Despite the fact that Representations and Warranties Insurance (RWI) was first introduced in 1997, the use of RWI policies has been very limited. A typical RWI policy covers losses arising from the breach of representations and warranties by sellers in M&A or investment deals. RWI policy may cover errors, misstatements and omissions made in connection with the seller's representations, including those regarding the seller's tax liabilities, accuracy of financial statements and their conformity with GAAP, condition of the properties conveyed, description of the intangibles, such as intellectual property, and other areas.

Before this product arrived on the scene, the typical tool to cover losses stemming from breaches of representations and warranties had been to enter into indemnification and escrow arrangements. These arrangements are most frequently used in private M&A and equity situations. Under the typical arrangement, if the seller omits or misrepresents a fact, the seller may be required to compensate the buyer -- in effect, the seller posts a bond that it has provided complete and accurate information. Buyers frequently demand security for the seller's indemnity obligations through escrowed funds or stock. The buyer must decide how much of a bond, and what exclusions to the seller's repayment obligations, it will accept. This assessment is especially difficult when there are inherent incentives for sellers to mislead buyers into overvaluing the seller's business. Since private companies do not have the external incentives to be accurately shared by public companies subject to the civil and criminal penalties inherent in the securities laws, buyers have had little choice other than to use indemnification arrangements. Clearly, the widely accepted indemnification/escrow arrangement is not without its drawbacks.

Even when buyers successfully negotiate to withhold a portion of the purchase price, other provisions limit the benefits of such withholding, such as baskets (the amount of loss the buyer must incur before being able to make a claim against the seller), caps (the maximum, aggregate amount for which the seller may be held liable) and survival periods (the span of time during which a buyer is able to make a claim against the seller). It is clear why insurance would be valuable if the facts do not hold up or the indemnification or escrow provisions are not sufficient and the seller has no money to satisfy claims.

A seller who might have offered an escrow in the past, because this was part of the "typical deal" and the buyer's expectation, might now offer to purchase insurance for, say, 20% of the deal value instead. In addition, by purchasing RWI that protects the seller in case the buyer makes indemnification claims, that seller may be more comfortable offering a larger indemnity, and may, thereby, attract a larger number of potential acquirers and, thus, obtain a better purchase price.

This article introduces the advantages of RWI over indemnification provisions and escrow arrangements and describes how having RWI available as an additional tool in the dealmaker's tool kit can change the dynamics of a deal.

When traditional arrangements are not available – The most revolutionary value of RWI occurs when a seller does not agree to provide any personal guaranties or escrowed funds for indemnity claims for breaches of representations and warranties, or when the escrow amount is less than the indemnification amount. The buyer or investor can purchase RWI to enhance or even replace the seller's indemnity against breaches. In its simplest form, RWI can stand in when a seller will not agree to provide any escrowed indemnity or personal guaranty to the buyer. RWI can basically take this issue off of the table, thereby reducing the time and energy spent on negotiating the terms of a seller's indemnification obligations. The RWI policy seems to be most useful for buyers in a certain subset of private M&A and private equity transactions involving emerging growth companies for the same reasons that escrow arrangements have been required in such deals in the past.

In an M&A transaction involving a buyer owning 100% of the target, there has been no place for the buyer to look for compensation in the event of a material breach by the sellers discovered after closing other than escrowed funds or personal guaranties by the sellers. Similarly in a Series A, B, C, or D round – without an escrow-backed indemnity, the venture capitalists traditionally only had their own money to go against if representations and warranties were breached. The structure of these deals made escrows hotly contested matters in the past. As a result, the representations and warranties sections of the agreement also become time-consuming and highly contested components of any deal. RWI is a promising alternative to make such deals easier to close, while possibly reducing the time spent on negotiating these provisions and maintaining a friendlier negotiating atmosphere.

RWI may be especially useful in bankruptcy situations, where the selling corporation is divesting the business to avoid a bankruptcy filing, or where the selling corporation is in bankruptcy. In such cases, the seller typically requires all of the proceeds immediately and will not agree to set aside a portion of the cash in an escrow account to guarantee its contingent financial obligations, or the proceeds will already be earmarked for payment to a creditor.

The high cost of low interest – RWI, as an alternative to escrow, could save the seller money. There may be a high cost associated with the escrow funds being kept in a low interest-bearing account, as well as hanging liabilities and delayed distribution of the deal proceeds. For the venture capital company seller, who is selling one of its portfolio companies, an escrow arrangement often prevents the prompt return of capital to investors hoping for an attractive rate of return. It also denies the investors the use of the sum for other investments for an extended period of time. This in turn, will have a negative impact on the buyout group's return-on-investment, which is critical to their future fund-raising efforts.

Consider the following example. The buyer believes that it needs $10 million in escrow for three years to cover losses resulting from breaches of representations and warranties. Alternatively, RWI policy would cover the same losses at a cost of a $600,000 premium covering 36 months, based on 6% premiums of each $1 million of coverage. The following calculation compares the cost of capital between the escrow account and the RWI policy, based on 5% interest on the escrow amount compared to 12% seller's expected alternative rate of return:

Cost to seller using an Escrow Account:

1. Amount in escrow: $10,000,000;
2. Interest income: $1,576,250 - amount that is earned on the money in the escrow account assuming 5% per annum;
3. Alternative income: $4,049,280 – amount that would have been earned on the money if invested at an expected 12% rate of return;
4. Total cost of using an escrow deposit: $2,473,030 ($4,049,280 - $1,576,250).

Cost to seller using RWI policy:

1. Amount of policy premium: $600,000
2. Future value: $842,957 - the premium amount plus interest, if invested for three years at a 12% rate of return;
3. Tax advantages: $200,000 - approximately 1/3 of the tax-deductible premium;
4. Total cost of using RWI policy: $642,957 ($842,957 - $200,000).

In this example, the difference in cost of using RWI over escrow is $1,830,073 or 18% of the escrow amount. Obviously, if the buyer will bring claims for breach of the representations or warranties, the seller would be even far better off having RWI policy. The overall value of the deal will be enhanced due to the cost savings and additional capital freed up for investment by the parties. Since the premium is always in the form of a one-time payment, the underlying transaction becomes financially "cleaner" because the price of the insurance becomes a part of the transaction costs and does not leave the target with an unclean balance sheet.

Survival Period - RWI can help with latent claims, either when buyer's claims become apparent only after the survival period has ended, or when the escrow arrangement is for a shorter term than the survival period of the representations and warranties. Usually, the term of RWI policy mirrors the general survival period of representations and warranties negotiated among the parties, prevalently two to three years. Some buyers, however, want the insurance to run for longer periods of time, for example, through the statutes of limitations applicable to title issues, tax matters and environmental matters. In the current market, some insurers have expressed a willingness to underwrite policies for as long as six years for such selected representations, in response to this demand. In this way, RWI policies provide flexibility where escrow arrangements do not, when a deal may not go through if the buyer insists on a six year survival clause for tax and environmental representations and warranties.

Litigation – Another risk and cost associated with the escrow arrangement is that buyers are not typically entitled to escrowed funds as a matter of right, but need the consent of the other party to get funds released. The escrow agent typically can release the money to the buyer only if the seller consents. If the seller objects, the matter may go to court for resolution. The buyer may abandon the claim in lieu of incurring the expense of litigation. In sum, the process may have a significant "deductible" for the buyer vis-a-vis claims against the seller.

Unlike escrow accounts, the claimant in RWI policy does not need the consent of the seller to get funds released. The insured presents its claim to a different third party -- the insurer. In theory, it should be easier for the claimant to recover the funds in this scenario since the claimant is dealing with a deal-neutral third party. However, the extent to which the theory is true is unknown because of the short history of RWI in the market. The catch-22 here is that buyers may shy away from RWI policies until there is a more certain claims-paying history for these products.

Who should use RWI - RWI seems most suited to private equity and private M&A transactions. Therefore, it is surprising that many VC firms claim to have never relied upon RWI either because it is unnecessary at the early stage in a start-up company's life, it is too expensive, or because there are other tried and true alternatives such as indemnifications that do the job. Even at the later stage, in the case of a merger or acquisition as an exit strategy, they claim not to have used RWI.

We believe that RWI is feasible for a portfolio/start-up company with intellectual property assets. In fact, one of the more common uses for RWI policies has been to indemnify buyers for intellectual property issues such as patents, trademarks and copyrights.

Last year, a large U.S. insurance broker, sold a RWI policy to facilitate a $1 billion deal between two software companies with patent-related concerns. The seller, a private company, was concerned that the buyer would hold it liable after the deal closed, if the buyer were sued over any patent claims arising from the period before the acquisition. The insurance broker was able to place a $200 million RWI policy covering the seller with a syndicate of eight insurers. It cost the seller approximately $7 million or 3.5% of the coverage amount.

Take a VC firm who is looking to buy a portfolio company but is concerned about the credit of the sellers, for an example of how RWI could change the dynamics of a deal. In the past, such firm would have had to insisted on obtaining personal guarantees or escrow arrangement for indemnity in case of a breach of representations and warranties. Today, such firm may be able to negotiate harder on other points and then give in on the personal guaranty issue, in exchange for making the sellers purchase RWI. Alternatively, such firm could buy the insurance itself, and lower the purchase price, but still argue that the sellers come out ahead because there will be no hanging liabilities for the sellers, and they will get more up-front compared to having to have some of the purchase price withheld in an escrow account.

Using RWI in addition to escrow - Buyers may also utilize RWI to supplement the financial caps or abbreviated survival period of a seller's indemnity. This is especially useful in those cases in which potential losses from a breach of representations and warranties exceed any escrowed holdback amount or personal guaranty that the seller can provide. The liability limits for RWI coverage are highly negotiable. Typical policy limits range from $1 million to $25 million, for as long as six years, but higher amounts in coverage can be assembled by purchasing multiple policies.

Interestingly, one insurer stated that about one quarter of its completed deals last year involved using RWI to free up all or a portion of the escrow. The rest of the policies were equally divided between sellers looking for "sleep easy" insurance to protect their deal proceeds and buyers looking to supplement inadequate indemnification they were able to get from the sellers.

RWI, therefore, provides an independent, contractual source of indemnity that is conditioned neither on the economic soundness of the target nor on the willingness of its corporate management to pay for losses associated with indemnity claims.

While RWI could be most useful in situations in which escrow arrangements have typically been required in the past, RWI is not a true substitute for such arrangements. To varying degrees, RWI can address some of the problems associated with escrow arrangements. It does not, however, mitigate the importance of having accurate representations and warranties themselves, and RWI has minimums and exclusions that may make it impracticable for many deals. Nonetheless, RWI is a valuable and often overlooked tool for businesses, financiers and lawyers alike.

In RWI, only the representations and warranties enumerated in the negotiated policy are covered. There are two general types of typical exclusions -- (a) exclusions that clarify what is not covered by RWI (such as covenants, forward-looking statements, financial forecasts and purchase price post-closing adjustments), and (b) exclusions that actually limit the coverage for representations and warranties, for which coverage may be negotiated with the insurer on a case-by-case basis. Examples for such exclusions include: losses resulting from fraud by the seller; fines, penalties and punitive damages; breaches of representations and warranties relating to environmental matters, adequacy of bad debt reserves, pension plan funding status and tax matters; and knowledge exclusion -- potential or actual breaches that the insured had knowledge of at the closing.

The knowledge exclusion - The knowledge exclusion is perceived to be the most troubling exclusion in the RWI policy. Depending on how "knowledge" is defined, such an exclusion could cast doubt on virtually any matter for which the insured seeks recovery. In some cases, the insured buyer has no recourse under RWI policy for breach of representations and warranties by the seller of which it was aware at the time of the closing.

The theory behind the knowledge exclusion is that if an insured actually knows about a fact or circumstance which is likely to result in a breach and loss, and if that insured does not expressly seek an indemnification for that loss, then it seems that the insured is either not worried about that breach or loss or willing to take the risk of that breach or loss occurring. Underwriters offer insurance policies that will insure against known risks or that will cap an insured's exposure on a known risk, and place these outside the RWI coverage.

This may be a clear disadvantage over the traditional escrow arrangement, where knowledge of the buyer does not eliminate indemnification rights.

Cost of RWI - Compared with other lines of insurance, RWI is costly -- on average, premiums range between 3% to 8% of each $1 of coverage. Since only few RWI policies resulted in claims against the policy provider, these rates may be reduced in the future. In addition to the high premiums, the up-front underwriting fee is relatively higher than for other insurance policies. The underwriting fees serve two purposes: to cover the underwriting expenses associated with analyzing these deals (including the cost of outside counsel) and to pre-qualify the real opportunities to avoid situations where the parties take advantage of the insurer. In such occasions, buyers or sellers use the due diligence of the insurance company as an objective measure of the risk of breach of representations and warranties, and once they get a price tag on such risk, pull out of any commitment to purchasing RWI or to pay the premium.

When to get the insurance company involved - Some legal practitioners recommend involving the insurer as early in the deal-making process as possible. The reasons that they give for this recommendation include: (i) the insurer's due diligence takes time; (ii) it's preferable to determine the insurer's willingness to underwrite the policy sooner rather than later, since insurers may decline to underwrite RWI policies in certain circumstances (such as if they don't believe the representations and warranties in the purchase agreement are the result of arms-length negotiations, or are simply too broad); and (iii) negotiating the policy itself takes time and effort.

However, the presence of RWI insurers too early in a deal can change the incentives of the parties. One of the insurer's "horror stories" is that a party seeking RWI coverage for the representations and warranties come to them with an early draft of the agreement, get a price quote from them, then go through several iterations of the agreement, substantially altering and broadening the scope of the representations and warranties, and still expecting the same pricing. Knowing that they are going to be covered by RWI, the sellers may think that they can fight less about the representations and warranties, but sellers do need to know that they might in the process make the deal uninsurable. In addition, if the insurer gets involved too early in the process, then the buyer will be fighting two people. It seems, therefore, better for all for the insurer to get involved after most of the arms-length negotiations are over.

At the same time, the RWI can work the opposite way, to the advantage of a party during arms-length negotiations. For example, a small medical device company was selling itself to a big pharmaceutical company, but, because of the difference in power, the parties initially negotiated an extremely buyer-friendly agreement with some outrageous representations and warranties running in the favor of the buyer. The sellers decided to get RWI, and had the insurers basically categorize the risk involved to determine which representations and warranties were insurable or not. The sellers in this case were able to use this information as leverage to go back to the big pharmaceutical company and have the representations and warranties and indemnities revised accordingly. In an example like this, it is obviously better for the insurance company to get involved at an early stage in the negotiations.

Involving the insurer too late may slow down the dealmaking process due to the involvement of the insurer's lawyers who will engage in their own due diligence process to evaluate the risk in the transaction. Thus, parties should start thinking about using RWI early on in the process, in terms of understanding their motivations for purchasing RWI, and then determine the appropriate strategic timing to bring the underwriters in. Most insurers should be willing to get on the phone to discuss on a preliminary basis the use of RWI in a deal at the letter-of-intent stage, and provide ideas of how and when to get the insurers involved.

Parties should also recognize that the other party may be negotiating the indemnifications while strategically hiding the fact that they will be getting extra security from RWI policy. A couple of insurers stated that they have seen deals come in both ways -- where both parties came in asking for RWI coverage, and where only one party requested RWI coverage, and asked to keep it confidential. Moreover, they have had cases where the deal was closed and the sellers purchased RWI after the closing. Although such cases might not always be insurable (especially if a substantial length of time has elapsed since the closing, and the motivation for asking for such coverage seems suspicious), RWI is flexible enough to accommodate various situations.

Conclusions

RWI has not really caught on yet. Even in the red-hot mergers and acquisitions market of 1999, the total value of publicly announced mergers was $1.4 trillion, but less than 1% of these transactions used some kind of deal insurance such as RWI.

This small percentage may be the result of poor marketing, since the message the insurers deliver along with this new tool is still evolving. It may also have a lot to do with the fact that the target audience of such product, which include not only buyers and sellers themselves, but the dealmakers, who are often lawyers, are a conservative bunch, reluctant to be the test case, and reluctant to reinvent the wheel.

Despite some drawbacks, RWI is a promising new product with the potential to enhance deal value in many situations. With increased experience on the part of the insurers over time, and more effective marketing leading to a greater awareness and understanding of RWI on the part of buyers, sellers, and their financial and legal advisors, we expect this product to become an essential part of the dealmakers' future tool kit.

 

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Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.