The use of Representation and Warranty insurance (RWI) policies has jumped from 29% in 2016 to 65% in 2021[i]. This increase was likely aided by a seller-favorable climate and rising inflationary pressures highlighting the benefit of having all transaction consideration in sellers’ hands at closing.
While RWI seems to have earned itself a seat at the table, there are several gaps in coverage that private-target M&A parties should keep in mind when relying on RWI as the main (or only) indemnification solution. Over 95% of RWI policies are obtained by the buyer, allowing them to recover directly from an insurer for certain losses incurred due to breaches of specific representations and warranties under the transaction agreement[ii]. The policy can provide full indemnification for all breaches or representations and warranties post-closing, a “no survival” deal, or carve-out specific representations from its coverage.
The cost of an RWI policy isn’t cheap, averaging about 2-3% of the coverage amount with a 1% retention[ii] (deductible). However, it can arm the Buyer with a more attractive offer in a competitive market. While we hesitate to say it’s too good to be true, there are key points to keep in mind when using RWI to ensure that the sellers and buyers are both receiving the full coverage they are looking for and not falling victim to a coverage gap.
Breaches between Signing and Closing
Roughly 51% of RWI policies are expressly bound at signing, leaving up to 49% of transactions potentially exposed for any breaches of representations and warranties that may come to light between signing and closing[iii]. While some policies do offer to extend coverage for several weeks or months without an additional fee between signing and closing, it’s important to note that this is typically only partial coverage. For instance, breaches of representations and warranties that both occur and are discovered during signing and closing may not be covered. To try to avoid the discovery of these breaches too early and work around the policy, we have seen some parties change the drafting of the covenant provisions in the transaction agreement to reduce the requirement for the seller parties to notify the buyer immediately upon a discovered breach.
Fundamental Representations
On 25% percent of deals with an RWI policy, Fundamental Representations are expressly carved out of the policy coverage[iv]. This could leave the sellers liable for breaches arising from common Fundamental Representations such as tax, due authority, broker fees, capitalization, or allocation spreadsheet errors, and fraud. Alternatively, on the 38% of transactions where the buyer has agreed to a “no survival” transaction, the buyer could be at risk if the policy has a gap in coverage for some of these fundamental representations. For instance, most RWI policies do not cover pre-closing taxes that are known to the Buyer prior to closing, such as accrued but not yet paid taxes. This is particularly key as tax is the second most common type of claim, behind breaches of financial statements[v]. Buyers might consider having a special tax escrow if there are known issues, including anticipated sales and use tax issues or a pending VDA agreement. While far less common, broker fees could become payable as part of the transaction post-closing due to additional transaction consideration becoming payable from a purchase price adjustment surplus, milestone, earnout, or tax refunds. This could become a liability of the Buyer if this fundamental representation is not covered by the policy. Additionally, errors on the capitalization table or the closing spreadsheet, including incorrect record keepings of an exercised option, the miscalculation of the pro-rata percentages or liquidation preferences, may also fall into the coverage gap for both sellers and buyers. And then, there’s the Fundamental Representation of fraud.
Fraud
While fraud is almost always considered a Fundamental Representation, it’s important enough to warrant a section of its own. Fraud is an area for buyers and sellers to pay particularly close attention to when considering their RWI policy and potential remedies under their transaction agreement. There have been numerous Delaware court cases in recent years looking (i) to further define fraud and the use of fraud carve-outs, (ii) to limit the seller’s ability to use anti-reliance provisions to defeat claims, and (iii) to question if contractual provisions allowing fraud representations to expire at closing were reasonable.
In the 2021 Delaware Supreme Court case Express Scripts, Inc.v. Breckel Holdings Corp, the buyer claimed that the seller had historically inflated revenue and working capital, a fact that was particularly pertinent as the purchase price had been calculated using an EBIDTA multiplier. The buyer initially sought recovery from their RWI policy for a breach of financial statement representations. However, due to the RWI cap the policy did not cover their full losses. The buyer then sought recovery directly from, the seller for fraud, which was not covered by the RWI policy. While the Delaware Superior Court awarded the buyer $82.1 million in damages, upon appeal to the Delaware Supreme Court the decision was reversed. The court stated that even though the common law definition of fraud included recklessness, the parties in the Express Scripts transaction had referenced “deliberate fraud” in the indemnification provisions of the agreement. Even though both deliberate and fraud were not defined in the agreement, the court ruled that it was clear the intention was to only include deliberate or intentional misrepresentations and not recklessly indifferent conduct. The buyer was not able to recover their damages.
A similarly impactful case from 2021 is the Delaware Court of Chancery case Online Health Now, Inc. et al v. CIRP OCL Investments, LLC. In this case, the sellers failed to disclose a known sales and use tax liability in the amount of $8-9 million dollars. They also represented in the purchase agreement that there were no outstanding tax liabilities. When the buyer brought a fraud claim against seller, they moved to dismiss stating that all representation and warranties, including those breached through fraud, had expired at closing. The court denied the motion, stating that the seller could not evoke a protection from an agreement that it was accused of procuring through fraud to protect it against the claim of fraud.
Fraud claims tend to be the most complex and highest dollar value claims that can be brought post-closing. It is essential to pay extra close attention to these provisions when drafting the transaction agreement to ensure that fraud is carefully defined. Additionally, they should take care when drafting any knowledge qualifiers or including company personnel tasked with the knowledge requirements. Sellers should also be mindful that a “no-survival” provision will not necessarily provide protection for fraud in the inducement.
Retention Amount: Duty to Seek Recovery
On 61% of deals where RWI is not the sole recourse, the buyer is not obligated to first pursue claims through their RWI policy[vi]. If this is combined with an RWI policy that counts recovery from the sellers towards the policy’s retention (deductible), then sellers will likely be required to pay the retention amount prior to the RWI policy being used for coverage. Buyers would not be incentivized to pursue a claim through the RWI policy if they could seek indemnification from the sellers up to the point their retention is exhausted. In these situations, it might be advisable to set aside an escrow fund to match the retention amount (typically 1% of the transaction value) to ensure coverage. This could be partially released after the first year, when the retention typically drops to half of its original amount.
Purchase Price Adjustments and Covenants
The Purchase Price Adjustment or any breaches of covenants are not typically covered by an RWI policy. While covenant breaches are rare, Purchase Price Adjustments occur in 93% of transactions[vii]. There has been an increase in stand-alone purchase price adjustment escrows[viii], likely due to the increase in RWI usage. These escrows can be held for a short period of time and quickly released to holders after the review period if the funds are not needed for indemnification. While breaches of covenants are very rare, it is again something for the sellers to pay particular attention to in an RWI transaction.
“Knowledge” and “Materiality” Qualifies
One benefit to RWI for both parties is the potential ability to include certain seller representations and warranties without the seller insisting on “knowledge” or “materiality” qualifiers. This can reduce the negotiation time and speed up the transaction process. However, if there are any instances where the RWI policy is not providing full coverage, such as for Fundamental Representations or fraud, it’s essential that counsel still stay vigilant as to how the removal of these qualifiers may affect their client should there be a claim that is carved out of the policy.
Overall, we anticipate that RWI will continue to have its place as an indemnification solution in private target M&A—at least while the market remains seller favorable. It’s important for both sides to thoroughly understand how gaps in coverage can arise in their transaction and the best way to protect themselves or their clients from these liabilities. Smaller and more targeted escrow funds, such as the adjustment account or tax account, have increased over the years on RWI deals to add an additional layer of protection for buyers and sellers alike. Parties should discuss whether the use of these specific matter accounts could be a helpful addition on their RWI transaction, so they don’t fall victim to the gap.
Equal Housing Lender. Bank NMLS #381076. Member FDIC.