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KEY ISSUES TO CONSIDER WHEN ALLOCATING M&A TRANSACTION RISKS

Representations & Warranties InsuranceTax Insurance

Specific Litigation InsuranceContingent Liabilities Insurance

TRANSACTION

M&A INSURANCEGUIDEBOOK

Insurance products placed by Acquiom Insurance LLC, an affiliate of SRS Acquiom Inc. Products or services may not be available in all States, and coverage is subject to actual policy language. Non-insurance products and services may be provided by affiliated companies or unaffiliated third parties. Certain property-casualty coverages may be provided by a surplus lines insurer. Surplus lines insurers do not generally participate in state guaranty funds, and insureds are therefore not protected by such funds.

Nothing herein constitutes an offer and is presented for general information purposes only.

TABLE OF CONTENTS

Foreword 1About SRS Acquiom 1M&A Transaction Insurance Overview 3Quantifying Transaction Risk: Data on Post-Closing Claims 4Allocating Transaction Risk: Representations and Warranties Insurance 5-23 - RWI Overview & Fast Facts 5 - FAQ: Representations and Warranties Insurance 6 - Escrows vs. Representations and Warranties Insurance: How the Choice Can Alter Deal Dynamics 15 - A Note on Purchase Price Adjustments: Managing the Risk? 20 - Post-Closing Purchase Price Adjustments 20 - PPAs vs. Breach of Rep or Warranty: Buyer’s Choice 22Allocating Transaction Risk: Other Forms of M&A Transaction Insurance 24-26 - Tax Insurance 25 - Specific Litigation Insurance 25 - Other Contingent Liability Insurance 26Appendix: Post-Closing Claims Data 27-31 - Claim Subject Matter 27 - Mix of Claim Types, by Deal Closing Year 28 - Claim Activity Generally 29 - Claim Sizes 29 - Claim Activity by Transaction Value 30 - Resolution Time by Claim Type 31Our Teams 32-34 - Insurance Team 32 - Business Development Advisors 33 - Claims Advocacy Team 34Representative Transactions 35Why Choose SRS Acquiom? 36Editorial Team & Contributing Authors Inside Back Cover

©2016 SRS Acquiom All rights reserved.

First Edition: October 2016

Key Issues to Consider When Allocating M&A Transaction Risk | 1

Foreword

Due to falling costs, faster underwriting, and improving policy terms, M&A transaction insurance has risen in popularity as a tool to allocate deal risk in private-target M&A deals to an insurer. Consequently, we are publishing this guidebook to aid deal practitioners in utilizing various forms of M&A transaction insurance. Such forms include Representations and Warranties Insurance (“RWI”) as well as specialized policies that cover risks excluded from RWI, such as those associated with taxes, litigation and other contingent liabilities. This guidebook provides the following information:

• An overview of the various M&A transaction insurance types,• Issues related to the various types of M&A transaction

insurance,• A comparison of the relative strengths of escrows and

insurance in managing deal risks, and• A discussion of how escrows and insurance can be used

together. This guidebook is not meant to be exhaustive; rather, we hope that it serves as a concise and convenient reference guide.

About SRS Acquiom

At SRS Acquiom, we have a history of shaking up the way M&A deals are done. We saw shareholders reluctantly taking on the role of post-closing shareholder representative, so we introduced the industry’s first professional shareholder representation service. We saw the slow, tedious process of mailing closing-payments documents, so we introduced the industry’s first online M&A payments solution to receive payment within hours. We saw the lack of options for processing payments to payees subject to income and payroll tax withholding, so we became the industry’s only full-service M&A payments administrator to handle all types of payments, including employee compensation. We saw billions in deal value sitting idly in low yielding

2 | M&A Transaction Insurance Guidebook

accounts, so we created escrow solutions that provide exceptional asset protection and yields. And now we’re shaking up the way M&A transaction insurance is bought and used.

SRS Acquiom simplifies your deal by being your single provider of insurance, escrows, payments, and shareholder representation in M&A deals. Formerly, deal parties bought transaction insurance from insurance brokers who only sold insurance. However, most M&A deals also require payments administration and, when particular risks are excluded from insurance coverage, one or more escrows. Further, deals with sell-side insurance may require a shareholder representative. Our ability to offer each of these products means that we are uniquely positioned to advise from an unbiased perspective on the optimal mix of tools as your deal’s needs evolve. Engaging a single provider also avoids the need to negotiate and share confidential deal information with multiple vendors.

In private-target M&A deals, the risks of claims are real: SRS Acquiom has negotiated over 1,600 post-closing claims across the 1,300 deals in which we’ve been engaged. Our claims database, the most extensive that exists today, shows that 60% of these deals received a claim. When a claim arises under an insurance policy bought through SRS Acquiom, you can leverage our claims-advocacy team that has unrivaled experience managing post-closing indemnification claims in order to protect your deal value.

For more information on how we can simplify your deal and protect your deal value, reach out to us at [email protected] or contact your SRS Acquiom advisor shown on page 33.


M&A Transaction Insurance Overview

Transaction Insurance Overview

Risk allocation shapes every M&A deal.

Transaction risks can be • Retained by the acquiring company, • Allocated to the selling securityholders through escrows or

holdbacks, • Allocated to an insurer through M&A transaction insurance, or • A combination of the above.

When the acquirer is the insured, insurance can reduce or eliminate the need for the sellers to fund a general indemnification escrow, although escrows for heightened risks or purchase price adjustments may still be needed.

When the sellers are the insured, they remain liable to the acquirer under the M&A agreement, but insurance serves to compensate the sellers against covered losses.

Common forms of M&A transaction insurance include • Representations and Warranties Insurance (p. 5) • Tax Insurance (p. 25) • Specific Litigation Insurance (p. 25) • Other Contingent Liability Insurance (p. 26)

SRS Acquiom provides these insurance solutions as part of a comprehensive suite of closing and post-closing services that also includes escrows and closing payments. We’re your single-source partner for all M&A closing and post-closing needs.


1.360%

25%2.9

$1.75 M

$4.25MDeals with at least

1 post-closing claim

Deals with more than1 post-closing claim

across all deals

in deals with claims

AVERAGE NUMBER OF CLAIMS PER DEAL

DEALS WITH CLAIMS AVERAGE CLAIMED AMOUNT PER DEAL

in all deals

in deals with claims

% of deals with claims that resulted in

arbitration or litigation

9%

7monthsAVERAGE TIME TO RESOLVE A CONTESTED CLAIM

A claim is the ultimate test of coverage, and it is critical to have an experienced advisor you can trust. More than simply a broker, SRS Acquiom stands by as your partner to facilitate payouts from an insurer. Having negotiated over 1,600 M&A indemnification claims and over $1 billion in claimed breaches across more than 1,300 deals—we have unrivaled M&A claims experience. Our claims team has core competencies in the following areas:

Quantifying Transaction Risk: Data on Post-Closing Claims

• Breaches of financial statements and undisclosed liabilities

• Intellectual property• Tax matters• Employee matters• Life sciences deals


Allocating Transaction Risk: Representations & Warranties Insurance

RWI Overview

Indemnification obligations can be collateralized by an escrow, a holdback, RWI, or a combination of these tools.

RWI allocates some or all risk of loss to an insurer.

When the buyer is the insured, RWI can reduce or eliminate the need for an escrow.

When the sellers are the insured, they remain liable under the M&A agreement but RWI serves to compensate them against covered losses.

Fast Facts

1 Premium – The premium is typically 3–5% of the insured amount.

2 Deductible – The policy deductible (the “retention”) is often 1–3% of the deal’s purchase price when the buyer is the insured, or the escrow amount when the sellers are the insured.

3 Policy Forms – Policies are tailored to each transaction, and repeat policyholders can often start with a previously negotiated form if engaging the same insurer.

4 Process – The premium, coverage and underwriting process each differ slightly depending on which party is insured.

5 Alternatives – Uninsurable risks can be collateralized with special escrows.


FAQ: Representations and Warranties Insurance (RWI)

Introduction

The allocation of risk shapes every acquisition, and the backbone of risk allocation is the right of the acquiring company (the “Buyer”) to be indemnified for breaches of the selling company’s representations and warranties (such selling company, the “Seller”). In a standard acquisition of a non-public Seller, the selling securityholders (the “sellers”) bear the indemnification risk. This risk has traditionally been managed using a two-tiered structure: (i) an escrow funded from proceeds due to the sellers1, and (ii) in the event of a claim beyond the escrow, the right of the Buyer to clawback proceeds from the sellers directly. In the 1990s, RWI emerged as a niche tool to shift some or all indemnification risk from the sellers to an insurer. Due to falling costs, faster underwriting, and improving policy terms, RWI has risen in popularity in recent years. However, it remains a specialized product—penetration of RWI in U.S. private-target deals remained less than 10% in 2015.

An RWI policy can be either “buy-side” or “sell-side”. When the Buyer is the insured (a buy-side policy), RWI can reduce or eliminate the need for an escrow because an insurer, rather than the sellers, indemnifies the Buyer for covered losses.2 When the sellers are the insured (a sell-side policy), they remain liable to the Buyer for breaches—typically through the two-tiered structure—but RWI compensates the sellers for covered losses. Buy-side

FREQUENTLY ASKED QUESTIONS

1 Escrows are typically funded with 10–20% of closing proceeds and set aside for one to three years. The average across SRS deals is 12% and 18 months.2 Whether the sellers remain liable for excluded matters or for clawbacks above the buy-side RWI limit is negotiated deal-by-deal. Buy-side RWI is often used as a tool to eliminate the post-closing liability of sellers entirely (except for Seller fraud), with the Seller’s representa-tions and warranties not surviving past closing.


policies are the dominant form of RWI today, comprising at least 80% of policies issued annually in the U.S. according to major insurers and market data.

Why do buyers and sellers use RWI?

A. Buy-Side Policies

Buy-side policies allow the Buyer to seek indemnification from an insurer for losses covered by the policy. Buy-side RWI is often used to:

i. Enhance the Buyer’s bid for a Seller. In an auction scenario, a Buyer’s ability to reduce or eliminate the sellers’ indemnification risk through buy-side RWI can make the Buyer’s bid more competitive.

ii. Protect deal relationships. Where a Buyer desires to protect seller relationships post-closing (such as key employees or investors), buy-side RWI can avoid the need to sue sellers in the event of a breach.

iii. Maximize sellers’ IRR. Where buy-side RWI reduces or replaces the use of escrows, proportionally more proceeds are available to sellers at closing. Institutional sellers can therefore boost IRR by distributing such proceeds to investors at closing.

iv. Cover Seller fraud. Buy-side RWI generally insures the Buyer against Seller fraud, whereas sellers are not insured against Seller fraud in sell-side RWI. In a buy-side policy, the insurer often retains the right to pursue a Seller fraud claim against the sellers (i.e., fraud claims are subrogated).

v. Bridge the gap in indemnification terms. Buy-side RWI can be used to supplement the sellers’ indemnification obligations where the Buyer desires greater protection than that provided by the acquisition agreement.

vi. Facilitate acquisition lending. Funds paid out under a buy-side RWI policy are assignable to acquisition lenders. This can be an important term for acquisition lenders, especially in highly leveraged transactions.


B. Sell-Side Policies

Sell-side policies insure the sellers against losses to the escrow and/or clawback risk from claims above the escrow. Sellers’ defense costs are also generally covered. Sell-side RWI is often used to:

i. Add certainty to the purchase price. Sell-side RWI compensates sellers for indemnification-related losses, adding certainty to the purchase price that sellers receive.

ii. Make a clean exit. Where sell-side RWI covers liabilities above the escrow, sellers can distribute the closing proceeds to investors with little or no risk of a clawback.

iii. Maximize IRR. Sell-side RWI can eliminate the need of institutional sellers to set aside internal reserves for contingent liabilities, allowing earlier distribution of closing proceeds to investors.

iv. Close quickly. With RWI backstopping sellers’ risk, sellers may be able to negotiate and close a deal more quickly.

v. Protect passive and minority sellers. Sell-side RWI binds at the deal level and protects all sellers, including passive and minority sellers.

vi. Reduce credit risk borne by the Buyer. In the event of a claim above the escrow, sell-side RWI allows a highly rated insurer to backstop the sellers’ credit risk at the time of the clawback (where sell-side RWI covers losses above the escrow).

What’s the buying process like?

A. Generally

RWI typically proceeds in three phases and involves the interested party, an agency such as Acquiom Insurance (SRS Acquiom’s insurance affiliate), and one or more underwriters. The process may take two to three weeks. Where time is of the essence, underwriters may be able to complete the underwriting process more quickly.


PHASE 1 Solicit Bids The party interested in RWI approaches an RWI broker. Because RWI policies are transaction-specific and highly specialized, the interested party’s regular insurance broker (e.g., for D&O or standard business liability lines) may not have the product experience to broker RWI. Therefore, RWI is generally sold to clients through specialized insurance brokers. The interested party initially provides the broker with the latest draft of the M&A agreement, disclosure schedules, and Seller financials. The broker uses such materials to solicit preliminary bids from RWI underwriters, who represent carriers and are authorized to underwrite on insurance on their behalf.

PHASE 2 Negotiate Preliminary Terms Underwriters review the information, request further diligence if

needed, and issue non-binding quotes that include the likely premium, limits, retention and possible exclusions. This takes approximately one week. The broker then assists the interested party and its counsel (which often includes specialized insurance counsel) in analyzing the bids and negotiating additions and changes to optimize coverage.

PHASE 3 Underwrite and Bind the Policy Once a policy is chosen, the interested party executes an agreement with the underwriter that sets forth the underwriting process and a non-refundable underwriting fee. Repeat policyholders can often start with a previously negotiated form if engaging the same insurer. Because changes in deal terms can affect the underwriting process and pricing, parties often wait to begin full underwriting until the primary deal terms are near-final. The deal team and data room are then made available to the underwriter. Within one to two weeks, binding terms are issued and the policy forms are finalized. Final policies can be made available at transaction signing if needed, and the policy is bound and paid for at closing.3

3 RWI should be obtained during deal negotiations and bind at closing, because binding after closing can leave deal parties uninsured during the interim. SRS Acquiom been engaged in deals where parties obtained RWI after closing, however.


B. Differences in Buy-Side vs. Sell-Side Underwriting

The underwriting process differs between buy- and sell-side policies. In a buy-side policy, the underwriter evaluates the thoroughness of the Buyer’s due diligence. The underwriter will examine the list of documents that the Buyer requested, the data room, and the Buyer’s external and internal due diligence reports. The underwriter will also interview the team in charge of the due diligence process. In a sell-side policy, the underwriter evaluates the reasonableness of the scope and depth of the Seller’s representations and warranties, as well as the processes by which the Seller assessed the accuracy of each statement. Because of these differences, the coverage terms and premium may also differ depending on the insured party.

What are typical policy terms and exclusions?

A. Typical Terms

Each policy is tailored to the transaction. Typical terms include:

i. Pricing. The premium is a percentage of the insured amount, generally 3–5%. Relevant factors include, but are not limited to, transaction value, deductible size, Seller industry and business line, scope and depth of indemnification obligations, gap between signing and closing, quality of the transaction diligence, identity of transaction principals and their advisors, and insurance market dynamics. Pricing also includes an underwriting fee (typically $25,000) that is due at the time of underwriting review and that is typically credited toward the premium when the policy is bound.

ii. Deductible. The deal parties bear a portion of the risk in the form of a deductible (also known as a “retention”) before a claim can be made under the policy. The deductible is typically 1–3% of the deal’s transaction value; it can be borne by the Buyer or the sellers or shared by both.


iii. Coverage. The policy generally covers the Seller’s representations and warranties as set forth in the acquisition agreement, but policies often have exclusions for high-risk areas or risks that an insurer is not willing to cover (such as environmental liability). Exclusions are discussed in the next section.

iv. Duration. The policy period usually mirrors the survival of representations and warranties and, in a buy-side policy, can be extended further. For example, it may be possible for the Buyer to extend general coverage to include a full audit period after the expiration of representations and warranties under the acquisition agreement. The policy period for tax claims usually matches the period stated in the acquisition agreement (typically six or seven years).

v. “No claims” declaration. Policies require a “no claims” declaration from the insured stating that it is not aware of any potential claims arising from a breach of the acquisition agreement at the time of the policy’s inception. The declaration is typically limited to actual knowledge of a breach.

vi. Subrogation. In buy-side policies, insurers may retain the right to “stand in the Buyer’s shoes” to seek redress from sellers for claims that the insurer has paid. This can be a delicate issue. Sellers may be prepared to negotiate with the Buyer in the event of a breach but may be weary of being pursued by an insurer. It may be possible to secure a waiver of the insurer’s subrogation right, but waivers are negotiated on a policy-by-policy basis (and potentially claim-by-claim).

B. Typical Exclusions

RWI typically does not cover the following risks. Such exclusions may be addressed outside of the policy by separate escrows and other risk-allocation methods.


i. Known or heightened risks. Such risks (e.g., those arising from matters disclosed in the disclosure schedules or matters that may be inherently difficult to diligence, such as net operating losses) are typically excluded from coverage. Other high-risk areas include environmental regulation, health-care regulation, and intellectual property in tech-centric deals. However, special escrows or specialty insurance products such as tax insurance, litigation insurance and special-situation insurance may be available to properly hedge such risks.

ii. Post-closing working capital or purchase price adjustments. These are typically excluded, as well as other matters where the insured has recourse through a mechanism other than standard indemnification for breaches of representations and warranties.

iii. Fraud, if the policy is sell-side. Insurers are unwilling to insure sellers against Seller fraud in sell-side policies. Coverage for Seller fraud is generally available in buy-side policies, but the insurer may retain the right to sue the sellers when such a claim is paid.

How are claims under the policy handled?

The insured must notify the insurer of potential financial losses that may erode the deductible or cause a claim against the policy. Further, the insurer often has participation and consent rights with respect to litigating and settling claims brought against the insured by third parties. Once an insurable loss materializes, the insured can make a claim under the policy. The insurer will review the claim to determine whether the loss is insurable and to what extent. If the loss is insurable, the insurer will either reimburse the insured for a loss incurred or, if the loss is owed to a third party, pay such third party on behalf of the insured. The RWI broker’s role during the claims process is to assist the insured in negotiating with the insurer to facilitate a claim payout.


What are the benefits and drawbacks of escrows vs. RWI?

Escrows and RWI are alternative means of collateralizing the sellers’ indemnification obligations. The primary benefits and drawbacks of using escrows versus using RWI are summarized below.

A. Escrows

Benefitsi. Guaranteed source of indemnification collateral for the Buyer.ii. Fast and easy to set up, with little or no out-of-pocket cost.iii. No need for underwriting or the involvement of a third-party

insurer in deal negotiations.iv. The Buyer and sellers negotiate directly when claims arise,

providing maximum flexibility to negotiate settlements.

û Drawbacksi. The sellers’ proceeds used to fund the escrow are at risk of

indemnification claims.ii. The sellers lose the use of escrowed proceeds during the

escrow period.iii. Escrow deposits generally earn a lower yield than what an

institutional investor may expect to earn by investing such capital pursuant to an investment strategy.

B. RWI

Benefitsi. Enhances the Buyer’s bid (in buy-side policies).ii. Protects relationships in the event of a dispute (in buy-side

policies).iii. Enhances sellers’ IRR where RWI negates the need for an

escrow (in buy-side policies) or for contingency reserves (in sell-side policies above the escrow), maximizing sellers’ distributable proceeds at closing.

iv. Adds certainty to the purchase price received by sellers.v. Allows sellers to exit with little or no risk of a clawback (in sell-

side policies above the escrow).


vi. Reduces credit risk borne by the Buyer (in sell-side policies above the escrow).

vii. The premium may be partially deductible as a transaction expense.

û Drawbacksi. The premium might be an additional transaction cost, resulting

in less proceeds overall for distribution.ii. Underwriting may add complexity and time to deal negotiations.iii. Policies typically have material exclusions, which may

require special-purpose escrows or alternative insurance to appropriately hedge.

iv. Claims against the policy must be negotiated with an insurer who may be less flexible than a deal counterparty.

v. A series of material claims by a Buyer against an RWI policy may impact that Buyer’s future RWI pricing (i.e., the Buyer’s perceived risk profile), similar to the impact of an insured’s claims against home or auto insurance.

Conclusion

RWI is a tool to efficiently allocate risk and increase deal value, and it may even be the key to winning a competitive bid. Whether RWI or an escrow is the right tool for your deal ultimately depends on the circumstances. In making this decision, it is critical to engage a neutral, experienced advisor that you can trust because the optimal tool may change as the deal evolves. SRS Acquiom is the only provider of a full suite of post-closing indemnification solutions and can advise from an unbiased perspective. For more information on our services, you may visit our website at srsacquiom.com, or contact your SRS Acquiom advisor shown on page 33.


Escrows vs. Representations and Warranties Insurance: How the Choice Can Alter Deal Dynamicsby Paul Koenig, Co-CEO, and Travis Bell, Director, Corporate Development and M&A Transactional Group

Background

Representations and Warranties Insurance (“RWI”) is emerging as a tool to allocate risk in a private-target M&A deal to an insurer. An RWI policy can be either buy-side or sell-side. When the acquiring company (the “Buyer”) is the insured (a buy-side policy), RWI can reduce or eliminate the need for an escrow1 because an insurer, rather than the selling securityholders (the “sellers”), indemnifies the Buyer for covered losses.2 When the sellers are the insured (a sell-side policy), they remain liable to the Buyer for breaches of the M&A agreement, but RWI compensates the sellers for covered losses.

Buy-side policies are the dominant form of RWI today. Sellers often push for buy-side RWI over sell-side RWI because, among other reasons, buy-side RWI allows sellers to receive the funds at closing that would otherwise be at risk in escrow. In principle, the economic protection afforded to the Buyer is largely the same between an escrow and RWI

1 Escrows are typically funded with 10–20% of closing proceeds and set aside for one to three years. The average across our deals is 12% and 18 months.2 Whether the sellers remain liable for excluded matters or for clawbacks above the buy-side RWI limit is negotiated deal-by-deal. Buy-side RWI is often used as a tool to eliminate the post-closing liability of sellers entirely (except for Seller fraud), with the selling company’s representations and warranties not surviving past closing.

FEATURE ARTICLE


(subject to both a premium and a deductible when using RWI, both of which the Buyer may require the sellers to bear).3 Deal parties should be aware, however, that using buy-side RWI rather than an escrow can alter traditional deal dynamics in non-economic ways. These include the quality of the Seller’s representations and warranties, the likelihood of indemnification claims, the indemnification recovery process, and the ability of serial Buyers to assert claims. These points are discussed in turn below.

Quality of Representations and Warranties

Buyers generally require detailed representations (reps) and warranties from the Seller for two reasons: risk allocation and due diligence. Buyers use reps and warranties to allocate to the Seller as much of the risk as possible regarding information asymmetry about the Seller and potential unknown liabilities, and the Seller naturally wants to avoid as much of this risk as possible. The Buyer can shift more of this risk to the Seller by requiring the Seller to give thorough reps and warranties about its business, with the Buyer having the ability to seek indemnification if it is harmed by inaccuracies. For example, the Buyer may require the Seller to represent that all of the Seller’s patents are valid and free of adverse claims at closing. Even if both parties believe this to be true, the Seller bears the risk for an agreed-upon period following closing that the representation is shown to be inaccurate when made.

In addition, Buyers use reps and warranties to supplement due diligence. That is, Buyers can minimize information asymmetry through a combination of conducting due diligence and requiring thorough reps and warranties. This allows the Buyer to maximize the information it receives about the Seller pre-closing, and the process shakes out disclosures that could trigger additional questions or even result in the renegotiation or termination of the deal. In these ways, a Buyer uses reps and warranties to maximize the probability of a successful deal. 3 For additional information on RWI and why parties opt to use it in M&A deals, please visit: srsacquiom.com/insights.


If risk allocation and information-gathering are key drivers of thorough reps and warranties, then a Buyer may question whether it can expect to get the same quality of reps and warranties if RWI replaces or significantly reduces the use of an escrow. One could hypothesize that a Seller may not negotiate as strongly to ensure accurate reps and warranties where its securityholders bear significantly less economic risk if the reps and warranties are wrong. This is the moral hazard problem. Even where the selling securityholders retain some economic risk before RWI is triggered (if they are liable for the deductible4), is it possible that the incentives are such that the Seller will not negotiate as strongly in making its reps and warranties as it would be in the absence of RWI.

While we have no statistical evidence to prove or disprove this hypothesis, a number of leading M&A attorneys have publicly opined on conference panels that, in the attorneys’ experience, using RWI rather than an escrow causes sellers to be less vigorous in negotiating reps and warranties. For example, Buyers will often push Sellers to capitulate on issues such as materiality and knowledge qualifiers when RWI is used, with the argument that the insurer rather than the selling securityholders bears the risk. According to these attorneys, this argument often prevails. While this may seem like a win for the Buyer from a risk-allocation perspective, it may be offset by both diminished comfort in the reps and warranties given as well as less thorough information-gathering as discussed above.

Likelihood of Indemnification Claims

The logical extension of the above hypothesis is the question of whether using RWI leads to more indemnification claims compared to using escrows. If RWI causes lower-quality reps and warranties relative to deals with escrows, then more inaccuracies may result in more indemnification claims by the Buyer. Claims can negatively impact the

4 Also known as “retention”.


Buyer in three ways. First, they can be costly economically, both in terms of dispute costs and the cost of the breaches incurred. Second, they can distract the Buyer from executing on its post-acquisition strategy, even if the Buyer recovers the economic cost of the claims. Last, the Buyer may be prevented from fully recovering economic costs. For example, if the terms of the RWI policy or acquisition agreement limit the Buyer’s recovery to direct damages, but a breach causes significant indirect damages, then the Buyer may be without recourse for the difference.

Indemnification Recovery Process

A third question is whether the Buyer’s ability to recover for breaches is equivalent between RWI and escrows. The party bearing the risk of loss (whether an insurer or the selling securityholders) may resist paying a claim if a colorable defense is available. Where an escrow is used, the Buyer must show a breach of a representations or warranty and that indemnification is available for such breach under the acquisition agreement. Where RWI is used, the Buyer will need to do the same, but must then also demonstrate that both the type and amount of loss are covered under the insurance policy. RWI policies typically incorporate the indemnification terms of the acquisition agreement, and thus Buyers are usually made whole. However, RWI coverage can include carveouts and exceptions. Further, an insurer may dispute the amount of loss claimed by the Buyer even if the claim subject matter is covered. In these ways, using RWI can add a layer of complexity to disputes compared to escrow-based indemnification.

Ability of Serial Acquirers to Assert Claims

Lastly, serial Buyers may want to consider whether they have the same ability to make claims against RWI as they do against an escrow. The potential exists that a series of material claims by a Buyer against RWI may impact that Buyer’s future RWI pricing (i.e., the Buyer’s perceived risk profile), similar to the impact of an insured’s claims against home or auto insurance. This could have a chilling effect on claims. According to RWI industry professionals, the effect of prior claims on future pricing depends on whether such claims are isolated and justified. A Buyer with


a propensity to make claims against RWI without sufficient justification may see higher pricing or have difficulty obtaining RWI going forward.

This chilling effect can similarly apply in an escrow-based deal where parties with whom the Buyer desires to have an ongoing relationship, such as key employees or investors, participate in the escrow. Protecting such relationships by shifting indemnification risk to an insurer is a frequent basis for using buy-side RWI.

Conclusion

Whether an escrow or buy-side RWI is a more appropriate source of indemnification collateral depends on the circumstances of the transaction. For the reasons above, deal parties should be aware that either option can materially influence the transaction in non-economic ways.


A Note on Post-Closing Purchase Price Adjustments: Managing the Risk

A loss from a post-closing purchase price adjustment (“PPA”) is generally not covered by RWI. Consequently, in a deal with RWI, whether a claim is brought as a PPA or as an indemnification claim determines the source of the Buyer’s recovery (the sellers vs. an insurer). This is important because 80% of deals have post-closing purchase price adjustment mechanisms, and PPAs happen frequently—nearly half of deals with a PPA mechanism see an adjustment in favor of the Buyer. Therefore, it is important for deal parties to consider these points:

Which claims the Buyer may bring as a PPA and which claims the Buyer may bring as an indemnification claim.

How the Buyer recovers PPA losses—either through a PPA escrow set aside at closing, or directly from selling securityholders post-closing.

First, we present data on the frequency and magnitude of PPAs. We then briefly explore the issues above.

Data Source: 2015 SRS Acquiom M&A Claims Study


Adjustment direction

Statement delivered, no adjustment 6%

Post-Closing Purchase Price Adjustments (“PPAs”)

Data set: Deals with PPAs

* Encompasses the maximum values in this data set.

PPA claim sizes as % of transacion value PPA claim sizes in dollars


Purchase Price Adjustment vs. Breach of Representations or Warranty: Buyer’s Choiceby Travis Bell, Director, Corporate Development and M&A Transactional Group

Where deals have post-closing purchase price adjustment (“PPA”) mechanisms, claims relating to inaccuracies in the selling company’s financial statements may often be brought by the Buyer as either a PPA or an indemnification claim. For example, if the Buyer discovers shortly after closing that the selling company failed to disclose the existence of a short-term contractual liability, the Buyer could seek recovery through either the PPA (if within the PPA period) or a claim for a breach of the financial statements representation. Because PPAs are generally excluded from coverage under Representations and Warranties Insurance (“RWI”), the effect in a deal with RWI and a PPA mechanism is that the sellers bear the risk of loss from PPA claims, while an insurer bears the risk of loss for breaches of representations and warranties covered by the policy. Therefore, it is important to consider which claims may be brought as a PPA versus an indemnification claim, and how PPA losses are funded (through a PPA-specific escrow versus direct recovery from sellers).

One take on this issue was addressed by the Delaware Chancery Court in OSI Systems, Inc. v. Instrumentarium Corp. (892 A.2d 1086 (Del. Ch. 2006)). In OSI, the Buyer tried to bring a PPA claim that would have resulted in a 54% adjustment to the purchase price. Much of the adjustment was based on the Buyer’s allegations that the selling company used improper accounting principles in preparing its estimated closing balance sheet. The court found that the agreement’s PPA

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provisions limited PPA claims to working capital adjustments computed under the selling company’s historical accounting principles, and that any claim alleging that such principles were improper or inconsistent with GAAP must be brought as an indemnification claim.

Another example of this issue is how deal parties account for contingent, unknown and unquantifiable liabilities at closing. A selling company may take an optimistic view and exclude such liabilities from the estimated closing balance sheet. When a Buyer prepares the final closing balance sheet, it may quantify these liabilities using a conservative analysis and attempt to recover the difference. Further, if after closing a contingent liability is incurred, an unknown liability arises or a previously unquantifiable liability is finally determined, the Buyer may suffer an actual loss. In any such case, the Buyer may be free to bring a claim as either a PPA claim or an indemnification claim, depending on the agreement’s language. To mitigate post-closing uncertainty, we suggest that during deal negotiation the parties clearly specify which claims may be brought as a PPA and which may be brought as indemnification claims.


Allocating Transaction Risk: Other Forms of M&A Transaction Insurance

Solutions to M&A risk allocation continue to evolve rapidly. As discussed earlier, RWI generally covers breaches of the selling company’s representations and warranties. However, RWI typically does not cover (1) known or heightened risks, or (2) risks that are not the subject of representations but are the subject of a special indemnity (e.g., successor liability on an asset sale or a reverse break-up fee triggered by CFIUS blockage). Products such as tax insurance, specific litigation insurance and contingent liability insurance complement RWI by covering these risks via specially tailored policies. Below is a breakdown of the frequency of breaches we see, and we briefly introduce these additional insurance products on the following pages.

Breaches of Representations & Warranties as a % of all breaches


Tax Insurance

Approximately 1/3 of breaches of representations and warranties involve taxes. Tax insurance may be appropriate to cover this risk, especially where selling companies have complex or uncertain tax positions. Sellers may secure tax insurance early in the M&A sale process to reduce risk ahead of the Buyer’s due diligence. Buyers may purchase it to transfer downside risk to an insurer, acquire the insurer’s tax expertise if the tax position is challenged, and/or enhance the Buyer’s bid for the Seller by removing the matter from the scope of indemnification.

M&A transactions are often enhanced by tax insurance for issues concerning the following: • Historic net operating losses • Subchapter S status• REIT status• Spin-offs, corporate restructuring, recapitalizations (e.g., valuation of

basis/gain, tax-free status, cancellation of debt income, etc.)• Transfer pricing, related-party transactions/fees, etc.• Nexus• Tax credits

Specific Litigation Insurance

The risk of pending or threatened litigation can be difficult for deal parties to allocate. To underwrite this risk, an insurer will review the schedule of pending and threatened litigation in the acquisition agreement’s disclosure schedules to determine whether claims against the Seller are insured under existing insurance. When they are not (or when they are not adequately insured), Specific Litigation Insurance may be available.

Insurers may insure pending litigation involving these situations:• Alleged breach of contract (not typically covered by other insurance)• Alleged patent, trademark or copyright infringement • Threatened litigation that appears to have solid legal (as opposed to

factual) defenses


Other Contingent Liability Insurance

This is a catch-all category to cover risks not discussed above. The underwriting process will depend on the specifics of the risks to be insured. It has been used to cover the following risks:• The risk of successor liability in the context of an asset sale• The risk of regulatory disapproval blocking the transaction and

requiring a break-up fee (e.g., CFIUS blockage of transaction)

M&A transactional insurance is a tool to efficiently allocate risk and increase deal value, and it may even be the key to winning a competitive bid. Whether insurance or an escrow is the right tool for your deal ultimately depends on the circumstances. In making this decision, it is critical to engage a neutral, experienced advisor that you can trust because the optimal tool may change as the deal evolves. SRS Acquiom is the only provider of a full suite of post-closing indemnification solutions and can advise from an unbiased perspective. For more information on our services, please contact your SRS Acquiom advisor shown on page 33 or visit our website at srsacquiom.com.


Appendix: Post-Closing Claims Data

Claim Subject Matter

* Claims pursuant to a post-closing purchase price adjustment mechanism (e.g. working capital).


Mix of Claim Types, by Deal Closing Year

* Claims pursuant to a post-closing purchase price adjustment mechanism (e.g. working capital).


Claim Activity Generally

Claim Sizes

* Includes only deals with a post-closing purchase price adjustment mechanism. PPAs are discussed on pages 20-24.


Claim Activity by Transaction Value

* Includes deals with no claims. ** Encompasses the maximum values in this data set.


Resolution Time by Claim Type

* Only includes claims resolved as the publication date. Does not include claims that have not yet been resolved and which may materially extend average resolution times.


Insurance Team

Travis BellDirector, Corporate Development and M&A Transactional Group, SRS [email protected]

Travis has negotiated $4 billion in M&A deals to closing on behalf of SRS Acquiom, working directly with investors and buy- and sell-side counsel. Travis, a licensed attorney, has deep experience in managing deal risk through RWI, holdbacks, earnouts and other post-closing risk-allocation mechanisms.

Nabeel TanveerManaging Director, Insurance SolutionsSRS Acquiom720.925.8092 [email protected]

Nabeel is a seasoned insurance executive with 25 years of in-depth operational, underwriting, commercial insurance and corporate development experience with deep knowledge of escrow and representations and warranties policies.


Business Development Advisors

Alex TsarnasManaging Director, Global Business Development, New [email protected]

Christa FancherSenior Vice President, Business Development, San [email protected]

Amanda JacksonSenior Director, Business Development, [email protected]

Heather KellySenior Director, Acquiom Business Development, [email protected]

Daren DiNicolaSenior Director, Acquiom Business Development, Los [email protected] BakerDirector, Business Development, [email protected]

Marc EiskowitzDirector, Business Development, San [email protected]

Bill KurzAssociate Director, Business Development, [email protected]


Claims Advocacy Team

Christopher Letang Intellectual Property, General Litigation, Tax

Raymond Cho General Litigation

Sara Wilcox Intellectual Property

Greg Brann Financial, Tax & Accounting

William Denebeim Financial, Tax & Accounting

Casey Mctigue Life Science Expert, General Litigation & Tax

Maria Schindler Life Science Expert, General Litigation & Tax

Michelle Kirkpatrick General Litigation & Employment

BREACHES OF FINANCIAL STATEMENTS AND UNDISCLOSED LIABILITIES

GENERAL LITIGATION

TAX MATTERS

EMPLOYEE MATTERS

INTELLECTUAL PROPERTY

LIFE SCIENCESEARNOUT DISPUTES


Representative Relationships

Deals shown represent transactions utilizing shareholder representation, payments, and escrow products and services offered by SRS Acquiom.


Why Choose SRS Acquiom?

1 Confidence in a Trusted Partner Partner with the most trusted name in M&A post-closing expertise. SRS Acquiom has been engaged on over 1,300 deals valued at $200 Billion.

2 Unrivaled Claims Expertise SRS Acquiom has negotiated over 1,600 post-closing claims comprising over $1.2 Billion in claimed transaction value.

3 More Data and Insights with Customized Coverage Leverage our extensive data on indemnification claims to determine what coverage your deal needs and doesn’t need.

4 Easy to Add an Escrow Seamlessly incorporate one of our escrow options to cover retention or exclusions. No need for yet another vendor to deal with, and there are no additional escrow fees when you buy RWI through us.

5 One Partner. Less Hassle No need to engage a separate broker. Easily pair one or more of our complementary M&A products and services. • Buy-side policies: bundle payments and/or escrow • Sell-side policies: bundle shareholder representation

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TRUSTEDPARTNER

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Trusted to manage over

1,400M&A indemnification

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Mark VogelExecutive Chairman

Paul KoenigCeo

Nabeel TanveerManaging Director, Insurance Solutions

Travis BellDirector, Corporate Development and M&A Transactional Group

Editorial Team & Contributing Authors

Sean ArendManaging Director, Corporate Development and General Counsel

Kim Halkett Chief Compliance Officer

Nicole Callahan Chief Marketing Officer

Dawn RobértAssociate Director of Marketing and Communications

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