By Howard T. Spilko and Scott A. Abramowitz R epresentations and warranties insurance (R&W insurance) is being used by middle-market M&A deal professionals at an unprecedent- ed rate. In this article, we will discuss market trends in the use of R&W insur- ance, key drivers behind this explosive growth, the underwriting process and key considerations for buyers and sell- ers in structuring transactions with R&W insurance. What Is R&W Insurance? R&W insurance is a transactional risk product that provides coverage to a buyer or seller against losses arising out of a breach of the seller’s or target com- pany’s representations and warranties in connection with an acquisition, divesti- ture, merger, or other business transac- tion. R&W insurance is an effective tool in bridging gaps between buyers and sellers negotiating M&A transactions. For example, R&W insurance is often effective where a buyer cannot convince the seller to agree to the desired level of indemnification, or alternatively, where a buyer has concerns about the seller’s Use of Representations and Warranties Insurance Grows in Middle-Market Transactions BIGSTOCK WWW. NYLJ.COM MONDAY, OCTOBER 26, 2015 A N E W Y O R K L A W J O U R N A L S P E C I A L S E C T I O N Mergers & Acquisitions
Transcript
By Howard T. Spilko and Scott A. Abramowitz
R epresentations and warranties insurance (R&W insurance) is being used by middle-market M&A
deal professionals at an unprecedent-ed rate. In this article, we will discuss market trends in the use of R&W insur-ance, key drivers behind this explosive
growth, the underwriting process and key considerations for buyers and sell-ers in structuring transactions with R&W insurance.
What Is R&W Insurance?R&W insurance is a transactional risk
product that provides coverage to a buyer or seller against losses arising out of a breach of the seller’s or target com-pany’s representations and warranties in
connection with an acquisition, divesti-ture, merger, or other business transac-tion. R&W insurance is an effective tool in bridging gaps between buyers and sellers negotiating M&A transactions. For example, R&W insurance is often effective where a buyer cannot convince the seller to agree to the desired level of indemnification, or alternatively, where a buyer has concerns about the seller’s
Use of Representations and Warranties Insurance Grows in Middle-Market Transactions
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A N E W Y O R K L A W J O U R N A L S P E C I A L S E C T I O N
Mergers & Acquisitions
ability to satisfy its indemnification obli-gations after closing. As noted below, R&W insurance also serves as an effec-tive component of a buyer’s bid package in a competitive auction as a means to differentiate its bid.
In a seller-side R&W insurance policy, the seller is the insured party, and the insurance carrier reimburses the seller for losses that the seller is required to pay the buyer for breaches of its or the target company’s representations and warranties in the acquisition agreement. Seller-side policies serve to backstop the seller’s indemnification liabilities by shifting the risk of loss for post-closing indemnification claims to the insurance company.
In a buyer-side R&W insurance policy, the buyer is the insured party, and the insurance company pays the buyer directly for any losses arising out of breaches of the seller’s or the target company’s representations and war-ranties in the acquisition agreement. A buyer-side R&W insurance policy has certain advantages to the insured when compared to a seller-side R&W insurance policy. For instance, the effec-tive scope of the knowledge exclusion, which excludes from policy coverage loss where the insured’s deal team had actual knowledge of the breach at policy inception, is more narrow in the context of a buyer-side R&W insurance policy relative to a seller-side R&W insurance policy.
While the overwhelming majority of R&W insurance policies currently being issued by insurance carriers are buyer-side policies, the determination as to whether the buyer or the seller will pay the policy premium is routinely nego-tiated as part of broader discussions around price and other economic terms of the transaction.
Recent Trends in the Use of R&W Insur-ance
Only a few years ago, most middle-market M&A deal professionals had either never heard of or would not consider using R&W insurance. Times
have changed. One leading insurance broker estimates that over $1.5 billion of R&W insurance limits were placed in North America in 2014, which was more than double demand from the prior year. Through the first three quarters of 2015, demand for R&W insurance has contin-ued to grow. A majority of these policies have been purchased by financial spon-sors, who have been quicker than cor-porate buyers to embrace the product. However, corporate buyers as a group are becoming more comfortable with the product and beginning to purchase R&W insurance on a regular basis, which is a trend that is expected to continue.
Key Drivers Behind the GrowthThe middle-market acquisition market
remains very active. There is significant competition among M&A buyers for quality companies, especially among financial sponsors who are eager to put their investors’ money to work. As a result, auctions are robust and com-petitive, with sellers often demanding favorable terms of sale, including limited or no post-closing recourse for breaches of representations and warranties. Sell-ers are motivated to exit the investment without any risk of post-closing liabil-ity—and to eliminate or reduce the size of escrow or holdback amounts—which enables financial sponsors to maximize receipt of sales proceeds and distri-butions to limited partners. An R&W insurance policy enables the buyer to enhance its bid by offering an indemnifi-cation package that provides for limited or no post-closing recourse against the seller for breaches of representations and warranties, while still providing the buyer with protection against breaches. Currently, many seller auction drafts of acquisition agreements contemplate that the buyer will purchase an R&W insurance policy, especially where there are numerous selling parties, and buyers must be willing to accept this structure in order to remain competitive in the auction process.
Market acceptance of R&W insur-ance among buyers, sellers and their
advisors has also been a key factor in growth. As the use of R&W insurance policies continues to expand, middle-market M&A deal professionals are becoming increasingly more familiar and comfortable with the product. Market acceptance has also helped to facilitate increased competition among insurance carriers, a more streamlined and efficient underwriting process and positive claims payment experience for the insured. In the past couple of years, several insurance carriers have entered the market, which has led to declines in policy premiums and policy terms to become more favorable for the insured. Coverage has expanded and exclusions have been narrowed. It is less common to see broad-based subject matter exclu-sions in R&W insurance policies unless compelling underwriting concerns exist. In addition, while there is limited pub-licly-available data on claims history, it is understood across the industry that insurance carriers have made payments and are continuing to make payments in respect of legitimate claims arising under R&W insurance policies.
Cost of Premium and Policy RetentionR&W insurance policies are priced
as a percentage of the limits of cover-age purchased. Increased competition among insurance carriers and broader claims experience has led to a signifi-cant reduction in pricing over the years. Currently, most buyer-side R&W insur-ance policies are being priced between 3.5-4.0 percent of the insured amount (down from between 8.0-10.0 percent of the insured amount 15 years ago). The amount of the premium in a given transaction can depend on several fac-tors, such as the insurance carrier’s assessment of the risks relating to the target company’s business and industry and the amount of the insurance being sought. For example, premiums tend to be higher (closer to 4.0 percent of the insured amount) for smaller poli-cies where the insured amount is less than $7.5 million. In addition, premi-ums are often higher in “public style”
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transactions where the seller does not retain any post-closing indemnification liability to compensate the insurance car-rier for the additional perceived risk of the seller having limited exposure in the deal and less incentive to negotiate and disclose exceptions against the agree-ment’s representations and warranties.
Like other insurance products, R&W insurance policies contain a deductible, often referred to as the policy “reten-tion.” Insurance carriers determine the policy retention as a percentage of the transaction value (as opposed to a percentage of the insured amount). Cur-rently, the standard retention is typically at least 1.5 percent of the transaction value, though the retention is often high-er (closer to 2 percent of the transaction value) in “public style” transactions.
Underwriting ProcessWhile insurance carriers have devel-
oped underwriting processes to match the pace and intensity of M&A trans-actions, prospective buyers should approach R&W insurance carriers as early as possible in the transaction process. This will enable the buyer and seller to structure the acquisition agree-ment, including post-closing indemnifi-cation obligations, taking into account the policy terms. Buyers should engage an experienced broker to canvas the market to obtain price and coverage quotes from insurance carriers, which can often be obtained within only a few days after initial contact from the bro-ker. Experienced insurance carriers will be prepared to quickly and efficiently negotiate and execute a non-disclosure agreement.
Once the insurance carrier is selected, it will begin its due diligence process and will send the buyer a list of diligence requests. At this stage, most insurance carriers will require up-front payment of their underwriting fee, which typically ranges between $20,000 to $40,000, and is used to engage outside legal counsel to assist the insurance carrier in evaluat-ing the transaction. Deal professionals should be aware that the underwriting
fee is in addition to, and is not credited against, the policy premium once the transaction is consummated.
Insurance carriers will not conduct their own, independent due diligence review of the target company. Instead, the insurance carrier, together with its outside legal counsel, will audit the due diligence performed by the buyer and its advisors of the target company. The insurance carrier’s due diligence review will include a review of the acquisition agreement (with an emphasis on non-standard representations and warranties made by the seller or the target com-pany), a high-level review of the materi-als included in the electronic data room and review of any diligence materials prepared by the buyer or its advisors in the case of a buyer-side R&W insur-ance policy. While not required by most insurance carriers, preparation of a legal due diligence summary by the buyer or its advisors is often constructive to the underwriting process for a buyer-side policy. Usually within a week after the underwriting fee has been paid, the insurance carrier and its outside legal counsel will schedule a due diligence call with the insured and its advisors, during which the insurance carrier will ask the insured questions about the dili-gence process, the negotiation of the acquisition agreement and any risks to the business that the buyer has identi-fied. Deal professionals should be aware that insurance carriers may exclude from coverage areas of diligence that have not been sufficiently pursued by the buyer. For example, if, during the diligence call, the buyer responds that neither it nor its advisors have per-formed any tax diligence, the insurance carrier may exclude the tax represen-tations from coverage under the R&W insurance policy.
Policy and Structural ConsiderationsShortly after the due diligence call,
the insurance carrier will provide a draft of the insurance binder and policy. The form of policy is subject to negotiation with the insurance carrier, and can be
customized to deal with the specific con-cerns and considerations unique to each transaction. Deal professionals should focus on maintaining symmetry between the terms of the acquisition agreement and the R&W insurance policy (for exam-ple, when negotiating the definition of “losses”). Deal professionals should also consider the interplay between the R&W insurance policy and the indem-nification paradigm in the acquisition agreement and the related complexities that may arise. For example, if the buyer and seller agree as a business matter that the R&W insurance policy should serve as the exclusive remedy for “non-fundamental” representation breaches and the R&W insurance policy is eroded by the breach of a “fundamental” repre-sentation, the buyer may not be able to recover losses under the policy arising out of a subsequent breach of a “non-fundamental” representation. As a gen-eral principle, differences in the timing and sequencing of claims should not result in different coverage outcomes. Timing and similar issues relating to the use of the R&W insurance policy should be considered and addressed in the acquisition agreement.
R&W insurance has become a promi-nent part of middle-market M&A trans-actions. M&A deal professionals have become comfortable with R&W insur-ance and have recognized the power and leverage that can be brought to bear on a transaction using the product. As the acquisition market continues to remain active, R&W insurance will continue to be an important tool for deal profes-sionals structuring and negotiating M&A transactions.
Howard t. Spilko is a partner at Kramer Levin Naftalis & Frankel, where he is co-chair of the corporate department. Scott a. abraMowitz is an associate in the department.
