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January 19, 2023

How to Approach Reps and Warranties Insurance

In recent years, there has been a surge in using reps & warranty insurance in M&A, especially in private deals. Buyers and sellers can save significant time and money using reps and warranties insurance. This article will discuss how to approach reps and warranties insurance, featuring Josh Holleman, Partner at Cooley LLP.

"Reps and warranties insurance is more advantageous to traditional indemnity structures because it's easier to recover against an insurer compared to a seller." – Josh Holleman

Benefits of reps and warranties insurance

In M&A, sellers always make a list of representations (reps) and warranties about the current state of their business, often found in the definitive agreement. These statements are presumed to be accurate and are used to persuade buyers to acquire a company. A seller will be held liable for any breach of the reps and warranties.

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. As good as it may sound for the seller, reps and warranty insurance also benefits the buyer.

  1. 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. 
  2. It is easier to recover against an insurer rather than a seller.
  3. Prevents buyers from seeking recovery against their newly acquired people, who might be crucial to the business's success.
  4. Gives buyers more extended coverage to make claims.

Josh recommends reps and warranties for most deals but also states that they are not applicable for every transaction. Here are instances where reps and warranties insurance is not suitable. 

  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. 

Contact a broker at least two weeks before finalizing a deal. Hiring a broker before submitting a bid or LOI can provide more certainty about reps and warranties insurance availability.

Due diligence

The insurer's diligence is not meant to replace the buyer's diligence, but rather support it. The underwriter focuses on historical risks and anything that could make any representations untrue. In contrast, the buyer focuses on things that could create problems or exposure in the future.

For this reason, underwriters expect the buyer to do thorough due diligence in critical areas, and their job is to confirm the buyer's efforts. Underwriters also want to ensure they get their hands on any diligence report from the buyer's advisors. 

Negotiation points

Insurances are like contracts and must also be negotiated. Insurers will want to protect themselves from massive liabilities, while buyers seek maximum protection. There are two commonly negotiated parts of reps and warranty insurance:

1. Exclusions - These are things not included in the insurance policy. There are two types of exclusions: standard exclusions and deal-specific exclusions. some text

a. 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.

b. Deal-specific exclusions are known issues or problems identified in diligence instilled in the target company's industry. 

2. Deemed edits - The insurer is looking to edit the purchase agreement to limit the scope of specific reps.

If a particular risk is excluded from a policy, the buyer would want the seller to backstop any potential exposure. But, conversely, the seller must watch out for subrogation, which allows an insurer to go after them if they commit fraud.

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