Editor's Note: This article accompanied the PLI program Understanding Insurance Law 2009 on April 6, 2009. The entire program is available at www.pli.edu.
When it comes to negotiating M&A deals, the tail often wags the dog. The deal makes strategic and financial sense for both the buyer and seller. The price is right. The timing is right. So why is this deal not getting any closer to closing? More often than not the sticking point is the scope of seller indemnification. In these situations, Representations & Warranties Insurance ("Reps & Warranties Insurance") can provide an invaluable tool to help the deal get done.
Although it has been underwritten in the United Kingdom for many years and is gaining in popularity in the U.S., Reps & Warranties Insurance is still a relatively new concept to most dealmakers. As awareness grows, and more domestic insurers enter the market, Reps & Warranties Insurance is becoming a more familiar tool for structuring U.S. transactions.
Reps & Warranties Insurance - When Does It Make Sense?
Depending on the circumstances, Reps & Warranties Insurance can solve a variety of problems and provide both buyers and sellers with substantial benefits.
For sellers, the advantages of Reps & Warranties Insurance are fairly obvious. Sellers will almost always find it attractive to be able to eliminate or reduce the need for an escrow of sale proceeds after the closing. It is perhaps even more attractive to be able to increase their certainty of keeping the sale proceeds after the closing by negotiating a significantly lower cap on the indemnity. Furthermore, there are many circumstances where providing a post-closing indemnity is more than just unattractive to a seller, it may be impractical or impossible. For example, Reps & Warranties Insurance has been used in deals where a significant selling shareholder was an ESOP or a trust (each presenting unique issues of fiduciary duty). Practical issues also arise when the selling shareholders are individuals, whose pending retirement or other personal situations may increase the need for certainty post-closing. Selling private equity funds also have unique needs that require minimal post-closing escrows and indemnities.
Buyers have used Reps & Warranties Insurance in a variety of ways to their strategic advantage. Often times the insurance offers a practical solution to get a strategically important deal "unstuck" and closed in a timely fashion. In a highly competitive deal climate (e.g., pre-credit crisis), where sellers often have the leverage to demand lower and lower indemnity caps, many buyers find themselves purchasing Reps & Warranties Insurance to mitigate the risk of a post-closing liability for themselves and their investors. Alternatively, Reps & Warranties Insurance presents an attractive option to buyers in an M&A market rife with financially distressed sellers, as an insurance policy is likely more secure than a seller indemnity when the seller has credit or other financial difficulties. The insurance is also favored on cross-border deals, in which a non-U.S. buyer may have some discomfort with buying a U.S. company, or vice versa.
Structuring The Policy: Key Issues To Consider
The potential for Reps & Warranties Insurance to successfully facilitate a deal often depends on a thoughtful approach to structuring the insurance and the transaction. There are several issues that should be addressed by the principals and their advisors early on in the process. Dealing with these issues up front will help determine whether Reps & Warranties Insurance provides a good fit for the transaction and will also help the process go more smoothly once the decision to move forward is made.
This article will focus on five key issues to examine early in a deal. They are: the function of the insurance; security or indemnity; determining who should be the insured; breadth of coverage; structuring the retention, and understanding the limitations.
The Function Of Reps & Warranties Insurance: Security Or Indemnity
Reps & Warranties Insurance may be incorporated into a transaction in one of several capacities. It is imperative that the parties determine up front what function the insurance will perform.
Insurance as security. A Reps & Warranties Insurance policy often stands behind a seller's indemnity for breaches of representations & warranties. In this structure, the seller remains contractually obligated to the buyer for the full indemnity amount, but the insurance acts as the security behind that obligation, much like an escrow or letter of credit. This approach is appropriate when the objective is to minimize or eliminate the need for an escrow of sale proceeds. Buyers also use this structure to address concerns regarding the seller's creditworthiness. In this case, the buyer's issue is not its ability to negotiate favorable indemnification terms, but its ability to collect.
When Reps & Warranties Insurance is intended to function as security behind a seller's indemnity, the policy may be structured in one of several ways. The policy may be written with the seller as the insured, in which case the Purchase & Sale Agreement ("P&S Agreement") will include a standard seller indemnity but no escrow. The P&S Agreement does not necessarily need to explicitly reference the purchase of the policy. If the buyer prefers to be the insured under the policy (factors affecting this decision are discussed in the next section), the same holds true. A prudent seller, however, may desire to include a provision in the P&S Agreement stipulating that the buyer will look first to the insurance policy in the event of a breach before making any indemnification claim against the seller.
Insurance as Indemnity. An alternative approach, usually preferred by sellers, is to use Reps & Warranties Insurance to completely replace all or a portion of the traditional seller indemnity for breaches of representations and warranties. In this structure, the insurer effectively steps into the shoes of the seller, rather than providing security for the seller's indemnity. Depending on the relative leverage of the parties, the seller may successfully negotiate that the buyer purchase a Reps & Warranties Insurance policy, which shall be the sole recourse for breaches. More often, the seller remains on the hook for some portion of the indemnity, but negotiates a lower cap, to be supplemented by the insurance. In many cases, the premium is paid jointly by the buyer and seller, as each is deriving a benefit from the policy - the buyer is the beneficiary of the policy proceeds, while the seller is able to lower its indemnity cap as a result of the policy.
As with the former approach using Reps & Warranties Insurance as security, the P&S Agreement need not expressly reference the existence of the insurance that is supplementing a seller's cap on indemnity. Indeed, depending on the circumstances, the seller may not even be aware that the buyer is purchasing a policy excess of the cap. In cases where the Reps & Warranties Insurance policy is the sole recourse for breaches, sellers will usually wish to have this explicitly stated in the P&S Agreement. It is important to note that, as an underwriting philosophy, insurers greatly prefer to insure deals in which the seller retains some liability for breaches, although most insurers will entertain deals in which insurance is to be the sole recourse.
Determining Who Should Be The Insured
Reps & Warranties Insurance may be written with either the buyer or the seller as the insured under the policy. Often the preference of the parties will determine this point, but the party paying the premium may not necessarily elect to be the insured. There are several issues that should be considered before making this decision.
As a threshold issue, the form of the policy and the claims handling procedures will vary, depending upon whether the buyer or the seller is the insured. A seller-based policy will be structured as a third-party liability policy, not unlike other liability policies, and generally will not include a duty to defend. In the event that the buyer makes an indemnification claim against the seller under the P&S Agreement, the seller will submit the claim to the insurer, but will be obligated under the policy to defend the claim, with the insurer's cooperation. Most seller policies provide for the advancement of defense costs, subject to the retention. The policy terms usually will obligate the seller to cooperate with the insurer in the defense and will require the insurer's consent to any settlement - all terms typical of third-party liability policies.
Buyer-based Reps & Warranties policies, on the other hand, contemplate that most claims will involve a first-party loss, and the claim mechanism will be a proof of loss form. In this case the buyer, after discovering a breach of a rep following closing, will bypass the seller and make its claim directly to the insurer. Often this approach is attractive to both buyers and sellers. Many buyers prefer to deal directly with the ultimate responsible party (the insurer), and most sellers are seeking to limit their involvement in the process as much as possible.
Besides claim handling, the most important issue in deciding who should be the insured under a Reps & Warranties policy revolves around the treatment of fraud. All seller-based policies will include an exclusion for a fraudulent misstatement by the seller in the reps and warranties. Buyer-based policies, however, do not typically exclude claims based on seller fraud. For this reason, buyer-based policies arguably provide materially broader coverage than a seller policy, and may sometimes be subject to a somewhat higher premium.
Breadth Of Coverage
In most cases, regardless of whether the insurance is being proposed by the buyer or the seller, both parties are looking to Reps & Warranties Insurance as a substitute for either an escrow or for the seller's indemnity. The insurance policy, however, is rarely a perfect match for what the buyer has negotiated from the seller. The differences should be closely examined to make sure that a Reps & Warranties policy accomplishes the parties' goals.
The indemnity provision in the P&S Agreement many obligate the seller to indemnify the buyer for items other than just breaches of representations and warranties. Depending upon the particulars of the deal, it is not uncommon to see indemnification for covenants, for specific contingent liabilities such as outstanding litigation, or for specific tax matters. In most cases, it is unlikely (although not impossible) that a Reps & Warranties insurer will be able to cover these other indemnified items. In these cases, buyers often agree to look to the insurance for breaches of reps and warranties, but to continue to hold the seller responsible for the other indemnification obligations. This approach usually allows the parties to reduce the amount of the seller's escrow and/or cap on indemnity.
Even with respect to breaches of representations and warranties, an insurance policy may not provide a perfect fit compared to a seller's indemnity. Even though Reps & Warranties Insurance generally covers all of the representations contained in the P&S Agreement, the parties should inquire up front as to the insurability of the subject matter addressed within their representations, to determine if any of them are likely to be excluded from coverage. For instance, only a few Reps & Warranties insurers are able to insure the environmental rep and typically only in cases where the environmental exposure is fairly minimal. When environmental issues are a principal risk factor of the target company, a customized environmental insurance policy designed specifically to cover the environmental exposure may be a good solution, with a Reps & Warranties policy covering the remainder of the reps.
Even if the insurer is able to cover the subject matter of all of the representations, parties should keep in mind that insurers will be reviewing the language of the representations as drafted in the P&S Agreement to determine insurability. Portions of reps that are perceived by the insurer to be overreaching and easily breached may be specifically excluded from coverage. Insurers generally highlight any problematic representations in their preliminary indications to allow the parties to decide how to address the issue.
Structuring the Retention
As previously emphasized, buyers and sellers should give some thought early in the process to the optimal structure of the Reps & Warranties insurance program, particularly the attachment point, or retention. In many cases, the most cost-effective approach may involve both the buyer and the seller retaining some portion of the risk for breaches of reps and warranties, before the insurance policy responds. Underwriters prefer this approach because they gain comfort that both parties are incentivized to act prudently in the negotiations and the due diligence process. This will usually be reflected in more attractive premium pricing.
Special attention should be paid to the structure of the retention if a buyer is looking to place the insurance immediately in excess of a seller's escrow, with the insurance as the sole recourse after the escrow is exhausted. This structure may be problematic if the escrow is available for matters that are not covered by the insurance, such as environmental matters or other specifically negotiated indemnities. Note that, in most policies, uncovered matters are not deemed to erode the retention, unless specifically permitted to do so (which most insurers will permit, for some additional premium). If uncovered matters such as an environmental claim exhaust the escrow, the seller's indemnity may also be exhausted, but a significant retention may still apply.
Understand Its Limitations
Although Reps & Warranties Insurance can be an invaluable tool for buyers, sellers and M&A professionals, it is imperative to keep in mind that the coverage has its limitations. Many of these limitations have been highlighted in the previous sections, including indemnities other than for breaches of reps and warranties, fraud, certain subject matter and the inability to cover certain representations as negotiated. A few others bear noting.
First, review and understand the exclusions. The policy forms used by the various Reps & Warranties insurers vary greatly, and some contain more exclusions than others. Common exclusions include fraud (on seller policies), actual knowledge of a breach (on buyer policies), covenants, debts and projections.
Also be mindful that, as in many insurance policies, exclusionary language is often contained in definitions. For instance, the definition of "Loss" or other similar term may exclude items such as fines and penalties, punitive damages, as well as purchase price multiples. See the Appendix for sample wording from several different insurance policies. Buyers should review this language closely to make sure it matches up reasonably with their expectations.
Most insurers are fairly flexible when it comes to amending policy terms and may be open to limiting or deleting some of the standard exclusions found in the policy forms, subject to their ability to underwrite the transaction.
Any given M&A deal, even one that makes business sense, is likely to face numerous obstacles to closing. Reps & Warranties Insurance may be very helpful in removing at least some of those obstacles. As with every contract that forms part of the deal, both buyers and sellers are well served by giving careful consideration to all of its terms and seeking the advice of competent professional advisers.
Mary McDougall Duffy, Esq. is Managing Director of Aon's Private Equity & Transaction Solutions group. Please visit www.metrocorpcounsel.com for the appendix to this article. This material has been published as Chapter 15 of Understanding Insurance Law, by Mary McDougall Duffy, available at 1-800-260-4754; www.pli.edu; (c) The Practising Law Institute. Reproduced with permission. All rights reserved.