Background on Representations and Warranties Insurance
Until the COVID-19 pandemic in the spring of 2020 eclipsed every other development, Representations and Warranties Insurance was generally considered the most significant development in M&A practice of the last few years.
As a brief background, Representations and Warranties Insurance allows the buyer or seller in an M&A transaction to obtain a third-party insurance policy to cover damages to the buyer that result from breaches of the seller’s representations and warranties in the acquisition agreement. Without Representations and Warranties Insurance, these damages are generally covered by direct indemnification from the seller, often accompanied by payment into escrow of a significant percentage of the proceeds otherwise payable to the seller. In exchange for a premium paid to the carrier, Representations and Warranties Insurance allows the traditional seller indemnification and escrow to be minimized or even eliminated. Carriers will require that damages exceed a retention of liability (generally 1% of total deal value – and usually less for larger deals) before the Representations and Warranties Insurance policy pays claims for covered damages.
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Availability during the Pandemic
Representation and Warranties Insurance continues to be available for transactions, without significant movement in premium or retention level. Some of the largest insurance providers, though, have signaled an intent to increase premium due to growing claims volume and loss payments, with AIG recently announcing a 20% hike in premium rates. Even prior to the advent of COVID-19, some degree of rate inflation was expected in 2020 as a result of the developing claims environment; it remains to be seen whether rate increases will be seen across the broader market or whether insurance provider competition for a smaller number of deals post-COVID-19 will dampen any desire to adjust pricing.
Carriers are eager to work with buyers and sellers on transactions that meet their criteria (generally deal value in excess of $50M, though policies for transactions with a lower deal value can be negotiated subject to minimum premium and retention amounts) and continue to actively quote and bind insurance policies for new deals.
Exclusions Related to COVID-19
While Representations and Warranties Insurance continues to be available for M&A transactions, carriers are proposing to exclude damages arising out of COVID-19 from coverage under their policies. Most carriers remain flexible on the scope of such exclusion and will consider narrowing to a defined set of known impacts on the target’s business (informed by buyer’s diligence results) or, in some cases, avoiding an exclusion altogether. A more limited number of carriers have required a broad exclusion of COVID-19 damages under every policy issued or as a presumption on most deals.
In either case, there remains an opportunity for negotiation. Even carriers that insist on a broad COVID-19 exclusion in every deal may be willing to specify that the exclusion will not apply to specified representations without obvious COVID-19 exposure (e.g. “fundamental” representations). Conservative carriers are considering moderating their position as they continue to get their arms around how COVID-19 is impacting deal risk. Favorable deal dynamics that have lent themselves to more narrow exclusions (or none at all) include the following:
- A more limited impact of COVID-19 on the seller’s operations.
- A shorter length of time between sign and close.
- Tailored drafting of the representations and warranties and associated disclosure schedules.
- Comprehensive diligence performed by the buyer’s team.
Carriers’ approaches to COVID-19 remain fluid and subject to change as the deal environment and the virus’s behavior continues to develop.
Impact on Underwriting
For active deals seeking Representations and Warranties Insurance, buyers and their advisors should be prepared for underwriting focus on the buyer’s diligence of COVID-19’s impact on the target’s business. Carriers will specifically look for diligence to address targets’ scope of operations and reliance on global supply chains, reduction in customer demand, material contracts and any rights to excuse performance thereunder, labor matters/workforce management, cyber risk, and financial statements/valuation. A buyer’s ability to demonstrate a thoughtful approach to diligence with COVID-19 in mind will help align the ultimate coverage position in the policy to the specific risk factors in the deal.
Deals structured with a staggered signing and closing should expect increased scrutiny on developments during the interim period, given the virus’s volatility and ability to alter the target’s operations. Carriers are keenly focused on the seller’s ability to restate the representations and warranties as of closing as well as compliance with interim operating covenants and other closing conditions, which is not surprising given the trend of buyer attempts to terminate some high-profile transactions. This environment has, for now, changed the breadth of bringdown calls with carriers; traditional 15-minute bringdown discussions have now tripled in length as the call agenda has expanded to include a detailed list of questions around buyer’s ability to assess COVID-19’s impact on the target’s business since signing. Allowing additional time to prepare for this enhanced bringdown exercise is recommended to ensure a smooth road to closing.
A likely consequence of the COVID-19 pandemic and the resulting economic loss is an increase in the percentage of transactions involving distressed businesses, including both non-bankruptcy and court-approved deals. In many distressed transactions, the traditional transaction structure of seller indemnification will not be available. Seller indemnification can be unavailable because of the following reasons:
- The seller is not willing to indemnify when virtually all transaction proceeds will be used satisfy outstanding indebtedness.
- The seller is no longer credit-worthy due to the distress.
- The nominal seller is a bankruptcy trustee or state receiver.
In each of these situations, Representations and Warranties Insurance can facilitate the transfer of risk and post-closing liabilities by helping protect buyers from losses resulting from a breach of seller’s representations and warranties, and thus eliminating the need for a related indemnity or escrow holdback by seller. If a distressed transaction is structured as a 363 sale, Representations and Warranties Insurance can work together with the liability cleansing accomplished by the 363 process to provide more fulsome buyer protections.
Aon’s recently released inaugural Reps & Warranties Insurance Claim Study noted an increase in the percentage of policies resulting in a claims notice in 2019, with a corresponding increase in the claim values and loss payouts resulting from such claims. We are monitoring claims experience during the pandemic, but have so far not noted any material changes, claims trends or carriers’ approach to claims handling. However, we have noted an increased attention by insureds to move active claims forward as they seek to monetize assets, including insurance.
While Representations and Warranties Insurance remains valuable and available tool to protect buyers in an acquisition, the ways policies are being handled due to COVID-19 merit additional consideration. Exclusions related to the virus’ impact on the target are common, but often can be negotiated, and underwriting will take into account the buyer’s diligence of this impact. Representations and Warranties Insurance can also work as a tool to subsidize risk transfer and liability cleansing in acquisitions of distressed targets. While there are some caveats to consider, the Representations and Warranties Insurance market will likely be a key force as M&A activity picks up on the tail end of the pandemic.
About the authors
Jon Stanley is a member of Bass, Berry & Sims, a law firm based in Nashville, Tennessee. He represents clients in a variety of corporate and securities matters, including mergers and acquisitions, securities filings, corporate governance, and other transactional matters. He can be reached at [email protected]
Allyson Coyne is Managing Director & Chief Broking Officer of Aon Transaction Solutions (ATS). The longest-tenured R&W broker in North America, Allyson was a co-founder of the ATS team in 2013 and specializes in securing tailored insurance solutions for private equity and corporate clients engaging in mergers and acquisitions, such as representations and warranties insurance, tax insurance, and other niche insurance products. She can be reached at [email protected].