Reproduced with permission from Corporate Governance Report, 17 CGR 3, 03/03/2014. Copyright �2014 by The Bureau of National Affairs, Inc. (800-372-1033) http://www.bna.com

BNA InsightsRepresentations and Warranties Insurance in M&ATransactions—Utility and Procedural ConsiderationsBY DAVID M. SMITH AND

NICOLAI M. SCHWARZ-GONDEK

R epresentations and warrantiesinsurance (RWI) has been avail-

able for more than 15 years, but hasemerged as a more viable tool inmergers and acquisitions only in thepast two to three years, mainly dueto increased cost effectiveness andimproved terms of coverage. Thisarticle takes a closer look at RWI inthe M&A context by highlightingthe utility of RWI to the transac-tional parties, outlining the proce-dures and timing for putting apolicy in place, and discussing someof the more heavily negotiated pro-visions of a typical policy.

Use of RWI in the M&A ContextIn M&A transactions, RWI poli-

cies primarily are used to substituteall or a portion of the seller’s indem-nity obligations under the purchase

agreement, meaning that the RWIpolicy (a) will serve as the buyer’ssole remedy for breaches of the sell-er’s representations and warranties,or (b) will provide recourse only forbreaches of a limited set of repre-sentations and warranties while theseller remains liable for breaches ofall representations and warrantiesnot covered by the policy.

In addition, RWI policies canserve as a tool for broadening theindemnification package under thepurchase agreement by providingadditional protection to the buyerbeyond the monetary and survivallimitations negotiated with theseller. Further, the seller can utilizea RWI policy to insure against itsown indemnification obligations forbreaches of representations andwarranties, with the insurance car-rier reimbursing the seller foramounts paid to the buyer on ac-count of indemnification claims un-der the purchase agreement.

RWI has been available for more

than 15 years, but has emerged

as a more viable tool in mergers

and acquisitions only in the

past two to three years, mainly

due to increased cost

effectiveness and improved

terms of coverage.

Regardless of its purpose, a RWIpolicy can be obtained by the seller(a ‘‘sell-side’’ policy) or by the buyer(a ‘‘buy-side’’ policy), depending onwhich party is seeking the benefit ofcoverage. The marketplace, how-ever, tends to favor ‘‘buy-side’’ poli-cies given their broader coverage,which includes seller’s fraud. Ac-cording to Peter Lambert, seniorvice president of insurance brokerWillis North America, more than 80percent of RWI policies placed byWillis in 2013 were ‘‘buy-side’’policies.

Cost and Allocation of CostCostOne of the main factors that has

contributed to the increased usageof RWI in the M&A context is thatinsurance premiums have de-

David M. Smith is a shareholder and Nicolai M. Schwarz-Gondek isan associate in the Santa Monica office of Stradling Yocca Carlson& Rauth, P.C., where they specialize in a wide range of corporatetransactions, including mergers and acquisitions, private equityinvestments, corporate finance, capital formation and general corpo-rate advice to boards of directors and senior management of publicand private companies on all aspects of corporate transactions.Mr. Smith can be reached at (424) 214-7024 or dsmith@sycr.com, andMr. Schwarz-Gondek can be reached at (424) 214-7044 ornschwarz@sycr.com.

COPYRIGHT � 2014 BY THE BUREAU OF NATIONAL AFFAIRS, INC. ISSN 1520-7625

Corporate GovernanceReport™

creased significantly over the years.Ten years ago, a potential insuredprobably would have considered thepremium for a RWI policy to be rea-sonable when it was in the range of 4to 10 percent of the covered amount.Today, these percentages would nolonger be competitive.

Says Peter Lambert: ‘‘Nowadays,RWI policies generally are priced inthe range of 2 percent to 3.5 percentfor each dollar of coverage purchasedbased on a number of factors, includ-ing the coverage limits sought underthe policy; the higher the amount ofcoverage, the lower the rate.’’

Generally, the coverage amountshould be at least $5 million for aRWI policy to be cost effective. RWIpolicies typically provide coverageranging from 10 to 20 percent of thetarget company’s enterprise value. Inaddition to the insurance premium,insurance carriers generally charge anon-refundable underwriting fee inthe range of $10,000 to $50,000 priorto initiating the underwriting processdescribed in greater detail below.

Allocation of CostThe question of who pays the pre-

mium for the RWI often is a functionof who receives the greatest utilityfrom the policy. Because those cir-cumstances vary from deal to deal, itis difficult to generalize. However, asexplained below, both the buyer andthe seller frequently benefit for differ-ent reasons and may agree just tosplit the cost.

Utility to Buyer/SellerUtility to BuyerFrom a buyer’s perspective, RWI

can provide additional protection andcomfort in situations where the sellerpotentially presents a credit risk orwhere there are multiple sellers andthe buyer is concerned about its abil-ity to collect for losses directly fromthose sellers. In addition, it has be-come increasingly common for abuyer to introduce the concept ofRWI in a competitive auction processto distinguish its bid from others.

For example, the use of RWI maypermit a buyer to offer only minimalor no survival of the seller’s represen-tations and warranties, and/or refrainfrom requiring a holdback or escrowof any portion of the purchase priceas security for the seller’s indemnityobligations. For private equity buyersspecifically, an additional advantageof RWI is that it may alleviate poten-tial problems associated with thebuyer having to pursue indemnifica-tion claims against selling stockhold-

ers that continue as management andother equity holders of the buyerpost-closing.

The question of who pays the

premium for the RWI often is a

function of who receives the

greatest utility from the policy.

Lastly, buyers can use RWI poli-cies in connection with public com-pany acquisitions where the repre-sentations and warranties typicallydo not survive the closing and there isno indemnity.

Utility to Seller

RWI also can be used in a numberof ways to a seller’s strategic advan-tage. In particular, RWI is beneficialfor sellers that want to reduce, oreliminate entirely, the amount of saleproceeds that a buyer holds back orthat are placed into an escrow ac-count. We have come across multipletransactions where a seller rejectedan escrow or holdback concept fromthe outset based on the argument thatit would lock up a significant portionof the purchase price for an extendedperiod of time. Although the buyer inmost cases could not get comfortablewithout any such protection, a RWIpolicy frequently saved the day andbridged the gap between the parties.

Another key benefit of RWI is thatit may allow the seller to avoid anyongoing liability for indemnity and toexit an investment with the assurancethat it will not be subject to contin-gent liabilities arising from breachesof its representations and warrantiesunder the purchase agreement. Theforegoing benefits are particularlyuseful for a private equity fund be-cause it will allow the fund to distrib-ute more proceeds to its investors atthe closing of the transaction or to re-deploy these proceeds into anotherinvestment, while reducing the risk ofa clawback.

Finally, by relying on a RWIpolicy, sellers can avoid or minimizeissues relating to joint and several li-ability in the case of multiple sellers,which can be particularly challengingin transactions with minority or pas-sive sellers with little knowledge of,or involvement in, the day-to-day op-erations of the company being sold.

Process and TimingOnce the determination has been

made that RWI is a viable tool for thetransaction at hand, the parties mustconsider the process for putting theinsurance policy in place.

Obtaining Non-Binding QuoteAs an initial step, the party seeking

the benefit of coverage should con-tact an insurance broker that has ex-perience in placing RWI policies.Says Peter Lambert:

One of the major benefits of involvingan experienced insurance broker earlyon in the process is that we are famil-iar with the major carriers in the RWIarea, such as AIG, Ambridge Partners,Concord Specialty, Allied World, Beaz-ley and Hartford, and can assist theparties in selecting the best carrier fortheir specific needs. In addition, we canbe instrumental in securing non-binding price and coverage quotesfrom one or more carriers based onpreliminary information about thetransaction and the parties. Typically,non-binding quotes can be obtainedwithin two or three business days at nocost to the potential insured.

To prepare a non-binding priceand coverage quote, the insurancecarrier generally will ask for copies ofthe offering memorandum or otherdocument containing a business de-scription of the target entity, a draftof the purchase agreement and acopy of the target’s most recent fi-nancial statements. Prior to the po-tential insured making any materialsavailable to the insurance carrier, it isadvisable that the parties enter into anon-disclosure agreement to ad-equately protect the confidentiality ofany such information.

UnderwritingAs soon as an insurance carrier

has been selected, the carrier willproceed with an in-depth underwrit-ing review during which it will con-duct its own due diligence. The insur-ance carrier’s due diligence, which istypically done with the assistance ofcounsel, involves a detailed review ofthe data room contents as well as areview of existing due diligence re-ports and related materials preparedby the potential insured or its advi-sors. This review may culminate inone or more conference calls with thedeal team members, including legalcounsel, outside accountants and fi-nancial advisors, to discuss their duediligence findings and to answer theinsurance carrier’s questions.

As part of its due diligence, the in-surance carrier also will review thenegotiated representations and war-

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ranties in the purchase agreement to-gether with the accompanying disclo-sure schedules. Because even minorchanges to the scope of the represen-tations and warranties in the pur-chase agreement or the related dis-closure schedules may have an im-pact on the coverage available undera RWI policy, it is advisable to keepthe insurance carrier apprised of anychanges in a timely manner.

Adds Peter Lambert:

Based on our experience, any major in-surance carrier with expertise in thespace will be able to familiarize itselfquickly with the transaction, to run anefficient due diligence process and toreadily assess potential risks associ-ated with the transaction. However, inorder to provide for sufficient lead timeto respond to the insurance carrier’sdue diligence requests, which some-times can be fairly extensive, we urgeanyone interested in RWI to start theprocess as early as possible.

Assuming the insurance carrier issatisfied with its due diligence re-view, it will issue a draft insurancepolicy that the parties then will nego-tiate. Upon conclusion of the under-writing and policy negotiation pro-cess, which can be completed asquickly as seven to 10 business daysif prompt attention is given to the in-surance carrier’s requests, the insur-ance carrier will bind coverage andissue the RWI policy at the closing ofthe transaction.

Key Negotiated ProvisionsIn negotiating the RWI policy,

careful consideration must be givento ensure that the policy is consistentwith the parties’ expectations and, tothe extent applicable, the provisionsof the purchase agreement. Based onour experience, the negotiation of theinsurance policy focuses on severalkey provisions that include thefollowing:

1) Scope of Covered Losses andExclusions:

As outlined above, RWI policiescan be structured to provide coveragefor all or a specific subset of repre-sentations and warranties in the pur-chase agreement. In either case, it iscommon for a RWI policy to providefor one or more of the following ex-clusions from coverage:

s RWI policies typically do notcover issues of which the in-sured had knowledge prior tothe inception of the policy. Fromthe insured perspective, it is

therefore advisable to limit thedefinition of ‘‘knowledge’’ in theRWI policy to the actual knowl-edge of a limited number of itsinternal deal team members.

s In addition, RWI policies ex-clude from coverage informa-tion described in due diligencereports or matters set forth inthe disclosure schedules to thepurchase agreement (e.g., pend-ing litigation).

s A RWI policy also may havedeal-specific exclusions wherethe insurance carrier cannot getcomfortable in insuring all or aportion of a particular represen-tation or warranty. For example,in situations where environmen-tal issues are a principal riskfactor of the target company, aRWI policy may exclude fromcoverage the representationsand warranties regarding envi-ronmental matters, and the in-sured may need to resort to acustomized environmental in-surance policy designed specifi-cally to cover the environmentalexposure. We also have encoun-tered situations where the RWIpolicy itself modified, solely forpurposes of the RWI policy, thelanguage of a representation inthe purchase agreement so as toensure that the representation(as modified) falls within thecoverage afforded by the RWIpolicy.

2) Term of Coverage:Frequently, the terms of a RWI

policy mirror the indemnity terms inthe purchase agreement, includingwith respect to the survival period ofrepresentations and warranties thatthe parties negotiated. Some buyers,however, want the RWI policy to runbeyond the 12 to 24 months survivalperiods commonly found in purchaseagreements.

In this case, an insurance carriermay be willing to underwrite a RWIpolicy for a longer period with re-spect to selected representations andwarranties under the purchase agree-ment and to cover claims that becomeapparent only after the survival pe-riod under the purchase agreementhas ended.

3) Subrogation:Under the terms of a RWI policy,

the insurance carrier generally willbe subrogated to any rights of recov-ery that the insured may have for theloss paid by the insurance carrier.Here, the negotiation typically re-

volves around any exclusions (e.g., aRWI policy may provide that the in-surance carrier may not assert subro-gation claims against the officers,members or partners of the insured)and whether the insured will be re-quired to take any actions to securethe rights and remedies of the insur-ance carrier in subrogation.

In the case of ‘‘buy-side’’ policies,insurance carriers typically agree towaive subrogation rights against theseller, except for fraud for which theinsurance carrier will preserve subro-gation rights in the event it pays aloss to the buyer based on the seller’sfraudulent conduct.Conclusion

We have successfully incorporatedRWI in several recent transactionsand it has proven to be an effectivetool for bridging gaps that otherwisestood to threaten the entire transac-tion process. Given its improved eco-nomic viability in the M&A context, aRWI policy can offer alternative ben-efits to the transaction parties com-pared to the more traditional escrowand holdback arrangements.

Given its improved economic

viability in the M&A context, a

RWI policy can offer alternative

benefits to the transaction parties

compared to the more traditional

escrow and holdback

arrangements.

Although insurance carries andbrokers have streamlined the processfor implementing a RWI policy overthe past couple of years in responseto market needs, the transactionalparties and their respective advisorswill have to understand that coveragecannot be obtained overnight. Ac-cordingly, the parties should initiatethe process as early as possible, butno later than three to four weeksprior to the anticipated binding ofcoverage at the closing of thetransaction.

Knowing the utility of RWI in cer-tain circumstances and the lead timeand process of obtaining RWI in thecontext of an M&A transaction issomething every transactional pro-fessional should have in his/hertoolbox.

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