Representations and warranties insurance (“R&W insurance”) has become a popular tool used in effecting private equity (“PE”) transactions. R&W insurance serves to shift responsibility for most seller representations and warranties to a third-party insurance underwriter. This can serve to bridge negotiation gaps while providing benefits to both buyers and sellers. R&W insurance brings with it, however, certain drawbacks that should be taken into account. This two-part article highlights key pros and cons of R&W insurance (as well as mitigants for certain of the cons), first from a buyer’s perspective and then from a seller’s viewpoint.
Pros: In today’s seller-friendly PE market, buyers are increasingly faced with sellers offering no (or a very low) seller indemnity. As a result, R&W insurance may be the only realistic option for the buyer to obtain something similar to a historically customary seller indemnity. Where sellers are offering a historically customary seller indemnity, a buyer’s willingness to forego that indemnity in reliance upon R&W insurance may distinguish such buyer from other bidders, enhancing the competitiveness of its bid and hence its chances of winning an auction. Thus, the key benefit of R&W insurance for buyers is facilitating getting the deal done. In addition, R&W insurance can benefit buyers by:
- providing a longer survival period of reps than could typically be obtained from sellers (e.g., 3 years for general reps and 6 years for fundamental and tax reps);
- providing coverage limits not tied to a percentage of purchase price (thus allowing buyer to obtain more coverage than could typically be obtained from sellers);
- avoiding indemnity collection issues in the case of multiple and/or foreign sellers, as well as replacing seller credit risk with that of a rated insurance company; and
- in the case of no-indemnity transactions, avoiding extensive negotiation of seller indemnity provisions (often one of the most difficult negotiations in a transaction).
Cons / Limitations:
- R&W insurance policies contain exclusions from coverage, which may include:
- issues identified in the buyer’s due diligence process;
- issues solely arising after signing of which the buyer becomes aware prior to closing;
- benefit plan underfunding issues;
- certain environmental liabilities;
- foreign corrupt practices and bribery issues;
- warranty and product liability claims in certain industries; and
- availability of net operating losses in certain contexts.
- R&W insurance policies may re-write (for purposes of the policy only) reps and warranties that are overly buyer-friendly to bring them back to “market” level;
- the policy premium (typically between 3-4% of the policy limits) and costs associated with negotiation of the policy and ancillary documentation may be borne wholly or partly by the buyer; and
- unlike indemnity payments under an acquisition agreement, proceeds from a R&W insurance policy may result in net taxable income to the buyer (though a tax gross-up feature may be available for additional premium).