This article was originally published in The M&A Lawyer, Vol. 19, Issue 7.
So-called representation and warranty insurance (“RWI”) has been an often-discussed innovation in M&A circles for several years, with seemingly perpetual speculation that a mature market for the product is just over the horizon. In the last few years, however, M&A practitioners have seen a notable increase in the number of policies priced and bound. A number of factors have led to this increase, including improvement in the pricing of policies by carriers against historical levels, expansion of coverage terms by carriers that bring the policies’ terms closer to a traditional seller indemnity and buyers’ increasing familiarity with the product and increasing comfort in carriers’ track records in paying claims, not to mention the general rebound in M&A activity since the recession.
In part because the market for RWI is still developing, there remain significant traps for the unwary in negotiating a policy. And although an RWI policy can be a useful tool in bridging negotiation gaps between buyer and seller—particularly in a rebounding yet still unstable environment where financial sponsors and even some strategics are looking to exit investments using a “public company” style approach without post-closing indemnities—it is paramount that buyers and their counsel understand what they are buying.
Find an Experienced Broker
A client’s first instinct when insurance is raised as a potential solution in a deal is to call their usual broker, which is not surprising. While those brokers may be knowledgeable or even expert in D&O coverage or property and casualty policies, etc., they may have limited familiarity with the world of RWI policies, which often require more familiarity with and comfort in M&A practice than traditional insurance concepts. While many brokers proclaim fluency with respect to RWI policies, there are few who can provide a truly transparent view on pricing and real assistance when it comes time to negotiate the terms of the actual policy. Most M&A lawyers would concur that there are only a handful of people in the country who spend enough time with this product on a daily basis to provide adequate counsel as brokers. It is worthwhile to ask your broker how many policies he or she has bound and about his or her experience with the product generally.
Process, Process, Process
For those new to the rep & warranty policy market, there are a number of procedures to be mindful of in order to keep the negotiation process running smoothly. The broker will need to provide prospective carriers with several pieces of information for the car- riers to provide quotes and draft a policy. In particular, the carriers will need:
- the offering memorandum or other promotional materials that have been circulated by the seller—which the carriers will use in order to under- stand the underlying business;
- one or more drafts of the underlying M&A agreement (typically after it has been revised to reflect a round or two of negotiations)—which the carriers will review in order to understand the scope of the reps and warranties, and the terms of any negotiated party-to-party indemnities; and
- access to any written due diligence reports prepared by the buyer’s advisors, including the buyer’s legal counsel and any advisor performing financial, tax or operational due diligence, and possibly calls to discuss these reports— which the carriers will need in order to under- stand the level of diligence performed on the deal, and the results of that diligence, key factors in getting the carrier comfortable with the risk.
In order to provide these materials, the buyer will need to have its counsel secure confidentiality arrangements with the broker and the carriers, and the buyers’ advisors undoubtedly will want to receive non-reliance letters from the carriers before providing their reports or getting on the phone with them. Better to get these squared away early in the process.
The number of carriers with whom the buyer will need to negotiate, and accordingly, put in place these arrangements, will vary with the amount of coverage sought. In order to diversify their risk exposure, carriers typically will not be interested in providing coverage in excess of $40 million-$50 million with respect to any individual transaction. As a result, in order to obtain coverage of, say, $200 million, the broker will need to syndicate it to four or five carriers, with each taking a layer. The one twist to this structure is that the carrier providing the first layer of coverage will often request to also provide the last layer on the tower of insurance (which of course is the least likely layer to incur claims) to spread its risk and available capacity across the entirety of the tower at different attachment points. Fortunately, however, with respect to policy terms, the buyer will negotiate the substantive primary policy terms only with the first carrier, and the excess policies for the other layers will be prepared on a “follow-form” basis requiring minimal additional negotiation.
Get the Seller to Keep Some Skin in the Game
Perhaps not surprisingly, the broker’s ability to syndicate the policy will be much improved if the seller retains some exposure for its breach of representations and warranties under the main M&A agreement. The carriers will take comfort in the seller having some skin in the game, and will expect that the seller will approach the negotiation of the representations and warranties, and related scheduling of exceptions, with more rigor if it has amounts at risk—even if the amount is negligible relative to the overall size of the deal. This will typically result in improved pricing of the policy and a lower retention (deductible) offered by the carriers.
As noted above, many financial sponsors, and even some strategics, are now looking to exit their investments on a “public company” style basis with no post- closing indemnities. To pave the way for a successful negotiation of the RWI policy, buyers should consider whether it is possible as a commercial matter to get a selling sponsor to agree to a “baby” indemnity where it only has 75-100 basis points of the deal value at risk (typically supported by an escrow of that portion of the deal proceeds).
Read the Fine Print
With the RWI policy market still developing, policy terms have not yet become standardized like many other insurance products. In some ways, this can be of great benefit. Specific terms can be negoti- ated and bespoke arrangements can be put in place— all for a price of course. On the other hand, a buyer will need to be particularly cautious in reviewing the terms of the policy, lest they end up paying for a policy with potential holes in it.
For example, carriers will often seek policy exclusions for items taken into account in the working capital or other purchase price adjustments in the M&A contract and the carryover of deferred tax as- sets such as NOLs. Buyers need to consider requests for these exclusions with care and, in consultation with its counsel and broker, ensure that these exclusions do not inadvertently carve out large swaths of risks for breaches of representations and warranties that the buyer believes will be covered by the RWI policy.
If You Know About It, You Own It
The typical RWI policy will not cover any breach that the buyer is or becomes aware of at or after sign- ing but prior to the closing of the transaction, docu- mented through certifications made by the buyer’s deal team. Oddly, this can create perverse incentives for the buyer to stop conducting diligence at signing and not turn over any rocks until after closing; this point is not lost on the carriers, who will often try to confirm that the buyer is not putting its head in the sand, or will even try to require some level of seller notification in the acquisition agreement. To address previously unknown matters discovered between sign- ing and closing, carriers are typically willing to incept coverage at the time of signing, for a fee of course, and subject to limitations on the length of the signing- closing period to be covered. This is often worthwhile for the buyer because issues may arise between sign- ing and closing that are not significant enough to provide the buyer with a right to walk away from the transaction (or threaten to walk in order to negotiate a special indemnity or purchase price reduction) but for which the buyer would like to have coverage. Even with that incremental coverage, though, the RWI policy won’t cover issues known at signing. If the buyer does not wish to bear the risk associated with such an issue, it will need to negotiate an acceptable arrangement directly with the seller.
It is unclear how the RWI policy market will develop as the number of policies written continues to increase. The U.S. market has yet to see a large tower wiped out by a significant loss (although large claims have been paid and documented overseas). Given the increasing use of this product and the more expansive coverage now being offered, it seems safe to assume that such a loss is inevitable at some point. How the carriers react—whether in revisiting their pricing models or in insisting on stricter terms—will likely determine whether this market is sustainable over the longer term. For the foreseeable future though, RWI is providing careful M&A lawyers with another tool in their toolkit in bridging gaps between buyer and seller.