Insuring reps & warranties risks in M&A transactions

March 2016  |  SPECIAL REPORT: INSURANCE COVERAGE

Financier Worldwide Magazine

March 2016 Issue

In recent years, representations and warranties (R&W) insurance has become a much more common feature of mergers and acquisitions transactions, driven in large part by private equity firms and other ‘repeat customers’. R&W insurance (or warranty & indemnity insurance, as it is often known outside the US) can facilitate an M&A transaction by taking off the table risks that neither side wants to carry into the future.

For example, a retiring founder may place great value on the peace of mind of being able to sell her business and walk away, without worrying about being drawn back into it in the event of post-closing litigation, contract disputes or other unexpected developments. Or a buyer may fear that the seller could slide into bankruptcy, leaving the buyer with little practical recourse in the event of any inaccurate representations or warranties by the seller.

With a R&W insurance policy, the buyer can obtain protection for the business without having to pursue the seller – or the seller can obtain ‘walk-away’ insurance. In addition, buyers are increasingly using R&W insurance as a strategic part of their deal negotiations: by offering to purchase the policy, they can sweeten their bids by reducing the amount of the purchase price that must be held in escrow. Of course, like other insurance products, R&W insurance is intended as protection against the unforeseen – not for known risks discovered during the due diligence for the deal. Nor should it be a substitute for thorough due diligence by the parties to the transaction.

But what risks are actually covered by R&W insurance? What sorts of claims are made by parties and paid by insurers, and how does the claims process work? Because R&W insurance tends to be a ‘low frequency, high severity’ line of business, and because most claims are resolved privately, without litigation, there is not a great deal of publicly available information about actual R&W claims.

First, it is important to understand what triggers coverage under a R&W policy. In short, there must be a breach of a covered rep or warranty, and there must be a resulting loss. Whether a particular rep or warranty is covered by the policy is usually a straightforward question: typically, most (but not all) of the reps and warranties in the acquisition agreement will be covered by the policy, and the policy will contain a schedule that specifies which reps and warranties are, or are not, covered. The policy also may contain exclusions for certain reps or warranties.

The most common coverage issues are whether there actually was a breach of the rep or warranty, and if so, whether the insured party can demonstrate that the breach resulted in a loss. The extent of the insurer’s investigation will depend on the complexity of those two questions and of any potentially applicable exclusions. A relatively simple example involved a buyer that purchased a manufacturing plant. The seller had represented that the plant was in compliance with all environmental regulations. In fact, after the deal closed, the buyer learned that the plant’s air quality permits had expired (demonstrating that the compliance rep had been breached). The buyer was required to spend approximately $1m to bring the plant into compliance (demonstrating the amount of loss resulting from the breach). The insurer’s investigation was quick and straightforward – essentially, obtaining documentation of the permit issues and the resulting expenses.

In other circumstances, a far more complex investigation may be required, both to determine whether a breach occurred, and to assess the amount of any resulting loss. For example, take the case of a buyer who discovers, post-closing, that the seller had been improperly recognising revenue, thereby overstating its revenue and earnings by 15 percent over the 12 months prior to the transaction. In this case, there may be complicated factual issues (when were the contracted services and products actually delivered?) as well as accounting decisions that require judgment calls and thus do not necessarily have a single ‘right’ answer.

Once the insurer has determined that there was a breach of a covered rep or warranty, it then must determine the amount of any loss that resulted. Did the buyer suffer a diminished cash flow as a result of the breach? Can the buyer demonstrate that the misrepresentation caused it to overpay for the company? Answering such questions is rarely straightforward. Often, an insurer will need to review underlying documents and retain expert consultants, such as forensic accountants, to assist with its claim investigation.

The nature and scope of the insurer’s claim investigation will therefore depend greatly on the nature of the R&W breach. Although financial representations are often uppermost in the minds of buyers and sellers when working on a deal, and although financial misrepresentation claims do result in some very significant claims on R&W insurance policies, there is a surprisingly wide and diverse range of R&W insurance claims. Claims arising from undisclosed liabilities, undisclosed material contracts, non-compliance with laws and regulations, undisclosed material customer disputes, and misrepresentations regarding assets are all very common. Such R&W breaches can result in substantial first-party losses and third-party claims involving, for example, environmental liabilities, intellectual property disputes, litigation with customers and vendors, and government investigations.

Even more than in other types of insurance claims, a successful resolution of a R&W insurance claim requires effective communication between the insurer and the policyholder throughout the claim process. The insurer’s claims representative should set expectations early by clearly communicating to the policyholder what the claim investigation will involve, what documentation will be needed, and what questions the insurer will need answered. This can be difficult at the outset of a complex investigation, as the insurer doesn’t yet know what it doesn’t know, and it is inevitable that new information will sometimes give rise to new questions and new information requests.

Throughout the process, the policyholder should be told what questions the insurer has and why the insurer is requesting information. The insurer should make clear that the investigation may evolve as new information is learned. Communicating well and often, and staying focused on what the ultimate questions are (was there a breach of the rep or warranty and what loss was caused by that breach?) will help both sides to manage the claim process to an efficient and successful resolution.

 

Diane Parker is vice president of the North American Claims Group at Allied World Insurance Company. She can be contacted on +1 (469) 248 4003 or by email: diane.parker@awac.com.

© Financier Worldwide

BY

Diane Parker

Allied World Insurance Company

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