There is an emerging trend to use representation and warranty insurance (R&W Insurance) in merger and acquisition (M&A) transactions, especially in those involving privately held companies. Representations and warranties are used in an acquisition to help allocate certain business risks between the buyer and the seller and are used in conjunction with the seller’s indemnification obligations. Traditionally, the seller would agree to indemnify the buyer for any breaches of the seller’s representations and warranties, which such indemnity is often secured by an escrow, holdback, parent guaranty or other form of security. Representations and warranties are often a heavily negotiated topic in M&A transactions with the buyer wanting broad representations and warranties and the seller wanting narrower and more deal-specific terms. R&W Insurance is now helping to resolve some of these disputes by enhancing or entirely replacing the seller’s indemnification provisions in a M&A transaction.

What is R&W Insurance?

R&W Insurance is an insurance policy that can be purchased by either a seller or buyer in an M&A transaction to help protect against breaches of representations and warranties, but is far more commonly purchased by buyers (90% of transactions using R&W Insurance are insured by the buyer). Recent studies have shown that about 20% of private transactions in the United States use R&W Insurance. Premiums for R&W Insurance can range from 2-4% of the coverage limits, which are often heavily negotiated. The policy coverage depends on the size of the deal and typically falls around 10% of the purchase price.

What does R&W Insurance cover?

Insurers conduct a rigorous and robust due diligence and underwriting process on each M&A transaction seeking R&W Insurance and then negotiate the specific coverage, duration, limits and exclusions from the coverage.

R&W Insurance will exclude the following standard exceptions:

• Seller’s breaches of covenants including in the transaction agreement;
• Purchase price adjustments (i.e., working capital adjustments);
• Representations and warranties that buyer had “actual knowledge” of; 
• Certain tax-related issues (including transfer taxes, R&D tax credits, net operating losses, and other taxes disclosed on the transaction’s disclosure schedules); 
• Wage and hour issues; 
• Asbestos and other environmental issues; and
• Forward-looking representations and warranties (including performance or revenue projections).

Other exclusions may include the following:

• Conduct or behavioral exclusions (for example, a buyer may be protected from fraud of the seller but not its own fraud);
• COVID-19 exclusions (Initially, these were really broad exclusions from the policy given the unpredictability of the COVID-19 pandemic; however, these have become and will likely continue to become more specific.); and
• Deal-specific exclusions based on the insurer’s due diligence/underwriting process.

Additionally, R&W Insurance policies can alter or delete language in the agreement’s representations and warranties. For example, the insurer can alter the language in the representation and warranty by adding a qualifier (such as materiality or knowledge) that the parties did not agree to previously.  The insurer can similarly delete language in the same manner as necessary. Both of these methods would not affect the underlying agreement but would modify the representations and warranties for the purpose of the insurance policy.

Who Should Purchase R&W Insurance?

R&W Insurance can be beneficial and help speed up and simplify the transaction because it provides a quick resolution to the highly negotiated topic of seller indemnification obligations. 

Prior to purchasing R&W Insurance for an M&A transaction, the parties should consider the following key factors: 

• Who will pay for the insurance; 
• Who will be liable for gaps in coverage; 
• When do the representations and warranties in the agreement expire and how long does the insurance coverage exist; 
• Whether coverage should enhance or completely replace indemnification obligations in the agreement; 
• The due diligence process will likely be more extensive and robust; and
• The size of the M&A transaction.

R&W Insurance has been found to be most suitable in M&A transactions valuing between $20 million and $2 billion; however, it is most often used in deals valuing between $100 million and $500 million. In smaller deals, the price of the premium may outweigh the benefits of purchasing the insurance. R&W Insurance can also be beneficial for M&A transactions where the buyer and seller cannot agree as to the allocation of risk under the agreement’s representations and warranties. It can further help protect existing and continuing business relationships between the buyer and seller, especially in situations where the seller is retained to manage the business or help with transition of services.

R&W Insurance can provide each party with certain benefits and/or require specific considerations:

Seller Benefits: 

• Reduction/elimination of seller’s indemnification provisions;
• Reduction/elimination of escrow or holdback that reduce seller’s proceeds; and
• Reduces seller’s contingent liabilities.

Buyer Benefits:

• Can give a more attractive bid without any escrow or holdback or limited seller indemnity provisions;
• Extended survival term for representations and warranties;
• Usually offers higher coverage amounts than indemnification provisions and therefore, enhances/increases amount of protection; 
• Buyer-purchased policies can provide protection against seller fraud;
• Provides extra security to buyer if seller is financially unstable/distressed; and
• Receives more representations and warranties.

In conclusion, R&W Insurance can be a useful tool in M&A transactions; however, there are certain considerations, some discussed above and more often, deal specific, that both parties in a transaction should consider prior to obtaining such coverage.

Taylor Kinard is an associate at Wyatt Tarrant & Combs in Memphis. She is a member of the firm’s Corporate & Securities team. She assists with counseling clients regarding mergers, acquisitions and dispositions. She also provides support to an array of clients in all types of commercial real estate and finance transactions. Taylor earned her law degree from the University of Tennessee College of Law and a bachelor of science degree in business administration, with a focus on finance and international business, from the University of Tennessee.