The Proposed Deal

Consider the following scenario:  You and your partners have spent years growing your business. Your professional advisors are encouraging you to sell, and you are ready. The buyer is willing to pay a cool $100 million, a fair price in a seller’s market. The new beach house that seemed like a pipe dream years ago is so close that you can smell the ocean.  What could go wrong?  Plenty.

Your lawyer tells you that negotiations have stalled over language in the acquisition agreement. The buyer seeks a $20 million indemnity for breaches of the seller’s representations and warranties. Moreover, the buyer wants most of that $20 million to be held in escrow following closing, and if there is any shortfall, you and your partners are responsible for it!  You are now thinking that the beach house is getting smaller, and no longer oceanfront. Is there anything that can be done to satisfy the buyer and the seller (and its owners)? Perhaps there is.

Representation and Warranty Insurance – What is it?

Representation and Warranty Insurance (“R&W Insurance”) is an insurance policy that provides coverage for a buyer’s losses resulting from certain breaches of a seller’s representations and warranties in corporate transaction agreements.  Although R&W Insurance has existed since before the 1990s, its use has proliferated greatly in the last ten years and is now commonplace in private deals.  It is especially useful when the buyer and seller cannot agree on the scope of either or both of the seller’s representations and warranties, and the indemnification obligations for any breaches. If R&W Insurance is purchased, the buyer recovers its losses directly from the insurance company. By shifting the risk of those losses from the seller to an insurer, the buyer and seller can reduce or in some cases, extinguish the seller’s liability for certain breaches of representations and warranties.

Benefits of R&W Insurance

R&W Insurance benefits to the seller include:

• Reducing or eliminating the need for an escrow from the seller, permitting the distribution of sales proceeds at closing.
• Protecting a passive or minority owner from personal liability for inadvertent breaches.
• Protecting an owner of the seller or other key management person who is going to remain with the buyer after closing.

R&W Insurance benefits to the buyer include:

• Making a bid more attractive to the seller by presenting limited indemnification provisions, but still providing protection to the buyer.
• Allowing for a longer survival period for certain representations and warranties (as long as 6 years).
• Purchasing loss coverage in amounts that exceed the seller’s proposed indemnification cap.
• Providing a method for loss recovery if pursuing the owners of the seller could be difficult (for example, a large number of shareholders or foreign shareholders).

Drawbacks of R&W Insurance

Despite its advantages, R&W Insurance is not a cure-all. Drawbacks include:

• Cost. R&W Insurance is not cheap. Premiums generally run in the range of 2.5%-3.5% of the policy limit purchased (or $25,000-$35,000 per $1 million of coverage), plus underwriting fees ($25,000-$50,000), plus broker commissions (10%-15% of the premium). In addition, since minimum premiums are currently around $150,000, R&W Insurance probably is not cost-effective if the buyer requires less than $5 million in coverage.
• Coverage Exclusions. R&W Insurance coverage is not as broad as the typical Seller indemnification obligations and escrow. R&W Insurance policies do not cover known breaches, breaches of covenants (such as non-compete restrictions), purchase price adjustments, underfunded pension plan liabilities, certain tax matters, and product liability representations.
• Retentions. This is the deductible under the policy and is generally 1% of the transaction value. Often, the buyer and seller will agree to split the deductible, with each being responsible for one-half.
• Lack of Judicial Guidance. Since most R&W Insurance policies provide for arbitration as the method of dispute resolution, there is very little case law interpreting these policies.

Back to the Deal

In the deal scenario above, R&W Insurance could be a perfect solution for the buyer and seller (and you and your partners). If the buyer obtains an R&W Insurance policy with a $20 million coverage limit and a $1 million retention (1% of $100 million), the buyer and seller could agree to allocate the first $1 million in losses between them. As a result, the seller’s liability will be capped at $500,000, or just 0.5% of the total deal value. Certainly a better result than $20 million and 20%!  Now you can start making plans to buy that oceanfront beach house!

Conclusion

R&W Insurance is increasingly available for mid-market (and larger) private transactions, and ought to be explored as an alternative to a traditional indemnity and escrow arrangement. If you want to know more, please contact me.