In recent years, deal volume and purchase prices have hit historic highs. To alleviate risk to buyers, both buyers and sellers have increasingly looked to insurance as a method of bridging the gap— allocating more risk to the insurance company as part of the sale of a business.
Representations and warranties is the most frequently used type of insurance in these circumstances. R&W insurance provides protection to the buyer against losses it could suffer from inaccuracies or breaches of the representations and warranties provided in a purchase agreement by the selling company and shareholders. If properly structured, the seller will have a greater percentage of the sales price guaranteed, while the buyer can turn to the insurance company to recover losses if the seller breaches the contract.
From a legal standpoint, much of the negotiating for an acquisition is over the allocation of risk between buyer and seller. The representations and warranties in a purchase agreement provide statements about various aspects of the selling business. Sellers try to limit the risk of a breach by narrowing the scope of the representations and warranties, as well as arguing for qualifiers regarding materiality and knowledge. Conversely, buyers seek broad representations and warranties that cover many aspects of the business, regardless of materiality or knowledge of the sellers. The scope of the representations and warranties becomes significant when viewed with respect to indemnification for breaches. The broader the representations and warranties, the greater the chance for the buyer to claim breach of contract and seek damages. The narrower the representations and warranties, the smaller the chance for such a scenario.
The buyer wants to ensure it receives the benefit of the bargain and is not stuck with unforeseen liabilities or damages following a closing. If unforeseen liabilities or damages arise post-closing, a buyer will want to argue that the seller breached its representations and warranties, so it must must indemnify the buyer for these liabilities and damages. Even though a buyer may be entitled to indemnification, it also needs to consider its ability to collect from the seller. Buyers frequently request a hold back of the purchase price, a third-party escrow, or a post-closing earnout to ensure that the funds will be available for indemnification.
Concerns of the Parties
The seller wants to retain as much of the purchase price as possible, with as little risk of losing it as possible. A seller usually places a premium on certainty, so it negotiates limitations on indemnification, such as baskets, caps and survival periods. A seller will always want to minimize the chances of returning some of the purchase price, shorten the period of risk for returning some of the purchase price and minimize the amount it would need to return.
R&W insurance can help both buyers and sellers address these concerns. Over the past few years, R&W insurance has become an increasingly popular alternative or supplement to traditional indemnification, especially in Europe. A typical structure negotiated by parties to a purchase agreement provides that a seller’s indemnification obligation is limited to the premiums for, and retention under, an R&W insurance policy. The cost of an R&W insurance policy is typically 2.5% to 3.75% of the limits insured under the policy. The policy period typically is the same as the survival period for indemnification under the underlying acquisition agreement, but can often extend up to six years. From a seller’s point of view, if the indemnification is limited to the policy, the time period is less important other than with respect to the payment of the retention, which is often funded by the seller. If a claim is made under an R&W insurance policy, the payments from the insurance company would be subject to a retention typically in the range of 1 percent to 3 percent of transaction value.
A typical R&W insurance policy generally will cover all the representations and warranties contained in a purchase agreement, even those relating to taxes. Environmental representations can be insured in certain circumstances. Items typically not covered in an R&W insurance policy are forward-looking statements and projections, covenants, known or disclosed items, asbestos and PCBs, and pension underfunding liability. There also may be additional exclusions that are deal-specific.
While the payment of the premiums for, and retention under, an R&W insurance policy is usually negotiated by a buyer and seller, both parties can benefit by the use of such a policy. Buyers need not worry about the collectability under any indemnification claims because an insurance company will stand behind the indemnification. Sellers need not be concerned about the amount of purchase price that remains at risk because they have fixed their exposure. Accordingly, sellers who are willing to spend some of the purchase price up front can ensure they will not be forced to set aside a large percentage of the purchase price in escrow for future indemnification risks, and they can sleep better knowing they diminished their future risk of returning part of the purchase price.
Both buyers and sellers are using R&W insurance policies more frequently in a competitive marketplace. Buyers often propose an R&W insurance policy in a competitive bidding situation as a way to distinguish their bids offering sellers limited indemnification obligations. Sellers often propose an R&W insurance policy as part of an auction situation so they can achieve a clean exit from the business with limited recourse. As part of a negotiation, buyers and sellers also use R&W insurance as a bridge to close gaps over escrows, deductibles and caps. In addition, lenders frequently request that buyers obtain R&W insurance because it diminishes lender risk by providing greater certainty of buyers collecting on any rights they may have to indemnification.
It is important to engage insurance carriers early in the M&A process. The first phase is for an insurance broker to go out to the insurance marketplace to obtain non-binding indication letters. To do so, the broker will need any available information regarding the sale, such as a confidential information memorandum on the target company, a draft purchase agreement and schedules and financing statements for the target.
Once an insurer is selected, the parties enter the final underwriting stage. The parties must pay a due diligence fee, usually $15,000 to $40,000, depending on the size and complexity of the deal. The underwriter and its outside counsel will want access to due diligence relating to the deal, including due diligence reports, and will consult with the parties’ respective transaction advisers. Following this, the insurer will bind the policy.
Mitchell Roth (pictured, lef) is a managing partner, and Michael Shaw is a principal at Chicago law firm Much Shelist.