The allocation of risk shapes every merger and acquisition, and the backbone of risk allocation is the right of the buyer to be indemnified for losses resulting from breaches of the sell-side representations and warranties, and in a typical private-target M&A deal the sellers bear the indemnification risk. This risk has traditionally been managed using a two-tiered structure: (i) an escrow funded from proceeds due to the sellers, and (ii) in the event of a claim beyond the escrow, the right of the Buyer to seek indemnification from the sellers directly. However, RWI has grown in popularity in recent years as a tool to modify or replace this structure. RWI shifts some or all indemnification risk from the sellers to an insurer. When the buyer is the insured (buy-side RWI for M&A), the coverage can reduce or eliminate the need for an escrow because an insurer, rather than the sellers, indemnifies the buyer for some or all of the losses resulting from breaches of the sell-side representations and warranties. When the sellers are the insured (sell-side RWI), they remain liable to the buyer under the acquisition agreement—typically through the two-tiered structure described above—but the insurance policy compensates the sellers for covered losses.
Buy-side RWI is the dominant form of RWI today. Sellers often push for buy-side RWI over sell-side RWI because, among other reasons, buy-side RWI allows sellers to receive at closing most or all of the funds that would otherwise be at risk in escrow. In principle, the economic protection afforded to the buyer in a traditional escrow structure is largely the same as that afforded to a buyer when RWI is used instead of an escrow structure (subject to both a premium and a deductible when using RWI, each of which may be borne by the buyer, the sellers or a combination). Deal parties should be aware, however, that using buy-side RWI instead of an escrow can alter traditional deal dynamics in non-economic ways. These include the quality of the seller’s representations and warranties, the likelihood of indemnification claims, the indemnification recovery process, and the ability of serial buyers to assert claims. These points are discussed below.
Quality of Representations and Warranties Insurance
Buyers generally require detailed representations (reps) and warranties from the sellers for two reasons: risk allocation and due diligence. Buyers use reps and warranties to allocate to the seller as much of the risk as possible regarding information asymmetry of the target company or acquired assets and potential unknown liabilities, and the sellers naturally want to avoid as much of this risk as possible. The buyer can shift more of this risk to the seller by requiring the seller to give thorough reps and warranties, with the buyer having the ability to seek indemnification if breaches of the reps and warranties result in losses. For example, the buyer may require the sellers to represent flatly that all of the target company’s patents are valid and free of adverse claims at signing and/or closing. Even if both parties believe this to be true, if the buyer discovers breaches during an agreed-upon period and properly brings a claim for indemnification, the sellers bear the risk that it was inaccurate.
Buyers also use reps and warranties to supplement their due diligence efforts. That is, buyers can minimize information asymmetry through a combination of conducting due diligence and requiring thorough reps and warranties. This allows the buyer to maximize the information they receive about the target company or acquired assets before signing the acquisition agreement, and the process shakes out disclosures that could trigger additional questions or even result in the renegotiation or termination of the deal. In these ways, a buyer uses reps and warranties to maximize the probability of a successful deal.
If risk allocation and information-gathering are key drivers of thorough reps and warranties, then a buyer may question whether they can expect to get the same quality of reps and warranties if RWI replaces or significantly reduces the use of an escrow. One could hypothesize that sellers may not negotiate as strongly to ensure narrower reps and warranties if the RWI will result in them bearing significantly less economic risk if the buyer discovers breaches of the reps and warranties. Even if the sellers retain some economic risk below the RWI coverage level, such as when the sellers’ escrow satisfies the RWI deductible (retention), it is possible that the incentives are such that the sellers will not negotiate as strongly in making their reps and warranties as they would have done in the absence of RWI.
While we are not aware of reliable statistical evidence that proves or disproves this hypothesis, a number of M&A attorneys have publicly opined on conference panels that, in their experience, using RWI rather than an escrow causes sellers and sellers’ counsel to be less vigorous in negotiating reps and warranties. For example, buyers will often push sellers to capitulate on issues such as materiality and knowledge qualifiers when RWI is used, with the argument that the insurer rather than the sellers bears the risk of breaches. While winning this negotiation point may seem like a win for the buyer from a risk-allocation perspective, it may be offset by diminished comfort regarding the accuracy of the reps and warranties.
Likelihood of Indemnification Claims
The logical extension of the above hypothesis is the question of whether transactions that use RWI result in more indemnification claims compared to transactions that use traditionally sized escrows. If RWI correlates with lower-quality reps and warranties relative to deals with traditionally sized escrows, then more breaches may result in more indemnification claims. Claims can negatively impact the buyer in three ways: First, they can be costly economically and reputationally. Second, post-closing indemnification claims can distract the buyer from executing on their post-closing strategy, even if the buyer prevails on their claim and recovers their economic losses. Third, the buyer may be prevented from fully recovering economic costs. For example, if the terms of the RWI policy or acquisition agreement limits the buyer’s recovery to direct damages, but a breach causes significant indirect damages, then the buyer may be without recourse for the difference. Similarly, if a buyer agrees to use an RWI policy as its sole or primary source of recovery for losses resulting from breaches of reps and warranties but doesn’t purchase enough insurance coverage, then the buyer may not be able to recover its full loss amount. While that outcome mirrors a situation where the escrow was not large enough to cover the buyer’s losses, one wonders whether the external cost of the RWI premium may influence parties to purchase lower insurance amounts than what would have been required in escrow had RWI not been used.
Indemnification Recovery Process
Another question is whether the buyer’s ability to recover their losses is equivalent between RWI and escrows. The party bearing the risk of loss (whether an insurer or the sellers) may resist paying a claim if a colorable defense is available. Where an escrow is used, the buyer must show a breach of a rep or warranty and that indemnification is available for such breach under the acquisition agreement. Where RWI is used, the buyer will need to do the same but must then also demonstrate that both the type and amount of loss are covered under the insurance policy. RWI policies often incorporate or mimic the indemnification terms of the acquisition agreement, thus allowing for appropriate recovery by the buyer. However, RWI coverage can include carveouts and exceptions, and insurers may have different settlement strategies or patience thresholds than sellers who were party to the original deal. In these ways, using RWI can add a layer of complexity to disputes compared to escrow-based indemnification.
Ability of Serial Acquirers to Assert Claims
Last, serial buyers may want to consider whether they have the same ability to make claims against RWI as they do against an escrow. The potential exists that a series of material claims by a buyer against RWI may impact that buyer’s future RWI pricing (i.e., the buyer’s perceived risk profile), similar to the impact that multiple claims may have against home or auto insurance. This could have a chilling effect on claims. According to RWI industry professionals, the effect of prior claims on future pricing depends on whether such claims are isolated and justified. A buyer with a propensity to make claims against RWI without sufficient justification may see higher pricing or may have difficulty obtaining RWI in the future.
This chilling effect can also occur in an escrow-based deal where parties with whom the buyer desires to have an ongoing relationship, such as key employees or investors, participate in the escrow. Protecting such relationships by shifting indemnification risk to an insurer is a frequent basis for using buy-side RWI.
Whether an escrow or buy-side RWI is the appropriate indemnification solution depends on the circumstances of the transaction. In our view, it is not the case that either product is fundamentally better or worse than the other. Rather, it depends on which is a better fit for your transaction, which means it is important for deal parties to understand the pros and cons of escrows and RWI and be aware that either option can materially influence the transaction in non-economic ways.