Corporate Law Newsletter – Representations and Warranties Insurance In M&A Transactions: April 2023
Representations and Warranties
Representations and warranties (“R&Ws”) are an integral part of M&A transactions across the globe. R&Ws are a set of factual representations and warranties that are made by sellers in secondary investment transactions with respect to various aspects of the target entity’s business. These warranties are provided as of the date of execution of transaction documents and are repeated on the date of consummation of the transaction. Typically, R&Ws are bifurcated into three categories, i.e., fundamental warranties, business/operation warranties and tax warranties. Additionally, R&Ws also include representations in respect of the authority and capacity of the parties to execute and perform the transaction documents. R&Ws act as an inducement for buyers to invest in the target entities. Over the years, the M&A market has grown tremendously in terms of number of deals and deal volume. Resultantly, R&Ws have become increasingly significant in M&A transactions as a risk allocation tool.
Significance of R&Ws
R&Ws are generally backed by indemnity protection and in the absence of indemnity may be considered as a misrepresentation or a breach of warranty which is remediable by way of damages. Although buyers conduct due diligence investigations into the business and affairs of the target entities to identify past non-compliances and potential risks, it is practically difficult to solely rely on the findings of such investigations as their scope is limited in nature and their findings are heavily based on the information and documents provided by the sellers and the target entities. Hence, R&Ws are quintessential to protect buyers from potential liabilities that may arise from identified and unidentified risks.
Role of R&W Insurance
Given the risks involved on both sides, R&W insurance is a viable solution as it shifts the financial liabilities arising from inaccuracy or breach of R&Ws to the insurer company. Both the warrantor and the buyer may procure R&W insurance. In a buyer’s R&W insurance, the buyer is entitled to directly make a claim with the insurance company without having to necessarily seek indemnity from the sellers. Whereas in a seller’s R&W insurance, the seller is entitled to make a claim with the insurance company for any costs incurred by the seller owing to any claims made by the buyer for inaccuracy or breach of R&Ws. Conventionally, alternate methods of sourcing funds for indemnity claims have been resorted to by the parties, which include escrow of fraction of consideration, a holdback of consideration and set-off mechanism. Often, this means that sellers do not receive the entire consideration on the date of consummation of the transaction as the escrowed or the holdback amount is received upon the expiry of the claims period or the agreed time period in the contract. R&W insurance helps in the mitigation or elimination of conventional methods of escrow and holdback to allow sellers to receive the maximum or the full amount of consideration on the closing date. However, in many deals, it has been observed that R&W insurance is obtained by the buyer as a safeguard over and above such conventional methods. R&W insurance has also been seen to be useful in acquisition deals where none of the sellers hold a controlling stake in the target entity and/or are not comfortable giving R&Ws for the target’s business on a joint and several basis. Buyers prefer a buy-side R&W insurance in cases where the sellers are expected to continue to be involved in the target’s business as it gives them the ability to avoid making direct claims against sellers which may help sustain relationships. Furthermore, it acts as appropriate protection for the buyers where there are concerns around the financial ability of the sellers to pay or in cases where buyers foresee challenges in the enforcement of contractual indemnity protections against the sellers.
Key Aspects of R&W Insurance
Insurance contracts are based on the underlying principle of uberrima fides, i.e., utmost good faith. This means that the parties to an insurance policy must negotiate in good faith and make an accurate and complete disclosure of all material facts related to the subject matter of insurance. Since disclosures are an integral part of such insurance policies, insurance companies conduct their own due diligence on the target entity’s business and affairs to identify potential risks. Buyer and seller are also expected to conduct due diligence on the target’s business and share the reports of such investigations with the insurance company; else, it may end up affecting the scope of insurance, coverage and the insurance amount amongst other things. Due diligence findings help insurance companies identify exclusions to coverage under R&W insurance policies. Typically, any breach of covenants by sellers and post-closing adjustments are not covered. Any concealment of fact, misrepresentation, omission or fraudulent non-disclosure will result in a discharge of liability of the insurer. Any breach of R&Ws which the insured had knowledge about is not covered. Hence, specific indemnity matters and matters disclosed by sellers in the disclosure letter may not be covered. This could mean that material issues identified by buyers in due diligence may be specifically excluded from insurance coverage. This is also the reason why R&W insurance cannot be treated as a complete alternative to conventional remedies available to the buyer. Furthermore, pecuniary and temporal limitations are customary exceptions to insurance coverage, wherein pecuniary limitations would include deductibles which would typically be a percentage of the total consideration and temporal limitations would include the survival period of R&Ws which would typically be aligned with the agreed limitations in the contract.
The usage of R&W insurance in M&A transactions is undoubtedly on the rise and continually evolving. Given the limitations of R&W insurance as a tool for recovery of claims liability relevant from an M&A standpoint, it may not be the ultimate solution but definitely acts as a safety net for warrantors and provides them considerable peace of mind. There is no one-size-fits-all model of R&W insurance; it would rather make more sense to assess the viability of R&W insurance on a case-to-case basis since such insurances are tailor-made following a thorough consideration of all relevant facts pertaining to the target’s business. In a nutshell, R&W insurance must be viewed as a risk management tool as opposed to a risk-elimination tool.