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Private Company M&A – Rep & Warranty Insurance: A “Zero-Liability” Promised Land for Sellers?

This article is part of a continuing series by Frank Jones outlining recurring issues of critical importance to sellers in private company M&A. Previous topics include Equity Rolls, Net Working Capital Purchase Price Adjustments and Indemnification Clauses and Claims.
 
Sellers like RWI for an obvious reason – it greatly limits a Seller’s post-Closing liability for breaches of its negotiated reps and warranties. Sellers want a clean exit after the Closing and, depending upon the retention and other terms of the RWI policy employed, a Seller can approach – if not achieve – a “zero liability” or walk away deal. 
 
There are several ways RWI can also benefit a Buyer. In an auction process, RWI makes a Buyer’s bid more attractive, by eliminating or reducing the Seller’s escrow amount (and allowing more of the proceeds to be distributed at Closing) and by limiting Seller’s overall post-Closing indemnity exposure, while still providing the Buyer with protection. A Buyer can also purchase RWI coverage in amounts in excess of the indemnity cap the Seller is willing to accept, and potentially with longer survival periods. RWI can also provide a mechanism for recovery when pursuing the Sellers post-Closing is expected to be difficult or undesirable (for example, if Sellers are numerous, reside in foreign jurisdictions, may be insolvent, or have stayed on and remain active and/or are rolled equity owners in the post-Closing management of the business).
 
Below is a summary of certain key RWI considerations and issues a Seller will need to consider during M&A negotiations. 
 
“Sell-Side” or “Buy-Side” RWI? (RWI can be purchased either as Sell-Side or Buy-Side)
 

• Buy-Side coverage is “first-party” coverage, in which the insurer directly compensates the Buyer for breaches of reps and warranties by the Seller. This is the most common type of RWI
• Sell-Side coverage is a liability policy purchased by the Seller to protect it against claims made by the Buyer for breaches of the Seller’s reps and warranties
• A common variation is a Buy-Side policy that also protects the Seller (by barring the insurer (except in cases of fraud)), from pursuing the Seller after it makes a payment to the Buyer

 
General Scope of Coverage (determines what specific reps and warranties are covered by the RWI policy; may include fundamental reps, special reps and “garden variety” reps)
 

• “Fundamental" reps typically include organization/good standing, authority and enforceability, equity ownership/capitalization, title to assets, brokers, tax and other matters
• "Special" reps often cover deal-specific issues or liabilities that are uncovered during the Buyer’s due diligence, such as employment/benefits, IP and environmental
• “General" or garden variety reps cover a broad array of other, largely operational, matters. All reps other than Fundamental and Special reps are General reps by default
• The type of reps covered by an RWI policy influences and reflects the negotiation of the indemnity cap and escrow amounts
• Typical reps covered include financial statements, undisclosed liabilities, ownership of asset issues, tax matters, intellectual property claims and certain contract claims
• Breaches of covenants and purchase price adjustments are not covered by RWI

 
Policy Coverage Limits (the maximum amount the insurer will pay under the RWI policy; often expressed as a percentage of the total enterprise or transaction value)
 

• Determines the maximum financial protection for the Seller
• Limits are often set at 10% to 20% of total enterprise or transaction value, often with a coverage floor of about $5 million
• The limit should align with the potential risks and value of the overall deal

 
Policy Exclusions (identifies risks that are excluded from coverage)
 

• Typical exclusions include issues known by the buyer, forward-looking statements (e.g., post-Closing financial projections), underfunded pension or benefit plans, fraud and certain tax matters
• Identifying exclusions helps the Seller understand what is not covered and manage potential liabilities accordingly
• Additional due diligence may be required to minimize the practical impact of exclusions

 
Retention (the amount the insured must pay out of pocket before the RWI coverage kicks in. Can be structured as a percentage of the deal value or a fixed amount)
 

• Retention acts as the deductible, meaning the insured (either the Buyer or Seller, depending on the policy) must bear initial losses up to the retention amount; often this amount is split 50/50
• Historically, retention levels for RWI policies were set at around 1% to 3% of the total transaction value; more recently retention has been set at around 0.5% to 1.5% of the transaction value (e.g., $500,000 to $1.5 million in a $100 million deal)
• Usually aligned with the “basket” amount in the purchase agreement
• Lower retentions can increase the premium but reduce out-of-pocket costs in the event of a future claim

 
Premium Costs (the cost of obtaining the RWI insurance, paid at Closing. Based on a variety of factors including the deal size, industry sector, perceived risk and current market terms)
 

• Represents an additional cost in the transaction
• Typically expressed as a percentage of the policy limit
• Historically, RWI premiums ranged from 2% to 4% of the coverage limit; recently the market is more competitive, and 2.25% to 3.25% is more typical 
• For example, a $10 million policy might cost between $225,000 and $325,000
• Larger deals often have lower percentage premiums due to economies of scale and perceived risk
• May be negotiated between the Buyer and Seller as to who bears the cost; often split 50/50

                                                                                                            
Duration of Coverage (the period during which claims can be made under the policy. Typically continues for several years post-Closing, but can vary based on the specific type of rep and warranty)
 

• Three years of coverage for garden variety reps and six years for fundamental reps is typical
• Longer coverage periods can provide extended protection but will increase the premium
• Sellers should consider the survival period of reps and warranties in the purchase agreement in relation to the insurance coverage

 
Claims Handling and Dispute Resolution (the process for reporting and resolving claims under the policy. Includes the insurer's rights to defend and settle claims)
 

• Affects the Seller's control over claims and potential disputes
• Sellers should fully understand their post-Closing claim resolution rights and obligations

 
Subrogation Rights (the insurer's right to take legal action against the Seller in the event of a breach of reps and warranties that results in a claim)
 

• Subrogation allows the insurer to pursue legal action against the Seller (i.e., the party who made the reps and warranties)
• Important to negotiate waivers of subrogation to limit the Seller's post-Closing liabilities
• Often waived against Seller except in cases of fraud

 
Seller’s Disclosure Obligations (the requirement for the Seller to disclose known issues during the underwriting process. Full and accurate disclosures are essential to prevent policy voidance)
 

• Critical for maintaining the validity of the insurance policy, as non-disclosure or misrepresentation can cause denial of coverage

 
Interplay with Representations & Warranty Provisions (the relationship between the insurance policy and the reps and warranties set forth in the purchase agreement)
 

• The key reps and warranties in a purchase agreement are often aligned with the key provisions in the RWI policy
• Negotiations over the key representations and indemnification provisions are often significantly smoother and less contentious because the RWI insurer is bearing much of the responsibility

 
Interplay with other Indemnification Provisions (the relationship between the RWI policy and the indemnity provisions in the purchase agreement; affects the structure of indemnities, such as caps, baskets, and survival periods)
 

• Can reduce or eliminate the need for traditional indemnification provisions
• Will significantly influence the overall negotiation of the purchase agreement   
• Caps, baskets and escrows typically lower in amount for deals where RWI is used

 
Underwriting (the underwriting market has grown significantly in recent years. Obviously, the carrier must diligence the Seller and the deal in underwriting any policy)
 

• Typically underwriting costs are $35,000 to $50,000, depending upon the complexity of the deal
• The underwriting process can be as short as seven days, though the initial phase of the effort typically starts earlier
• The first step is working with an insurance broker to provide basic information and drafts of the transaction documents to one or more carriers
• The carriers then provide non-binding indications of the coverage they would be willing to bind, with premium estimates
• After it has performed its diligence, the carrier will provide a draft RWI policy, and this is often followed by negotiations over coverage and other key terms

 
RWI can be a powerful and valuable tool for Sellers in M&A transactions, reducing escrow requirements, limiting post-Closing exposure and streamlining and smoothing negotiations. By understanding the different types of policies, what is typically covered and often excluded, and the associated costs and other terms, parties can better manage the liability complexities of M&A deals and structure transactions that are beneficial for all.  Consequently, it is crucial for a Seller to carefully consider the terms, costs, and strategic implications of RWI insurance to maximize its benefits and minimize potential post-Closing exposure. 

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The above executive summary has been prepared for general informational purposes only and is not intended as legal advice.  Sellers and Buyers alike are urged to consult their legal counsel concerning any particular situation and specific legal questions.

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