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Representations & Warranties Insurance: Trend or Fad?

To readers: M&A Monthly columns consist of paid content from companies and organizations that have information and opinions to share with the business community. They do not represent the views of Finance & Commerce. Columns are accepted on a variety of topics and are subject to approval by Finance & Commerce management. To contribute contact Bill Gaier at 612-584-1537 or [email protected].

By: Kyle Moen & Arlo Allen-DiPasquale

Kyle Moen

Kyle Moen

Buying and selling a business is full of uncertainty.  Ultimately, though, sellers want a fair price for their business and don’t want to be looking over their shoulder for years after closing. Buyers want to be sure they get what they paid for, and don’t want to be on the hook for unknown liabilities.  Representations and Warranties Insurance (RWI) is becoming a popular tool for both parties to reduce this uncertainty.

What is RWI?

Gathering information about an acquisition target is a significant part of a M&A transaction, and stems from the buyer’s asymmetrical knowledge of the seller’s business. This asymmetry is especially pronounced for private companies, which are not subject to securities regulations, disclosure requirements, and public oversight.

To address this imbalance, parties make representations and warranties to one another.  Representations and warranties are a series of binding promises the that give each party certain assurances that the transaction is what they believe it to be, while also providing legal recourse if it is not.  Both parties make representations and warranties in a typical M&A transaction, but the majority, and most significant, are made by the seller.

But what happens if a seller’s representations or warranties turn out to be false and the buyer is financially harmed as a result?  How does a buyer recover damages from a seller for this breach if, for example, the seller is a business entity that is planning to dissolve after closing of an asset sale?

Customarily, the seller might agree to place a portion of the sale price in escrow for a period of time after closing to be used to compensate buyer for seller’s breach of the purchase agreement.  In recent years, RWI has emerged as another source of recovery.

RWI is a type of insurance policy that covers indemnification for certain breaches.  Put another way, it is breach of contract insurance designed to enhance (or even replace) seller’s obligation to indemnify buyer against breach of seller’s representations and warranties.

In the past decade, RWI has become increasingly popular in private M&A transactions.  According to a recent study by the American Bar Association, the percentage of private M&A transactions using RWI increased from 29% to 52% between 2016 to 2020 alone.

Coverage limits on a typical RWI policy are 10-15% of the purchase price.  Premiums are typically 2% to 3% of the coverage limit, due in a lump sum at the start of the coverage period.  The policy deductible, which is excluded from coverage, is commonly around 1% of the purchase price.  The RWI policy term is usually 3 to 6 years, but negotiable with the insurer.  ABA data suggests that the buyer pays the RWI premium in over 90% of transactions.

What are the Benefits of RWI?

In an uninsured deal, a portion of the purchase price (usually 5-20%) is typically placed into escrow for 12-36 months after closing, and used to compensate the buyer for a breach of seller’s representations and warranties.  For the uninsured transaction, this escrow is often a buyer’s sole recourse for breaches of non-fundamental representations.

RWI appeals to sellers because, in an insured deal, the escrow can be substantially lower (typically capped at the policy deductible) and is usually released earlier (often 9-12 months after the closing).  Additionally, where RWI affords coverage, the insurance company will cover the buyer’s losses.  Practically speaking, this typical means less money held in escrow and for a shorter duration and a lower overall risk of the seller going out of pocket to cover an indemnity claim.

RWI appeals to buyers because it can supplement (or even replace) the seller’s indemnification obligation, and be leveraged to shorten the acquisition process timeline. The ability to offer the seller “friendlier” indemnity terms, and get to closing faster, can give a buyer the edge in a competitive marketplace, or at least level the playing field when other bidders are using RWI.

Sound Too Good to be True?

RWI provides unique opportunities, but hasn’t completely disrupted the way M&A deals are structured.  RWI is expensive and, therefore, not suitable for most main street deals.  Additionally, RWI will not cover known problems or seller’s fraud.  Even with RWI in place, the insurer may deny coverage if it can show that (a) the parties had knowledge of the facts or circumstances constituting the alleged breach or (b) the scope of due diligence was insufficient for the transaction.  To mitigate the risk of voiding coverage, sellers still need to take steps to ensure the completeness and accuracy of their representations and warranties, and buyers still need to conduct old-fashioned due diligence on their target.  But where the seller is honest and due diligence is properly performed, RWI can provide a meaningful source of recovery, and, therefore, another layer of protection for both buyers and sellers navigating an otherwise uncertain landscape.

Kyle Moen is a partner at Schindel Segal Mendoza, PLLC, where he advises clients in purchase and sale transactions and represents private companies as outside general counsel.  Arlo Allen-DiPasquale is an associate in the firm’s corporate and M&A practice groups.

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