Representation and warranty insurance (RWI) provides insurance against certain indemnifiable losses that may be incurred if there has been a breach of a representation or warranty. The insurer takes a fee in exchange for assuming the risk of such loss. Often, the insurance will provide excess coverage only in the event losses are greater than the escrow amount or will only insure against certain types of claims (such as environmental or intellectual property matters).
In SRS Acquiom’s experience, the parties on many deals decline to purchase this insurance because they perceive the cost to be too great for the risk that is being mitigated.1 Since it is rare for escrows to be wiped out completely, having insurance that provides coverage above the escrow is not typically seen as having a high probability of coming into play. Similarly, if there is a known risk related to a certain issue, the insurance provider understandably is going to charge a high premium to assume that exposure.
However, there are situations in which RWI makes sense and is used. First, some pooled investment vehicles like venture and private equity funds will need a high level of certainty that under no circumstances will they be required to contribute money back in connection with a transaction. For instance, some end-of-life funds will be looking to wrap up operations and dissolve the fund. In order to do so, they will want to know that all remaining liabilities and contingent liabilities have been satisfied. Other funds will want to distribute closing proceeds to their investors as quickly as possible without holding more than is necessary as reserves. In either case, RWI provides comfort that even in the unlikely event that a claim exceeds the escrow amount, the former stockholders should not need to pay back any portion of the closing proceeds. Note, however, that RWI usually lowers this risk, but does not wholly eliminate it. In the extreme example of a claim that would require repayment of the entire purchase price or any amount in excess of the RWI coverage, the stockholders would still be on the hook. Even if the acquirer agrees that most claims are limited to the escrow plus insurance, there could still be exposure to claims of fraud.
Second, on some transactions, there may be a specific operational issue related to the target company that presents a hurdle to getting the deal closed. The issue maybe unusually risky, or the nature of the issue may present bigger issues for the buyer. For instance, the buyer could say that it acknowledges that the risk of a claim that the target improperly paid a foreign official seems to be low but that the buyer cannot have any exposure to it whatsoever. In that case, the parties might want to specifically insure against such issue if it can be done at a reasonable price.
The challenge with RWI policies is that they are complicated and can contain numerous exceptions. Sellers need to understand the risks implicit in the representations and warranties given by the target company to the buyer and ensure that the policy covers such risks. Particular attention should be paid to the circumstances under which payments will and will not be made under the policy. As noted above, many will not pay out prior to the escrow first being extinguished. Other restrictions include caps on total payouts, and limits on the time in which the claim must be submitted. The administrator of such a policy (usually the shareholder representative) needs to be fully aware of the required claim policies and procedures. Similar to the timelines required under merger agreements for responding to claims, RWI policies often have strict guidelines for reporting claims that might be payable by the insurance provider. Failure to comply with such terms could limit the insured’s ability to recover under the policy. Further, RWI policies may limit the representative from selecting counsel or may only partially cover the cost of such counsel. Given these restrictions, the shareholders need to make sure the policy really provides the protection they think they are getting.
When purchasing RWI, sellers are advised to consult with specialized insurance counsel. There are also specialized consultants who can assist in risk analysis and negotiation of coverage and are unaffiliated with the insurance companies and insurance brokers. Finally, sellers should ensure the shareholder representative is familiar with such policies, has negotiated their role in such coverage and has the necessary experience to ensure compliance with the administrative and claim obligations required.
RWI may be a valuable adjunct to the management of investor risk with respect to M&A post-closing claims, but buying the insurance and managing claims requires specialized expertise.
1 SRS Acquiom notes, however, that the use of RWI seems to be on the rise.