Nuts and Bolts of Representations and Warranties Insurance
John Black | April 13, 2018
Directors and officers of public and private companies have traditionally faced a myriad of exposures to third-party risk. Traditionally, directors and officers (D&O) liability insurance responded to one of the biggest exposures faced by directors and officers—claims by investors and shareholders of mismanagement, breaches of fiduciary and other duties, and, in the public company realm, violations of the federal securities laws.
Acknowledgment
The author would like to acknowledge and thank coauthor Ted Carleton for his contributions to this commentary.
In the past decade or so, however, another form of insurance has emerged to address another prevalent risk faced by management: transactional risk arising out of deals among entities. Representations and warranties insurance (RWI) is now a standard component in the executive tool kit to shift deal-related liability exposure to a third party, in this case, the RWI insurers.
RWI is a widely available and frequently employed product in mergers and acquisitions (M&A) transactions, and thus should be considered as part of the risk management insurance arsenal available to company executives when considering a combinatory transaction.
This article addresses how RWI functions and why it should be part of the tool kit available to company management when considering an entity transaction.
RWI versus Escrow
As is familiar to parties who are regularly involved in entity transactions, in a given M&A deal, the acquiring company or buyer will insist on an escrow to cover contingencies and liabilities arising out of potential post-sale breaches of the acquisition agreement. The current M&A market is generally viewed as seller-friendly, and as a result of the seller's leverage, sellers are reluctant to agree to an escrow since it effectively delays the sellers' realization of compensation for the transaction.
In this instance, RWI steps in and essentially takes the place of the escrow. While there are both buy-side and sell-side policies, given the current market dynamics, buy-side insurance (i.e., under which the buyer purchases an RWI policy to take the place of the seller's escrow) is much more prevalent. While less prevalent, sell-side RWI policies are available; sell-side policies function to insure the sellers' escrow fund.
What Do RWI Policies Cover?
The typical policy covers legal defense expenses and related costs arising out of third-party claims in the context of a buy-side policy and in response to a buyer indemnification demand in the case of a sell-side policy. With respect to third-party claims under a buy-side policy, this means a claim by a party other than the buyer or seller, against the buyer, which is related to a representation or warranty contained in the purchase agreement. By way of example, if the seller represented that all of its sales contracts had been fulfilled, but following the acquisition, the buyer was sued by third parties alleging that the acquired company had not performed existing contracts, the defense of that claim would be covered by the buyer's RWI policy.
RWI policies also afford indemnity coverage. In this regard, a buy-side policy would cover amounts buyers were held liable to be responsible for as a result of some breach in the sales agreement. In the sell-side context, the indemnity coverage would cover loss when the seller was obligated to pay indemnitees.
Unlike many types of liability insurance, there are few exclusions in RWI policies. The two primary exclusions are for actual knowledge of a breach of a representation or warranty at the time the policy is placed and for material inaccuracies in a warranty letter—a document executed at the time the policy is placed disclosing all claims (or lack thereof) that could lead to an exposure under the RWI policy.
RWI Seals the Deal
RWI policies are viewed by the M&A bar as deal facilitators. As an initial matter and among investor groups that may have frequent dealings and historical relationships, RWI policies shift disputes over reps and warranties from the dealmakers to a third-party insurer. The advantage is twofold. First, the RWI coverage means that the buyer doesn't have to engage in a dispute with a counterparty with whom it may have frequent dealings. Second, by placing the third-party insurer as the source of recovery for a breach, the acquired company can continue management of its operations unencumbered by the distractions and costs of pursuing such a claim against a counterparty, whether through litigation or otherwise.
All in all, the cost for RWI coverage is typically 3–5 percent of the policy limits. Limits, in turn, are typically equal to around 10 percent of the deal value and are typically subject to a self-insured retention of around 1–3 percent of the deal value. While capacity varies among underwriters, RWI insurance is employed across a broad range of deal sizes, from transactions involving microcap entities to large publicly traded companies in which RWI limits may be stacked by multiple insurers in amounts into the hundreds of millions of dollars.
Conclusion: RWI Insurance Assists Mergers and Acquisitions
In summary, RWI is a commonplace tool in M&A dealmaking. Corporate executives considering an M&A transaction should be familiar with the basic scope of its coverage and the benefits it can confer to both sides of a transaction.
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