The use of representations and warranties insurance is becoming increasingly commonplace in M&A transactions, particularly in competitive auction processes where use of the product has become almost ubiquitous. While much has been written about the deal terms of M&A transactions that make use of representations and warranties insurance, there is little practical guidance available that addresses either the underwriting process and timeline, or the negotiation of key policy terms. These areas can be challenging for parties using a representations and warranties policy for the first time, and this commentary is intended to provide a high-level overview of representations and warranties insurance to help demystify an otherwise imposing process.
The Insurance Timeline and Process
When working on a transaction where a representations and warranties insurance policy will be used, it is critical to understand the timeline and process considerations and to calibrate expectations accordingly. Given that the vast majority of underwritten policies are buyer-side policies rather than seller-side policies, this discussion assumes that the parties have selected a buyer-side policy.
Underwriting Process Timeline. Underwriters typically state that they need 7-10 business days from the date they are engaged to underwrite a policy, although this timeline can be shortened in certain circumstances. The following steps are prerequisites to commencing the underwriting process:
Broker selection. Selecting a broker is generally the first step in the process. Most of the large insurance brokerages have individuals that specialize in brokering representations and warranties insurance policies, and many of these brokers are former practicing M&A attorneys or other deal professionals who understand M&A transactions and their often fast-paced timelines. Brokers can provide invaluable assistance in managing the insurance underwriting process, negotiating with underwriters and providing substantive comments to draft policies.
Underwriter selection. Once the initial draft of the transaction agreement is available, the broker will typically seek nonbinding premium indications from prospective underwriters. These indications will be based upon the representations and warranties in the draft agreement provided to the underwriters, so if there are substantial changes in the scope of the representations and warranties in the final definitive agreement, the indicated premiums may end up being adjusted when the insurer provides the final, binding quote. In addition to the estimated premiums, the indications will set forth expected coverage exclusions and areas of heightened diligence scrutiny. The “insured” (the party purchasing the insurance, presumed to be the buyer for purposes of this guide) then selects the insurer offering the most favorable terms by executing the underwriting proposal and paying the insurer’s underwriting fee. Note that this underwriting fee is distinct from the premium and typically is a relatively inexpensive fee that the underwriter charges as compensation for incurring the time and expense of the underwriting process.
Substantial Completion of Diligence, the Definitive Agreement and Disclosure Schedules. The 7-10 business day clock doesn’t start running until the underwriter has received substantially complete third-party diligence reports, including reports from the company’s legal, financial/accounting and tax advisers. Similarly, underwriters will require substantially complete copies of the acquisition agreement and related disclosure schedules to kick off the underwriting diligence process. Although negotiations between a buyer and seller (and related changes to the acquisition agreement and disclosure schedules) will often continue until the signing date, the acquisition agreement is ready for purposes of beginning the underwriting process once the general scope of the representations and warranties is settled and the draft disclosure schedules have been updated accordingly.
Underwriter Diligence Considerations. Once engaged, the underwriter must complete its diligence in order to finalize the policy prior to the signing date. Set forth below are a few key considerations for buyers and sellers with respect to the underwriter’s diligence process.
Sharing of diligence materials. An underwriter typically requires the buyer to share its third-party diligence reports with the underwriter in order to jump-start the underwriter’s diligence. These reports are provided on a non-reliance basis, and third-party diligence providers will need to prepare and enter into non-reliance letters with the underwriter before the buyer is able to share the reports. A buyer should make sure that its advisors are aware that an underwriter will be reading their diligence reports, and should carefully read the diligence reports to look for any red flags that will likely draw the attention of the underwriter: Does the report satisfactorily address any issues uncovered? Does it convey to the reader that the diligence process was robust? Does it provide in-depth analysis of significant issues? Failure to adequately address key issues or to convey the robust nature of the diligence review can lead to deeper probing by the underwriter, which can in turn delay the process and/or lead to coverage exclusions or limitations. The underwriter typically will convene a diligence call with the buyer and its advisers to review diligence findings as a final step in its diligence, and proper preparation for such a call can go a long way in assuring a successful underwriting.
Risk-Sharing Dynamics. Although the underwriter diligence process in some ways parallels the lender diligence process in a leveraged transaction (e.g., the tight diligence timeline and the sharing of diligence materials on non-reliance basis), the risk-sharing dynamics are quite different in the underwriter diligence context. Lenders are generally accepting of a buyer’s decision to limit the scope of its diligence review, as the lender is protected by its higher position in the capital structure vis-à-vis the equity-holding buyer, and so the buyer is properly incentivized to analyze material diligence issues given that it bears the primary risk for issues not uncovered. In contrast, in a transaction using a representations and warranties policy, the underwriter bears the primary risk for issues not uncovered in due diligence, and so an underwriter will be highly focused on the quality and depth of the diligence review conducted by the buyer. Failure to look into a material issue may result in the underwriter insisting upon a deal-specific exclusion for claims related directly to that issue.
Dealing with Diligence-Based Exclusions. Inevitably, the diligence process will uncover some issues that will be excluded from coverage under the policy—whether due to the fact that any known risks are automatically excluded from coverage, or because the underwriter is uncomfortable with a risk due to an insufficient diligence review (in the opinion of the underwriter) or an ambiguity in the diligence findings. This often results in the need for buyers and sellers to address these carve-outs at a very late stage in the negotiation, likely only days before signing the definitive acquisition agreement. There are myriad ways for buyers and sellers to solve such issues, e.g., special indemnities, separate escrows, etc., and such solutions will depend upon the particular facts at hand, but as a general matter, buyers and sellers should anticipate the need to address quickly such issues late in the process.
The Insurance Framework
The policy form usually is finalized concurrently with the underwriter due diligence process.
As a starting point, the insuring agreement of the typical policy obligates the insurer to pay on behalf of the insured “Loss” on account of a “Claim” for the “Breach” of any of the designated representations and warranties in the acquisition agreement. From here, coverage is tailored to the specific transaction based upon the definitions of key terms, and policy conditions and exclusions.
The definition of Loss (sometimes referred to instead as “Net Provable Damages”) describes the damages that the policy will cover, and some that it will not. In general, covered Loss should be defined to encompass the damages that the buyer would be entitled to under the acquisition agreement. But the insurer may propose initially a definition that carves out key categories of damages, as discussed below.
Consistent with the term “representations and warranties insurance,” a Breach is the failure or inaccuracy of any representation or warranty contained in the acquisition agreement. In contrast, covenants are not insured, and neither are post-transaction price adjustments or earn-outs based upon future revenue targets or other metrics.
Insurers usually require the parties to share some liability in the event of a Breach, typically in the range of 1–2.5 percent of the transaction value. This “retention” can vary depending upon the deal holdback negotiated by the parties (among other factors), but in a transaction where the seller has escrowed a portion of its proceeds to secure its indemnification obligations, the retention is often an amount equal to twice the amount of the seller’s initial escrow. Once the escrowed funds are released to the seller pursuant to the terms of the acquisition agreement, there is a corresponding reduction in the retention (taking into account both the amount of the escrowed funds released to the seller and the amount of any escrow payments previously made by the seller to the buyer). This structure avoids an unanticipated “gap” in the buyer’s protection.
Opportunities for Improvement
Many of the key policy provisions are negotiable, some for payment of additional premium but many at no cost to the insured. Insureds should inquire about potential coverage enhancements, including the following:
Diminution in Value/Multiplied Damages. Some policies restrict the definition of Loss to exclude the diminished value of the target company due to the Breach, including damages calculated by using any multiple on which the purchase price was based, such as earnings, revenue, etc. This is a significant limitation on coverage that should be removed if possible. Some insurers may require a small increase in premium to do so.
Consequential Damages. All policies include within Loss “actual” and “general” damages that flow naturally and directly from a Breach. But some policies expressly exclude from Loss “consequential” damages, which are reasonably foreseeable damages incurred due to the special circumstances of the buyer. This exclusion likely narrows the coverage from what the seller would have been required to indemnify, and usually is negotiable with the insurer. With respect to both this exclusion and that for diminution in value/multiplied damages or similar measures of damages, the underwriter is often willing to omit such express exclusions if the underlying acquisition agreement is likewise silent on the topic. On the other hand, if the acquisition agreement expressly excludes recovery for such categories of damages, then the policy will almost certainly exclude such damages as well.
Materiality Scrape. The seller’s representations and warranties usually are qualified by acquisition agreement terms such as “material’ or “material adverse effect.” Just as it is common to include a “materiality scrape” provision in an acquisition agreement—which removes such qualifications when determining both whether a Breach has occurred and the amount of covered Loss attributable to a Breach—policies can be negotiated to include a materiality scrape. Note, however, that underwriters typically are willing to include a materiality scrape only if the underlying acquisition agreement includes one.
Loss Adjustments. Policies typically reduce covered Loss to account for collateral benefits received by the insured, such as amounts obtained under other insurance policies, tax benefits, etc. But these adjustments are not always net of the insured’s costs to obtain them, such as legal fees, policy deductibles, increased premium, etc., and this point should be negotiated with the insurer.
Actual Knowledge. Policies only insure against claims unknown to the buyer at closing, but committing this principle to writing often is subject to negotiation. “Actual Knowledge” should be defined as actual conscious awareness, with the definition stating clearly that constructive or imputed knowledge of a fact is insufficient.
Closing Letter. All buyer-side policies bar coverage if it is discovered that the buyer’s representative falsely stated at the time of closing that he or she did not know of any Breach by the seller. But this exclusion can be limited to claims related causatively or logically to the statement, and only if the insurer is materially prejudiced by the statement.
Mitigation. All policies require the insured to take reasonable steps to mitigate Loss caused by a Breach. This issue arises most often in the context of a potential claim by the buyer against the seller, however, and it is possible to negotiate an express statement that mitigation steps against the seller are not a pre-condition to the buyer making a claim or receiving payment for Loss under the policy.
Understanding the underwriting process and timeline, and the opportunities for negotiating the most favorable policy terms, will pave the way for successfully implementing representations and warranties insurance in a transaction. Consult counsel and an insurance broker experienced with these concepts for the best results.