It was rumored years ago that Bruce Springsteen took out an insurance policy on his voice in the event he lost it and had to cancel a tour. The truth is that insurance companies, like all companies involved in sales, are constantly finding new products to market. While not as exotic as a policy on The Boss’s voice, insurance companies have stepped into the private equity game with representations and warranties insurance (often abbreviated as reps. and warranties coverage, or RWI). It’s not an entirely new product, but it is one that is often misunderstood, yet growing in importance.
But first some background. A private equity transaction obviously carries with it many risks. There can be a wide source of potential liabilities related to customers, employees, litigation and other factors. This, of course, is why the seller of a company will typically be required to make numerous representations and warranties in the purchase agreement. These representations and warranties include myriad different subject areas and contingencies.
In order to protect against a breach of any representation or warranty, the purchase agreement will often provide that a portion of the purchase price be placed into an escrow fund. The escrowed funds will typically be paid out over specified intervals. During that time period, if a breach of a representation or warranty occurs, the buyer can freeze those escrow funds until the claim is resolved. This provides the buyer with some security (i.e., cash held by an independent third-party) to satisfy any loss resulting from the breach. Otherwise, the buyer would have to chase after the seller’s assets (and may still need to do so if the amount escrowed is insufficient. But for various reasons those assets may be depleted or otherwise difficult to reach. But sellers don’t want sale proceeds tied up in an escrow account for many years, and buyers don’t want to spend years litigating with sellers over the breach of a representation or warranty.
Recognizing a need to provide protection (and of course an opportunity to collect premiums), the insurance industry created representations and warranties coverage. While this is not an entirely new product, it is quickly becoming a popular tool used in private equity transactions. This is in part because the premiums for this coverage are coming down in cost, therefore making the coverage more accessible. This is at least likely in part due to insurers having more confidence in pricing this product.
Buyer-side vs. seller-side policies
Both buyers and sellers can benefit from this coverage, and for that reason, insurers offer separate products to each. The most common policy is a buyer-side one. With this coverage, if there is a breach of a representation or warranty, the buyer can look directly to the insurance to cover any claim, rather than looking to escrow funds or the seller itself. Thus, there is a direct source of insurance proceeds the buyer can (in theory) access. This may be particularly important if the seller group involves numerous individuals in different geographic locations who are severally liable and must be individually pursued. The fact that the buyer has a direct source of recovery may also help avoid business disruptions, particularly where certain members of the seller’s team may be continuing in an ongoing role at the acquired company in a management or other position, which is often the case.
As stated previously, a purchase agreement will often require a holdback of certain sale proceeds in escrow to protect the buyer against breaches of representations and warranties. With the policy – and a source of recovery and protection – in place for the seller, the seller may be willing to forego the withholding of sale proceeds in escrow. This allows the seller to immediately reap the full assets of the sale, and oftentimes allows the private equity sponsor to immediately make distributions to their investors. And, the seller or its investors will not need to be concerned about having to return or pay back a portion of the proceeds. For this reason, a prospective buyer whose proposal includes a buyer-side policy may be a more attractive proposal than one that does not include such a policy.
With a seller-side policy, it is the seller itself that is seeking insurance coverage in the event the seller is sued for violating a representation or warranty (in other words, this is a form of third-party liability coverage). In this situation, the policy will typically obligate the insurer to defend the seller against a claim or lawsuit that a representation or warranty has been breached, and to indemnify the seller against any coverage judgment or settlement of such a claim. The fact that a seller has a policy in place may be attractive to a buyer, because it means an additional source of funding if a buyer prevails on a claim for a breach.
Both buyer-side and seller-policies are useful tools to consider bridging an impasse in negotiations that involves representations or warranties, and in particular the escrow holdbacks associated therewith.
Exclusions to coverage
Like any insurance policy, certain claims will be excluded from coverage. For example representations and warranties policies will typically exclude coverage for a knowing breach of a representation or warranty. In other words, if the seller knows of a situation that violates the representation or warranty, a subsequent breach will not be covered. Similarly, claims arising out of fraud will usually be excluded. Policies also typically do not cover injunctive or other non-monetary relief sought by an aggrieved buyer. Certain policies may also preclude coverage for specific types of claims, such as environmental liability. As with any policy, insureds must pay attention not only to the types of claims covered, but also those excluded.
Reps. and warranties policies will typically include a deductible. The amount will be depend on the size of the transaction, the insurer’s and policyholder’s appetite for risk, and premium pricing. The policy period will also depend on the nature of the transaction, but will usually closely match the time period during which the various representations or warranties are in place (but keep in mind the time period for certain representations or warranties may be unlimited, whereas policy periods are not). Also, unlike many other forms of insurance coverage, the insurer will often charge a non-refundable underwriting fee, as it will need to conduct certain due diligence that is often unassociated with other types of coverages. That said, underwriters can move surprisingly quickly when necessary in order to get coverage in place for an impending transaction. As with any policy, insureds need to be mindful of their own obligations, particularly in the event of a claim, such a providing timely notice to the insurer.
Because this insurance product has only taken hold in recent years (and because many include arbitration provisions), there are few reported legal opinions addressing and interpreting these policies. That may change in the coming years as this coverage continues to grow in usage and more claims come to fruition. This coverage may also be adopted by other industries, and could potentially be used to manage risk in real estate transactions, loan agreements, and other types of deals where representations and warranties are important.
Private equity transactions always involve risk. There are many tools to reduce risk, such as increased due diligence and proper contract drafting. Insurance is simply another tool that can be used to reduce risk. In private equity transactions, representation and warranties coverage can have the added benefit of making a proposal more attractive to a potential suitor. For those on all sides of the deal, however, knowing when and how to use this insurance is an important consideration to keep in mind for when things go other than as planned.
Based in Chicago, Jason Rosenthal is a partner with Honigman Miller Schwartz and Cohn where he represents businesses in complex litigation with a particular emphasis on insurance recovery litigation and counseling.