclude certain items from the post-closing calculation when, for example, such items are purported to be “final”. When “final” items turn out to be inaccurate and the buyer incurs a loss, the buyer may decide to bring an insurance claim for a breach of a representation or warranty. Unfortunately, RWI may not cover such claims if they are deemed to have been a part of the PPA mechanism that was specifically excluded from the policy. Therefore, who bears the risk of such losses and whether special-purpose escrows are appropriate to cover such risks are worth consideration by deal parties when a deal involves RWI.

These questions are important not just to the determination of risk allocation. One of the primary reasons many selling shareholders push for the transaction to use RWI is that they want to be able to walk away from the transaction at closing without any risk of a future clawback of proceeds. If the agreement provides that the buyer can pursue remedies against those shareholders for any matters not covered by the PPA escrow or RWI, the sellers may not have the level of closure they were hoping to obtain.

Alternatively, if the buyer limits its remedies to an ability to collect from either the PPA escrow or RWI, it should understand that there could be issues for which neither is available, leaving it to absorb the resulting loss.

For these reasons, it is important that parties in deals with both RWI and a PPA carefully consider whether RWI covers exclusions to the PPA, and whether special-purpose escrows are appropriate to cover any coverage gaps.

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