Escrows vs. Representations & Warranties Insurance: How the Choice Can Alter Deal Dynamics

Background

The allocation of risk shapes every merger and acquisition, and the backbone of risk allocation is the right of the acquiring company (the “Buyer”) to be indemnified for breaches of the selling company’s representations and warranties (such selling company, the “Seller”). In a standard acquisition of a non-public Seller, the selling securityholders (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[1], and (ii) in the event of a claim beyond the escrow, the right of the Buyer to claw back proceeds from the sellers directly. However, Representations and Warranties Insurance (“RWI”) is emerging as a tool to modify or replace this structure. RWI shifts some or all indemnification risk from the sellers to an insurer, and a policy can be either buy-side or sell-side. When the Buyer is the insured (a buy-side policy), RWI can reduce or eliminate the need for an escrow because an insurer, rather than the sellers, indemnifies the Buyer for covered losses.[2] When the sellers are the insured (a sell-side policy), they remain liable to the Buyer for breaches—typically through the two-tiered structure—but RWI compensates the sellers for covered losses.

Buy-side policies are 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 the funds at closing that would otherwise be at risk in escrow. In principle, the economic protection afforded to the Buyer is largely the same between an escrow and RWI (subject to both a premium and a deductible when using RWI, both of which the Buyer may require the sellers to bear).[3] Deal parties should be aware, however, that using buy-side RWI rather than 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 in turn below.

Quality of Representations and Warranties

Buyers generally require detailed representations (reps) and warranties from the Seller 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 about the Seller and potential unknown liabilities, and the Seller naturally wants 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 about its business, with the Buyer having the ability to seek indemnification if it is harmed by inaccuracies. For example, the Buyer may require the Seller to represent that all of the Seller’s patents are valid and free of adverse claims at closing. Even if both parties believe this to be true, the Seller bears the risk for an agreed-upon period following closing that the representation is shown to be inaccurate when made.

In addition, Buyers use reps and warranties to supplement due diligence. 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 it receives about the Seller pre-closing, 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 it 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 a Seller may not negotiate as strongly to ensure accurate reps and warranties where its securityholders bear significantly less economic risk if the reps and warranties are wrong. This is the moral hazard problem. Even where the selling securityholders retain some economic risk before RWI is triggered (if they are liable for the deductible[4]), is it possible that the incentives are such that the Seller will not negotiate as strongly in making its reps and warranties as it would be in the absence of RWI.

While we have no statistical evidence to prove or disprove this hypothesis, a number of leading M&A attorneys have publicly opined on conference panels that, in the attorneys’ experience, using RWI rather than an escrow causes sellers 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 selling securityholders bears the risk. According to these attorneys, this argument often prevails. While this may seem like a win for the Buyer from a risk-allocation perspective, it may be offset by both diminished comfort in the reps and warranties given as well as less thorough information-gathering as discussed above.

Likelihood of Indemnification Claims

The logical extension of the above hypothesis is the question of whether using RWI leads to more indemnification claims compared to using escrows. If RWI causes lower-quality reps and warranties relative to deals with escrows, then more inaccuracies may result in more indemnification claims by the Buyer. Claims can negatively impact the Buyer in three ways. First, they can be costly economically, both in terms of dispute costs and the cost of the breaches incurred. Second, they can distract the Buyer from executing on its post-acquisition strategy, even if the Buyer recovers the economic cost of the claims. Last, the Buyer may be prevented from fully recovering economic costs. For example, if the terms of the RWI policy or acquisition agreement limit the Buyer’s recovery to direct damages, but a breach causes significant indirect damages, then the Buyer may be without recourse for the difference.

Indemnification Recovery Process

A third question is whether the Buyer’s ability to recover for breaches is equivalent between RWI and escrows. The party bearing the risk of loss (whether an insurer or the selling securityholders) 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 typically incorporate the indemnification terms of the acquisition agreement, and thus Buyers are usually made whole. However, RWI coverage can include carveouts and exceptions. Further, an insurer may dispute the amount of loss claimed by the Buyer even if the claim subject matter is covered. 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

Lastly, 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 of an insured’s claims 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 have difficulty obtaining RWI going forward.

This chilling effect can similarly apply 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.

Conclusion

Whether an escrow or buy-side RWI is a more appropriate source of indemnification collateral 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. For the reasons above, deal parties should be aware that either option can materially influence the transaction in non-economic ways.


[1] Escrows are typically funded with 10–20% of closing proceeds and set aside for one to three years.

[2] Whether the sellers remain liable for excluded matters or for clawbacks above the buy-side RWI limit is negotiated deal-by-deal. Buy-side RWI is often used as a tool to eliminate the post-closing liability of sellers entirely (except for Seller fraud), with the Seller’s representations and warranties not surviving past closing.

[3] For additional information on RWI and why parties opt to use it in M&A deals, please see our website.

[4] Also known as a “retention”.

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