The use of representations and warranties insurance (RWI) has grown dramatically in recent years as buyers (and to a lesser extent, sellers) have increasingly relied on RWI to allocate risks and provide other benefits in M&A transactions. The COVID-19 pandemic and its economic impacts have led to significant uncertainty for buyers, as well as for the RWI insurers underwriting their transactions. However, as we have grown more knowledgeable about the effects of the pandemic, both the M&A market and RWI insurers have adapted to the meet the changing times.
What is RWI
RWI is used by transacting parties to hedge the uncertainty and risk from breaches of the representations and warranties in a deal. Buyers are usually the ones obtaining RWI to cover the unfortunate event of a seller’s breach of representations and warranties, including those related to financial statements, tax, compliance with laws, material contracts, and intellectual property. Sellers may also obtain RWI to facilitate transactions in situations in which they are seeking to limit their exposure post-closing.
Benefits of RWI
Buyer Benefits Include:
- By assuming certain risks, an RWI insurer can reduce the cost and risk of the transaction because the buyer can claim directly from the insurer instead of claiming against the seller, which may be a more complex and difficult process. This is especially true if the seller is distressed or if there are multiple seller entities, which could complicate the seller’s payment obligations.
- The amount of the purchase price held in escrow may be reduced (or negated altogether), thereby increasing the amount that the seller receives and making the buyer’s offer more enticing than competing offers.
- Preservation of the relationship once an acquisition is complete by not requiring the buyer to seek compensation from the key members of the new team.
Seller Benefits Include:
- Reducing the seller’s potential liabilities and obligations (e.g., survival periods, indemnity coverage).
- Reducing the seller’s disclosure obligations.
- Reducing the amount of the purchase price held in escrow so the seller receives more value upon the closing of the transaction.
- Negotiations may be made easier and more efficient as materiality and knowledge qualifiers and other specifics in the representations and warranties themselves become less important and the parties can focus on matters not covered by RWI.
Drawbacks of RWI
The breadth of insurance coverage and its duration are key aspects for any RWI policy and may be limited. RWI may exclude certain claims by the buyer, such as pension liabilities and will exclude breaches that the buyer discovers through its due diligence process. RWI will also not cover breaches of covenants and forward-looking statements. RWI may also not provide the protections that policyholders are seeking for new, uncertain risks, such as COVID-19.
Impact of COVID-19
At the beginning of the pandemic, when risks and impacts of COVID-19 were more unknown, insurers were broadly excluding RWI coverage for any breaches of representations and warranties linked to COVID-19. As insurers have grown more comfortable with COVID-19-related risks over the past months, they have been more willing to provide narrower COVID-19 exclusions on a case-by-case basis. In order to maximize their ability to obtain efficient RWI during COVID-19, RWI policyholders should consider several factors, including:
- Carefully analyzing any RWI COVID-19 exclusions to ensure that they are clearly defined and seeking to ensure that these exclusions do not overlap with other important RWI coverage.
- Carefully researching and performing due diligence on the impact and risks of COVID-19 on the transaction and the seller (e.g., industry effects, regulatory concerns, labour and employment changes) and being prepared to make a case to insurers on why certain COVID-19-adjacent risks should be included in the RWI coverage. The due diligence process on the seller is essential to help uncover and evaluate these risks.
- Considering the predicted changes in COVID-19-related regulations in relation to the timing of the transaction and the RWI coverage breadth and duration.
- Considering the impact of COVID-19 on shareholder activism and any potential impact that may have on the transaction and RWI coverage.
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