Representations and warranties insurance (RWI) is a category of insurance policies which covers the insured (i.e. the buyer, the seller, and/or the target company) for some or all representations and warranties provided by the other party(ies) within the share purchase agreements (SPA) mainly in relation to mergers and acquisitions (M&A) transactions. Typically, RWI policies do not cover known breaches of representations and warranties, which must be disclosed in the transaction documents prior to signing and / or completion. In our experience, some of the most significant obstacles which may cause M&A transactions to be delayed or aborted are due to the parties’ inability to agree on the scope and financial limit of the seller’s liabilities under the SPA, as these have a direct impact on the allocation of unknown risks between the transacting parties.
RWI policies are typically purchased by either the seller or the buyer in M&A transactions, and this tool allows parties to transfer the unknown financial risk from the parties to the insurer. Whilst both the buyer and seller (and in some cases, the target company itself) make representations and warranties to each other, the majority of them are made by the seller. A big portion of the representations and warranties made by the seller concern the business of the seller. In a typical scenario, the RWI policy would require the insurer to directly compensate the buyer for the seller’s alleged breach of the representations and warranties, whilst barring the insurer from pursuing the seller — save in the cases of fraud — after it compensates the buyer for the breach.
By shifting the unquantified financial risk from the parties to an insurer, RWI policies enable parties to agree to broader representations and warranties which provide better assurances to the parties whilst mitigating the potential financial loss which may be incurred the breaching party. The financial backing of a reputable insurer also reduces, and potentially eliminates, the need for the seller to provide an escrow to the buyer, thereby enabling the seller to attain a clean exit post-closing.
As illustrated above, the ability of RWI policies in mitigating financial risks and uncertainty is central to their effectiveness in closing deals that would otherwise not be consummated. Indeed, it is estimated by an insurance brokerage firm, that RWI policies are used in around 75% of private equity transactions and over 60% of larger acquisitions.
If you are considering whether to use RWI policies for your M&A transaction, we would highly recommend that you retain legal counsel with specific expertise in the use of RWI policies in M&A transactions. Legal counsel with such deal experience are best-placed to advise you and protect your interests during the negotiation stages of the transaction.
Although there is no prevailing market practice, RWI policy coverage typically falls between 10% to 30% of the deal value, with premiums typically ranging between 2% to 3% of the policy limit.
For claims against breaches, policyholders are limited by post-closing claim periods which are set by insurers. In typical cases, coverage for fundamental warranties usually lasts up to 6 years, general business warranties are covered for 2 to 5 years, and tax warranties are subject to the prevailing statutory time limit. In Singapore, the statute of limitations in Singapore is 4 years after the relevant year of assessment, though the Singapore tax authority is not time-barred from raising additional assessments if a taxpayer commits fraud or willful default.
RWI policies can smoothen the negotiation process between parties by affording the buyer with added protection beyond the negotiated liability caps and survival periods in the SPA whilst minimising the unknown financial risks undertaken by the seller. In a seller-friendly M&A environment, a buyer who proposes to obtain comprehensive coverage for the seller’s representations and warranties by way of an RWI policy would improve the competitiveness of its bid because it reduces the sell-side exposure.
Separately, in transactions which involve several sellers or financially-distressed sellers, RWI policies protect buyers against either a collectability or solvency risk of unsecured representations and warranties. Given that any claims made for breaches would primarily involve the insurer and not the transaction counterparty, RWI policies preserve key relationships post-closing between the parties, which is especially important in transactions where the seller will continue to represent the management of the target company.
Buyers should keep in mind, however, that RWI policies are only designed to cover unexpected issues which arise and would not cover known breaches, which should be disclosed within the transaction documents prior to signing and / or completion. When engaged, a buy-side legal counsel’s role is to ensure that the buyer puts in place a robust disclosure process for the seller to fully disclose any known issues in the target company and thereafter, to conduct a comprehensive due diligence on the target company to uncover in detail all known pre-existing issues.
If the insurer receives any indication that the disclosure process for an M&A transaction is not comprehensive or that only a limited due diligence exercise has been conducted, this may result in higher premiums being quoted by the insurer for a less comprehensive coverage. For this reason, buyers who engage experienced legal counsel will likely enjoy cost savings, better policy coverage and by extension, greater deal protection.
Sellers who purchase an RWI policy to cover themselves for any of their breaches of the SPA can mitigate one of their biggest concerns in M&A negotiations by replacing or backstopping the indemnity obligations which they have negotiated with buyers. Doing so will accelerate the deal-making process and increase the certainty of the financial return. These factors are typically of great importance to private equity and venture capitalist investors.
Moreover, because RWI insurers are of investment grade security and therefore provide superior counterparty exposure, RWI policies offer additional comfort for the insured who are individuals or family sellers. It also protects minority sellers concerned about joint liability.
Given that any claims are generally made directly to the insurer, sellers are well-positioned to enjoy a clean exit under a RWI policy as such policies would minimise any post-closing disputes and litigations involving sellers.
By engaging legal counsel, sellers will be well-advised to draft the SPA in a manner that protect their interests. Further, the customisable nature of RWI policies also means that counsel can provide professional input to sellers regarding how the policies should be tailored to fit their specific needs.
Where the policyholder is the buyer in an M&A transaction, there is no requirement under a typical policy for the buyer to attempt to recover losses from the seller. The seller is therefore out of the claims process, and is afforded a clean-exit post-closing.
Although both the buyer and insurer waive virtually all their subrogation rights against the seller, the insurer is typically still entitled to subrogate in the event of seller fraud. While buyers are required by RWI policies to mitigate losses arising from any breaches, they do not have to waive any legal rights or undertake any action to this end that is detrimental to their own interests. A failure to mitigate losses, however, may result in a claims deduction.
It is recommended that legal advice is sought both before agreeing to an RWI policy and prior to making claims under it. For buyers, legal counsel will be able to advise on whether their legal rights are protected in relation to their intended course of action. Conversely, sellers who engage counsel will be better positioned to respond to any subrogation claims made against them by insurers.
As elucidated above, RWI policies can be used as a tool to potentially provide a win-win solution for both buyers and sellers in an M&A transaction. Instead of requiring the participants to fully bear the unknown transaction risk, RWI policies enable a significant portion of this risk to be transferred to an insurer. For a premium, an RWI policy benefits the seller by reducing their overall risks and potential liabilities, and also provides comfort for the buyer in knowing that covered losses can be recouped under the policy.
As the process of introducing RWI into transactions adds an additional layer of complexity to M&A transactions, we would recommend that transacting parties consult legal counsel throughout the M&A process to ensure that their commercial interests are well-protected.
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The author, Waltson Tan, is a corporate lawyer trained in London and Singapore. He is qualified as an advocate and solicitor in Singapore, and has more than eight years of post-qualification experience.
Waltson focuses his practice on mergers and acquisitions, private equity, joint ventures, investment funds and other general corporate and commercial transactions. He has also represented numerous leading multinational organisations on a broad spectrum of corporate, regulatory, cross-border restructuring and employment matters.
Waltson also advises clients on a monthly and yearly retainer basis, where he provides dedicated services to each client in relation to the issues which clients face, including general corporate and employment related matters.If you require further information and/or expert guidance on the above or any other area of law, you may wish to contact the author of the article, whose details are as follows:
Waltson Tan Director +65 8079 0028 waltson.tan@28falconlaw.com |
Office address: 101A Upper Cross Street #13-11, People’s Park Centre Singapore 058358Singapore |