How to Approach Reps and Warranties Insurance

Benefits of reps and warranties

In the definitive agreement of a typical M&A, whether it's a merger agreement, stock purchase agreement, or asset purchase agreement, sellers always make a list of representations (reps) and warranties about the current state of their business.

• Capitalization 
• IP
• Litigation
• Employee benefits
• Other kinds of potential liabilities

The parties then negotiate the extent to which the seller will be held liable for any breach of the reps and warranties.

Traditionally, the parties would agree to escrow or hold back a portion of the purchase price, around 10% to 20%. Lasting for somewhere between the range of 12 to 24 months, the reps and warranties will cover the buyer's damages in case of a breach of one of those representations.

The buyer's recovery for breaches of the standard or general reps, which means anything other than specified fundamental representations, would be capped at that escrow amount.

And for the fundamental representations, which encompass a subset of representations negotiated by the parties—often including the seller's authority to do the deal capitalization, IP, and taxes—the buyer would frequently be able to recover directly from the sellers for amounts above and beyond the escrow.

Sometimes capped at the purchase price, and sometimes, especially for IP, capped at some amount between the escrow and the purchase price, around 30% to 40%. Recovery for those fundamental reps would also be available for some time beyond the expiration of that escrow setup. 

But with the introduction of rep and warranty insurance, buyers and sellers can fundamentally change this post-closing risk profile.

The traditional escrow can be reduced to a fraction of the traditional 10% or so escrow size, or the escrow can be eliminated altogether. That is because with reps and warranties insurance, the insurer replaces the seller as the liable party for breaches, which reduces the chances of post-close risks for the seller, subject to certain limitations and exclusions. 

But suppose the buyer uncovers a breach of one of the seller's reps. In that case, the buyer claims against the rep and warranty insurer, much like any other insurance policy. This approach can benefit both parties. 

• Better for the seller because the escrow is much smaller or eliminated altogether. Reps and warranties insurance allows buyers to make a more appealing offer to sellers by avoiding escrow and paying the seller the entire purchase price. 

• Better for the buyer because in instances where founders or members of the seller's management team hold equity, the reps and warranties insurance prevents buyers from seeking recovery against their newly acquired people, who might be crucial to the business's success.

         That often puts buyers in a bind if they choose between recovering against their own employees and potentially upsetting them or forgoing recovery for the damages altogether. 

• It is easier to recover against an insurer rather than a seller, particularly for any amounts that may exceed the amount of that escrow. Where otherwise, sellers would be forced to write checks back to the buyer in bank accounts that may not have sufficient funds to do so. 

The insured amount depends on the coverage you purchase. Most buyers purchase a policy that covers 10% to 20% of the purchase price. You can think of it as replicating what would've been an escrow in a traditional indemnity deal with an escrow or a holdback. 

That said, there are excess policies that can be purchased that allow coverage for certain representations and warranties above and beyond that primary coverage. You can also buy more coverage than the 10% to 20% if you want. It just becomes more expensive.

The cost of these policies all-in is typically between 3.5% to 4.5% of the coverage amount you're purchasing. A portion of that is an underwriting fee. 

Where reps and warranties insurance is not applicable

I believe rep and warranty insurance was first developed and utilized in European markets in the early 2000s. In the years that followed, it was used modestly and primarily in instances where: 

• Deal negotiations broke down;
• The parties needed to find a way to bridge the gap; and 
• There wasn't necessarily a known issue of any kind, but rather a major disconnect between the parties as to the amount of post-closing risk the buyer and the seller were willing to bear. 

The product then essentially sat on the shelf, at least here in the United States, until we rolled out of the Great Recession. Some enterprising private equity funds realized they would get a leg up by using it in competitive auctions to win bids.

If you step back and think about it, what matters most to sellers is about three factors: 

• price or valuation
• deal certainty
• post-closing risk allocation

Where a PE firm's bid may not have won based solely on the first two factors, having rep and warranty insurance as a tool to use on the third, particularly against strategic buyers, was very powerful.

It allowed them to offer the cash upfront to sellers without losing some to escrow or indemnification claims. 

But as more private equity funds started to use this as a tool in competitive situations, strategic acquirers started to lose auctions. As a result, the strategics started catching on and using it themselves. 

We now see it used in most private company deals, which is consistent with what the deal studies are showing, too. But there are some instances when a policy may not make sense.

1. Restricted companies and industries - Insurers may not be willing to underwrite the policy for specific companies or industries, such as Cannabis and Crypto.

2. Cost - Depending on the deal size, the policy may be too costly for some deals. Reps and warranties insurance doesn't make sense for deals under $30 million.

3. Self-insure option -  The cost of capital is lower for strategic buyers than private equity funds. As a result, some strategics may prefer to underwrite the risk of damages associated with potential breaches by themselves rather than pay for a policy.

4. Public deals - Typically, public deals have no indemnity because no one is left to indemnify. People expect the buyer to take the risks of breaches, though this might change over time. 

There are also other reasons why public deals don't use reps and warranties as much:

1. Public companies are subject to reporting requirements. Thus, less diligence is performed, and insurance won't accept the risk. 

2. Similarly, the reps look different in public deals as they're subject to exchange ACT reports and are largely MAE qualified, which means a materiality scrape is more difficult to get in the public company context.

3. Retention, typically 0.5% to 1% of the overall enterprise value or purchase price, may also be very large in larger public deals, making a policy unpalatable. 

There are a lot of arguments to be made, and I see reps and warranties insurance being used more in public deals in the future. 

Small vs. Large deals 

Regarding deal size, how small is too small changes over time, deal by deal, because pricing is constantly evolving on these products. Sometimes the deal dynamics make it worthwhile.

But a rep and warranty insurance policy generally doesn't make much sense for deals smaller than around $25 to $30 million. That's given that the minimum spend is around $200,000 to $250,000 on the costs, including the underwriting fee and premiums, regardless of deal size. 

The coverage and the minimum retention may be around $150,000 to $200,000, no matter how small the deal. So although it has been used on deals smaller than $25 million, you can understand why that wouldn't make sense in most cases. 

For instance, on a $15 million deal, to replace what otherwise would've been a 10% or $1.5 million escrow, you might have to spend $250,000 on the policy. On top of that, you'd likely have a retention of $150,000 or more. So the math doesn't quite work out. 

The Process

The process starts by reaching out to a broker who specializes in the placement of rep and warranty insurance policies. The broker will then gather basic information on the deal and the target, including financials and any information memorandum prepared by the seller and, if available, the draft purchase agreement.

The broker then goes to the market to determine which of the two dozen insurers for this type of insurance would make sense for the particular policy and solicits bids.

In response, the broker gets back from those insurers, hopefully more than one bid, with a non-binding interest letter. Those NBILs summarize the terms on which the insurer is willing to underwrite the policy and the proposed exclusions from the policy.

Although it can happen more quickly, that process typically takes around a week from the date all that information is provided to the broker. At that point, there's no cost to the buyer for doing the work so far. 

Once those NBILs come in, the broker and the buyer's in-house or outside council will review them with the buyer and determine which insurer to select. 

After one is selected, an underwriting fee of typically around $30,000 to $50,000 is paid to the insurer, called a diligence fee. It's used to cover the costs of the legal, due diligence that the underwriter's counsel will be doing alongside the buyer's council. It is non-refundable, and it's not applied toward the premium. That is the first point of the process when the buyer has expended any money.

The next step is for the underwriter's counsel to get access to the data room and perform its own diligence. It's important to understand that this diligence doesn't replace the buyer's diligence but rather supplements it. In fact, the underwriter's counsel relies heavily on the diligence performed by the buyer. 

Ultimately, there's a 2-3 hour call between the underwriter's counsel, the buyer's deal team members, and the buyer's third-party advisors. That includes their accountants and legal council, in which the underwriter's counsel asks questions about the diligence performed on the target. 

Around 24 hours after that call, the underwriter will deliver a draft of the policy to the buyer, along with any follow-up questions and, importantly, any proposed exclusions to the policy. 

Once that happens, the buyer and its council respond to those questions and negotiate the policy and the proposed exclusions. 

Turnaround time

In terms of timing, although a policy can be placed in just a matter of days, that is exceedingly difficult to do. What I'd recommend to clients is reaching out to a broker at least two weeks before you anticipate signing a transaction.

In some cases, reaching out to a broker before even making your bid or delivering an LOI can make sense as it gives a buyer more certainty about the availability of rep and warranty insurance. You don't always know you'll be able to get it and the terms to get it.

That, in turn, can factor into the terms of your bid or the terms of your letter of intent if it's not a competitive auction and you are just providing an LOI to a prospective target. 

Also, you can tell the seller you've already discussed the availability of a rep and warranty insurance with your broker.

You can get it and know what the terms may look like. Generally, it can also provide more certainty to the prospective seller and signal to them that you're serious about proceeding with the deal.

It would still be contingent on the diligence from that underwriter. Normally, an insurer would be very uncommon to provide an NBIL to indicate that they're willing to underwrite insurance for a deal and back out entirely based on diligence.

Based on the diligence that's performed, you would more frequently see changes or deal-specific exclusions to the policy that could be material and potentially make the use of a policy not make sense in the transaction if those exclusions were wide-ranging enough.

Due diligence

The insurer's diligence is not meant to replace the buyer's diligence. It's not any more thorough than the buyer's diligence, but rather it supplements it. 

The dollar amount that underwriters spend on their council to perform their diligence is typically much less than the buyer is spending on its council.

The underwriters expect the buyer to do thorough due diligence in critical areas, and their job is to confirm the buyer's efforts. That's one of the things that are important from the underwriter's perspective. 

Underwriters also want to ensure they get their hands on any diligence report from the buyer's advisors. 

For that matter, if you didn't provide one, that could become a real problem for getting the insurance. They want to know that you, as the buyer, are doing true, thorough diligence. 

Then their council comes in and looks at specific things they go through.

• Look at the buyer's diligence reports.
• Do their own assessment of risk.
• They may focus on particular items identified or not identified in those reports. 

It's important to remember that the buyer's perspective versus the underwriter matters. While the buyer may be focused more on things that could create problems or exposure in the future, the underwriter is focused on historical risk and anything that could make a representation untrue because that's what they're insuring against. 

Negotiation points 

Lawyers can and should negotiate the insurance policy and the coverage. Some buyers have internal risk management functions that run these negotiations with their M&A teams, but most rely on their outside counsel to help with that process.

At Cooley, for instance, we have an insurance group that works hand in hand with our M&A attorneys on the team to negotiate the policy for most of our buy-side clients. 

Insurances are like contracts and must also be negotiated. The most commonly negotiated parts are the exclusions and the deemed edits to the purchase agreement. 

On the first point, policies contain two types of exclusions: standard exclusions and deal-specific exclusions. 

Standard exclusions are typically excluded from almost every reps and warranties insurance policy, such as net operating losses, wage and hour issues, underfunded pension liabilities, and forward-looking reps.

Although there is some negotiation of these types of exclusions, and some are moving toward a case-by-case evaluation and negotiation over time, we see more significant negotiation devoted to the deal-specific exclusions.

Deal-specific exclusions are known issues or problems identified in diligence instilled in the target company's industry. Lawyers spend a lot of time trying to narrow or remove these exclusions from the policies. 

These exclusions may involve performing additional diligence on potential issues to get the underwriter and their council comfortable with them or narrowing the language of the exclusion to exactly the known issue uncovered in diligence.

For example, if an exclusion is proposed for any unpaid sales and use taxes because a buyer diligence report identifies a nexus in two particular states. We might try to narrow that exclusion to include just those two states rather than all jurisdictions, which may be the initial position that the insurer takes with their proposed exclusion.

On the second point, we have recently seen an increasing number of deemed edits in policies. The insurer is looking to edit the purchase agreement to limit the scope of specific reps.

These are instances in which the insurer wants to limit the scope of certain reps such that they won't cover the entire scope as written in your purchase agreement. That could include the addition of knowledge qualifiers to a particular representation or the deletion of specific words within a particular representation. 

An example of that is when a rep says ""there is no liability of a specified nature, and there's no reasonable basis to believe that there ever could be a liability of that nature in the future." 

The policy may edit that sentence to remove the words "no reasonable basis to believe" or that clause just because the insurer deems it too broad of a rep in scope to cover. 

On the buy side, it's vital to keep the scope as broad as possible. Trying to limit those deemed edits and narrow the exclusions is exceedingly important. That also becomes more important in a competitive deal. You might find it difficult to get the seller to cover them.

Ideally, from a buyer's perspective, if a particular risk is excluded from a policy, the buyer would want the seller to backstop any potential exposure. But in some competitive situations, getting the seller to cover any of those risks is difficult. 

On the seller's side, there's something called subrogation. The seller must watch out for subrogation, which allows an insurer to go after them if they commit fraud. That tends to be the most important piece of a policy for a seller, especially where they do not agree to be responsible for any exclusions from the policy or any breaches of reps. 

Seller's liability

It depends. Even a few years ago, the seller would still have some indemnification obligation, even in deals with rep and warranty insurance, and would cover half of the policy's retention in escrow. That equates to a quarter of a percent to half a percent of the overall purchase price.  

That's because the retention under a typical policy is between 0.5% and 1% of the overall enterprise value or purchase price. 

We used to find that the sellers would be responsible for a portion of that retention in many deals. The reason for that was driven partly by the pricing of these policies. The insurers used to provide better pricing where sellers had some skin in the game. 

Over time, that pricing differential has decreased. In many cases, it just doesn't even exist anymore. As a result, buyers have less incentive to insist on the sellers covering a portion of that retention. 

In a competitive scenario, it's better to go to a seller and propose that you eliminate their indemnification obligation for breaches of reps altogether. Therefore, we're seeing many more deals now where the sellers have no indemnification obligations.

It is still sometimes true that sellers will be responsible for things outside of breaches of reps and warranties, such as breaches of covenants or matters excluded from coverage under the policy. 

But in many competitive auctions these days, buyers are proposing true no-indemnity deals, much like public company deals, to try to win those auctions.

Largest Claim 

Fortunately, I haven't seen any massive claims in the deals I've worked on. In some instances, when public company buyers have claims being made against an insurer instead of against a target seller, they will occasionally run those through internal processes outside counsel may not be exposed to the claims being made in some cases. 

But in recent years, a few large claims have made the news where the claim exceeded the primary layer of insurance and went against the whole tower. 

An example is a case with a company called Novolex, where the claim was for over $150 million. Some very large claims are starting to be made these days. As a result, some of the carriers we're seeing now engage in limits management. 

That means that whereas in the past, they may have taken the entire risk on a deal or underwritten the entire amount of coverage on a policy, now they may be capping their exposure at something like $25 million and then getting other insurers to co-insure that with them. 

These insurers are very good about paying these claims; many get rejected for various reasons. But generally, there are claims and they do get paid. Therefore, these policies are real; the insurers backing them are true insurers.

If a claim is made against the policy, it would be like making claims against any insurance. It would go through their in-house process, and they come with some blunt statement about which doesn't fit right. 

Suppose it's a large enough claim and meaningful enough that you care about getting the recovery from the policy. It could be costly and potentially lead to litigation, just like an indemnification claim.

One of the reasons that companies think reps and warranties insurance is more advantageous to traditional indemnity structures is because it's easier to recover against an insurer compared to a seller.

Roles of Brokers, Insurers, and Underwriters

Many brokers in this industry are licensed ex-M&A lawyers. It may be that they are finding something better about the life of a broker than the life of an M&A practitioner. But what's interesting is that many of these brokers are experienced deal lawyers too, who understand the nature of reps and warranties. 

Also, the insurers have a lot of ex-M&A lawyers on their staff, which means they don't want those reps and warranties to be too broad upon looking at your purchase agreement because they're insuring against the risk that the seller is in breach of those.

It's to their benefit to have experienced deal people on their team who can identify where those reps and warranties are broader than you would usually see. 

I've talked a bit about who is on the actual insurance teams, the underwriter's teams, and who becomes the brokers or who the brokers are. The underwriters are indeed the ones who are looking to minimize the coverage. 

For that reason, it would behoove them to have people on their team who understand reps and warranties, purchase agreements, what's common and standard, and where the purchase agreement may be going away from the typical reps and warranties you see in a purchase agreement.

For the brokers, their job is not to limit the coverage, as you point out, but it's still very helpful for them to have a deep understanding of M&A transactions and the reps and warranties themselves. Among other things, they are or should be an advocate for the buyer. 

They are also engaged by the buyer, helping you procure the policy and find the best one available. But to the extent that you have exclusions from the policy, it's helpful for them to:

• Understand those exclusions in the context of the overall deal
• Understand whether those are exclusions that one would expect to see
• To have that sense of the insurance market

For brokers, having that combination of experience with the insurance market in which they participate and M&A in general, is very useful.

Recommendations

Reps and warranties are good for most deals but not for every deal. On the sell side, when I represent sellers and transactions, unless there's some reason that you couldn't get a policy for that deal, I will recommend that they encourage or require the buyer to get a policy in every single deal. 

On the buy side, buyers should consider it. In many cases, our buy-side clients are purchasing companies with either founders or management members with significant equity in the company we're buying.

In a traditional indemnity structure, the indemnification obligation of the sellers on a post-closing basis is typically tied to the amount of equity they hold. So you can be in this very awkward position of making an indemnification claim against people who are still working for you.

Maybe this is now a subsidiary of your company, but that management team is responsible for that subsidiary's day-to-day operations or success. So the last thing you want to do from a morale and retention perspective is go after your employees to pay out an indemnification claim.

A rep and warranty insurance policy can be particularly beneficial because you now have a third-party insurer you can go after instead of your own employees. 

Also, it can be easier to recover from. It can be difficult to recover from sellers and private company transactions where you must seek money out of their pockets. An insurer should have the funds available to pay you should you need to claim them. 

Finally, another reason these policies are great for buyers is it gives buyers more extended coverage to make claims.

For a traditional indemnity deal, you would often have an escrow that lasts a year to two, which would be your sole source of recovery for the general or standard reps. With a rep and warranty insurance policy, the baseline coverage for standard or general reps is around three years. For certain fundamental reps, you get coverage for six years. 

Also, it is important to note that there can be a coverage gap if you have an extended period between the signing and closing. In general, representation warranty insurance policies will cover breaches that occurred before and were discovered or after or between sign and closing.

But if a breach occurs between signing and closing and you discover it between signing and closing, generally speaking, a rep and warranty insurance policy won't cover that.

There are instances in which you might have a very long gap between sign and close, and there's a real risk of something going wrong that you would discover in that period and wouldn't have insurance coverage for. That doesn't necessarily mean that you forgo a policy. 

But there can be instances where you may have to consider whether you would also need to layer onto some exposure of the seller in the transaction for things that the policy wouldn't cover because they occurred and were discovered between sign and close or otherwise factor that into the overall deal certainty. 

Whether you weren't going to have insurance coverage, you, as a buyer, could back out of the transaction.