Reps & warranty insurance: Bridging the M&A liability divide

Representations and warranties insurance (RWI) provides buyers and sellers in mergers and acquisitions with the ability to structure mutually beneficial indemnification packages whereby sellers are able to minimize their post-closing indemnification obligations while buyers maintain robust indemnification protection and a fulsome set of representations and warranties.

Private mergers and acquisitions have long relied on the standard indemnity package, under which sellers provide representations and warranties about the condition of the equity or assets being transferred and agree to indemnify the buyer for any breach for an agreed upon survival period.

To ensure the availability of funds for indemnification, substantial portions of the purchase price are put into escrow for the duration of the post-closing period during which the representations survive. Each component of this package is highly negotiated, as sellers seek to walk away from the business with as much consideration and as little contingent liability as possible, while buyers are incentivized to build out representations and expand escrows as much as possible. RWI provides an increasingly accessible way to ease this tension.

RWI underwriters agree to insure buyers against damages suffered from breaches of the representations and warranties made by sellers in exchange for an upfront premium payment. This allows the buyer and seller to structure the transaction as what is referred to as a “public style” deal with no indemnity, enabling sellers to walk away with little to no money held in escrow and without liability for breaches of representations and warranties (other than for limited situations, such as fraud or willful misconduct).

The rise in prominence of RWI over the past decade has coincided with a red-hot, seller-friendly mergers and acquisitions market, as buyers were willing to cover the costs of premiums and retentions on RWI policies to secure deals with sellers over competitive offers. As the power dynamics in mergers and acquisitions markets have regularized, it is increasingly common for buyers and sellers to split the premium for RWI, with sellers funding an amount equal to half of the retention (with retention generally set at 1 percent of the enterprise value of the target) into escrow for any losses suffered before RWI coverage applies.

A new high-water mark for RWI was achieved in 2021, with records set both in terms of the number of transactions closed and the aggregate value of the transactions. One insurance provider reported a 71 percent increase in RWI placements over 2020, and RWI underwriters struggled to meet client demand in this rapidly growing market. While figures for 2022 are unlikely to resemble the growth rate in 2021, RWI remains a standard consideration in almost all transactions from the lower middle market and up.

The maturity of the RWI market, the established precedent of transactions using this structure, and the potential efficiency of interacting with the underwriter’s claim process instead of the seller or the court system, indicates that this trend will continue to grow, making it the norm in transactions with access to RWI policies.

Legal advisors have adapted to this trend, with multidisciplinary legal teams acting as guides to the still developing RWI market. Balancing the robustness of the representations and warranties covered by the policy with the underwriting processes is a new priority in transactions. This requires sophisticated counsel with significant transactional and insurance experience to navigate the process of drafting the transaction documents to maximize the benefits of the RWI, negotiating the RWI policy, and overseeing both the underwriting and claims processes. While RWI often simplifies aspects of the transaction by reducing negotiation over representations, survival periods, escrows, caps, etc., RWI policies are negotiated contracts that require experienced attention to ensure adequate coverage. Transactional and insurance attorneys must work in tandem to negotiate these complex agreements with insurers.

Our mergers and acquisitions/private equity and insurance teams at Lippes Mathias LLP work with clients on all aspects of RWI in transactions and post-closing claims. To discuss our knowledge and experience in this growing landscape, please contact John Koeppel (partner and private equity leader) at [email protected], Kevin Merriman (partner and insurance recovery, counseling and litigation leader) at [email protected], Sean Balkin (senior associate – private equity) at [email protected], or Tyler Finn (associate – private equity) at [email protected].