A Solution to Representations & Warranties Risks

Dean V. Cavey, Managing Partner

Verdant Partners has become increasingly aware of a relatively new insurance product that is rapidly gaining popularity in support of merger & acquisition (“M&A”) transactions.  That product is Representations & Warranties  (“Reps & Warranties”) insurance.  Verdant recently met with AJ Gallagher (“Gallagher”), a global insurance brokerage and risk management firm based near Chicago, who is the creator of this coverage.  Accordingly, we want to pass this information along to our clients and other friends who might be in a position to use such coverage sometime in the future.

Reps & Warranties insurance is designed to provide insurance coverage for breaches of reps and warranties statements made by the seller in a purchase agreement.  Sellers are usually required to indemnify the buyer for breaches of the Reps & Warranties made in the purchase and sale agreement and often required to hold some level of transaction proceeds in escrow or through a holdback to ensure that funds are available in the event of a breach.  Reps & Warranties insurance is intended to supplement or even replace seller indemnity obligations by insuring most or all of the representations made within the purchase agreement.

The popularity of this insurance has virtually exploded because it may effectively reduce or replace the seller’s indemnification or escrow requirements.  According to Gallagher, some sellers have even taken a “no indemnification, no escrow” position.  In those cases, the sellers are literally dictating that buyers accept insurance to get the desired level of comfort on the transaction.  Most buyers are looking for risk mitigation which is driving interest in this product.  Additionally, sellers want to distribute the full proceeds without waiting for indemnification periods to run out or escrow monies to be returned.  In some cases, the cost of insurance may be less than the cost of capital tied up by a seller’s escrow, so the insurance may deliver upfront value even without claims.

The Reps & Warranties insurance product was invented in 1999.  Donna Ferrara, then an attorney at Shearman and Sterling, and now an Executive with Gallagher, was instrumental in the development of this product.  Carriers quickly realized that both buyers and sellers were interested in such a product, ultimately leading to both buy-side and sell-side policy forms.

Graph 1 is Gallagher’s estimate from carrier sources as to the number of M&A transactions over the period 2011-2016 that used insurance to mitigate the risks from Reps & Warranties.

According to Gallagher, underwriters will review all items within the Reps & Warranties section of a purchase and sale agreement and offer a list of items they are willing to insure.  They usually provide coverage for all items listed unless there is a unique circumstance requiring either a separate insurance policy or additional premium beyond what is typical.  Frequent examples are significant environmental issues, intellectual property violations including Plant Variety Protection (“PVP”), or patent liabilities.  Of course, fraud and existing, confirmed risks would not be covered.

This coverage is not limited to large-scale transactions.  It is available to cover many of the transactions to which Verdant’s clients have been a party over the last 20 years.  Coverage is available for transactions that occur in the United States, Canada, and Europe.  The amount of coverage is typically for the amount of the escrow or hold-back amount but is available up to the total value of the transaction.  Oftentimes, parties will secure coverage to bridge the gap between what buyer and seller can agree to when negotiating Reps & Warranties limits.

Considering the possible risk involved, coverage is not expensive.  Premiums are approximately 3% of the coverage amount, while the deductible is 1-2% of the transaction value.  There is a one-time underwriting fee that is usually in the range of $20,000-30,000.

Verdant is bringing this information to your attention as part of our services.  Should a Verdant client secure coverage, Verdant does not, in any way, benefit from such coverage, nor do we receive any portion of the premium or underwriting fee.  Verdant can put you in touch with a representative of AJ Gallagher should Reps & Warranties coverage be needed.