R&W Insurance Facilitates Merger Deals

While the number of major corporate mergers and acquisitions has slowed in the past year, business of all sizes, both public and private, continue to buy and sell assets. Regardless of the type of deal, these transactions generally include the seller making representations and warranties with regard to the state of the business/asset being sold. In recent years, insurance for representations and warranties has played an increasingly important role in facilitating many types of transactions. Many investment bankers and attorneys negotiating mergers and acquisitions are using representations and warranties insurance to facilitate the often contentious, time-consuming and possibly deal-breaking negotiations over indemnities, escrows and holdbacks, helping to break stalemates and close the deals.

Representations and warranties are written factual statements about the acquired company buyers require from sellers as a condition of the purchase. The representations and warranties will typically cover all aspects of the operations including areas such as tax status, intellectual property, environmental compliance, employee benefit plans, financial statement accuracy, litigation, corporate authorization and title to property.

R&W insurance helps protect against financial loss arising from unknown or undisclosed liabilities that emanate from a purchase, merger, sale, acquisition or divestiture. Coverage will typically reimburse the insured for losses suffered as a result of a breach or inaccuracy in the sellers representations and warranties. Either a buyer or a seller in the transaction may obtain coverage, but in both scenarios the underlying loss is a breach of the sellers representation.

The coverage can be structured to cover all of the representations or selected representations within the transaction. Premiums typically range from 310 percent of the limit of liability purchased. Coverage will typically match up to the survival period of the sellers indemnification obligation, as well as the amount of indemnity that the seller is required to provide. In addition, when there is no seller indemnification, as in the case of an acquisition of a public company, or where the indemnity obligation is fairly limited, a reps policy can be used by the buyer as a replacement or supplement to the sellers indemnification.

So why would a buyer or seller purchase a policy? There can be a number of motivating factors, which will vary from deal to deal and between buyer and seller. First, despite the fact that the deal may have been zealously negotiated and the diligence conducted to the appropriate level, there is always the risk that factual matters are inadvertently missed, undiscovered or overlooked during the process. There is always an element of unknown risk–which is why the indemnities are there in the first place. In essence, the R&W insurance can act as a backstop to both the buyers due diligence as well as the sellers disclosure process.

From the buyer's perspective, they may be seeking additional confidence in support of their due diligence efforts. For example, a buyer may be considering a cross-border transaction, acquiring a line of business that is outside of their historical core operation or can only conduct a limited amount of diligence. Alternatively, the seller may be a competitor or a very suspicious entity and wont let the buyer look at confidential information.

There may also be a bidding process where the time constraints limit the buyers ability to conduct full diligence. In these situations, an R&W policy may be able to give the buyer an added level of comfort in closing the deal. The insurance, however, should act as a supplement to some level of buyer diligence, not a complete substitute of the process.

The policy can also provide protection against the risk that a seller defaults on its indemnity obligation. The buyer may be concerned, for example, about the financial condition of the selling corporation who is divesting the business to avoid a bankruptcy filing. As a result, the seller requires all of the proceeds immediately and is unwilling to set aside a portion of the cash into an escrow account to guarantee their contingent financial obligations. If there is a breach, the buyer may be left with a worthless indemnity agreement. Additionally, the buyer may not be able to obtain sufficient escrow or indemnity. In these situations the insurance can either supplement or replace the sellers indemnification for representations and warranties.

A sellers motivation to purchase R&W insurance can be very different. As noted above, the coverage can backstop the sellers disclosure process by protecting against an unintentional non-disclosure. Additionally, a seller may simply wish to lock in all of the sale proceeds when the deal closes. For example, a company may be going through a strategic reorganization, divesting a non-core business, and does not want to be concerned with disclosing a future liability to shareholders two years after the fact, thus avoiding a future hit to earnings. Perhaps, as part of that strategic reorganization, the company needs every dollar of the sale proceeds to refinance existing bank debt. Therefore the company cannot afford to have funds tied up in escrow.

Private equity and venture capital firms can also utilize R&W insurance. These firms are especially motivated to minimize escrows in order to distribute the proceeds from a transaction to their limited partners as quickly as possible. Retaining an indemnity obligation for representations and warranties may hinder the liquidation of the full amount of the deal proceeds, while keeping 10-to-20 percent of the purchase price tied up in an escrow account certainly will. In addition, tying the funds in a low interest bearing escrow account will have a negative impact on the buyout groups return-on-investment, which is critical to their future fund raising efforts.

Beyond addressing the basic risk of a representations and warranty breach, R&W coverage can be a strategic negotiating tool. Buyers are typically seeking to minimize their purchase price while maximizing the indemnification and escrow, whereas sellers are attempting to eliminate or minimize the indemnity and escrow while maximizing their purchase price. Its easy to see how either a buyer or a seller in the deal can spring value into the deal by employing the insurance to their advantage. A buyer could agree to reduce the sellers indemnification obligations to fraud or intentional misrepresentation in exchange for a purchase price reduction. On the flip side, a seller could agree to offer a larger amount of indemnity for reps and warranties in exchange for getting the purchase price it is seeking. The following is an illustration of the latter scenario:

A seller is seeking $100 million for the sale of a family business. The buyer is only offering $95 million and is unwilling to go to $100 million because the seller is negotiating hard on the amount of indemnification he is willing to offer. Buyer is seeking indemnity of $30 million. The seller is also refusing to set aside any of the proceeds in an escrow account. The deal has reached a standstill over the terms of indemnification.

By incorporating an R&W insurance policy into his negotiation strategy, the seller agrees to a $30 million indemnification obligation for reps and warranties in exchange for a $5 million increase in the purchase price. The cost of the $30 million policy is $1.5 million. The seller achieves a net $3.5 million increase in the purchase price with the added benefit of transferring the risk of a rep and warranty claim to an insurance policy, thus helping to secure his proceeds. The buyer gets the indemnity it was seeking, backed by additional security in the form of an insurance contract.

Given the many issues to be negotiated in a transaction, it is equally important for buyers and sellers to understand what R&W insurance does not cover. This will help ensure that the coverage matches up with the parties objectives. Since the coverage is still relatively new to the U.S. market, there are still some common misconceptions. R&W insurance does not insure any known potential liabilities, such as existing lawsuits or environmental cleanups. There are other insurance coverages, known as loss mitigation insurance and environmental cost caps that are frequently used to address such issues in a transaction. R&W policies will also not respond to the failure of the seller to perform a covenant. A covenant is an obligation to perform–or in some instances refrain from performing–a particular act, often at some point in the future. On a R&W policy, the underwriter is really evaluating whether or not the representations and warranties were factually true when made, not how sellers will conduct themselves after closing. Additionally, R&W policies will not respond to a purchase price adjustment, since it too is not a breach of a representation. Generally purchase price adjustments are required to “true-up” the balance sheet or income statement for items that the parties anticipated, but were not able to incorporate into the financial statements when the parties agreed on the purchase price.

While R&W policies will not insure everything the seller is required to indemnify for, it does insure the principal risks in the transaction–the representations and warranties. By insuring the principal components of the indemnity obligation, the insurance can be an effective tool in reducing or eliminating escrows and facilitating the negotiations over the terms of seller indemnification.

Brian Benjamin is a senior vice president of American International Groups Mergers & Acquisitions Division in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, December 3, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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