Representation and Warranties Insurance in M&A transactions
It is becoming increasingly common to use representation and warranties insurance policies (known as R&W insurance or W&l insurance) in M&A transactions. These insurances allow the compensation that the seller must pay to the buyer, for certain damages caused because of the breach of contract, to be paid directly by an insurer in exchange for the payment of the corresponding premium.
However, taking into account that it is a fairly recent and novel figure, we are going to try to briefly explain what it consists of, the minimum requirements for insurers to be interested in covering the risk, their vision from the point of view of the buyer and the seller, as well as the type of coverage that these insurances offer.
What is R&W insurance?
As is evident, the potential buyer faces a number of risks in executing the acquisition of a business or company. These risks are basically the limited information available to him about the situation of the company and the possibility that the price offered may not be consistent with the real value of the company or business he is acquiring.
Therefore, the inclusion of representations and warranties (R&W) and the specific liability regime designed by buyer and seller are the buyer’s remedy for the above mentioned risks.
With all this, it is increasingly common for buyer and seller to agree that the seller will not be liable to the buyer for the total or partial breach of the representations and warranties, but that an insurance company will assume the corresponding indemnity. Therefore, the purpose of the R&W insurance is basically to cover – or rather to replace – the indemnity that the seller would have to pay to the buyer as a consequence of the liability regime of the contract being activated due to the breach of all or part of the representations and warranties given by the seller in the contract of sale. In other words, it is not a guarantee for the buyer of the seller’s compliance with the liability regime under the contract, but the indemnity mechanism to which the buyer is entitled in the event that the representations made by the seller are false.
What requirements must be met?
As for the minimum requirements that the insurers are demanding, the main one is that the negotiation of the contract and, in particular, of the representations and guarantees, has taken place between independent parties and in a position of equality, that is to say, that the buyer and seller do not have a link that could in any way contaminate the negotiation of the contract in favour of one of them, more specifically, in favour of the buyer who would be the beneficiary of the potential indemnity to be paid by the insurer.
Therefore, the representations and warranties given by the seller must have been negotiated on market terms. Therefore, the insurer will not be willing to cover the risk in those operations in which the seller would not have granted such representations if there was no coverage on the part of the insurer.
Another of the requirements is that the buyer must have carried out, through its advisors, a due diligence process of the business or company to be acquired, covering areas such as legal, financial, commercial, environmental, etc.
Finally, insurers require that the parties involved in the operation disclose the potential and known risks so that the insurer can assess whether it is appropriate to include these risks within the coverage of the policy.
Seller and buyer policies
Without prejudice to the fact that, as we explained at the beginning, it is usual for the insurer to directly indemnify the buyer in the event of non-fulfilment of the representations and guarantees (what is known as buyer policies in which the insurance works as a cover for damages suffered directly by the buyer), there are also the so-called seller policies.
The particularity of these seller policies is that the seller is the one who compensates the buyer for the damage generated because of the breach of the representations, but the insurer then compensates the seller with the same amount paid by the seller, or by the percentage that is agreed through the insurance policy. In other words, the responsibility of the seller is not cancelled, but the amount of the payment made is recovered, at least in a percentage if the coverage is not for the total indemnity amount.
Coverage and exclusions
The indemnity limit usually varies depending on the volume of the transaction, the sector in which the business or company to be acquired is located, as well as the buyer’s perception of risk.
It is true that W&I insurance can cover the total liability under the contract for breach of representations and warranties but depending on the volume of the transaction (value of the company) the percentage of coverage may go up or down, being higher for transactions with smaller values and lower for those with higher values.
In any case, the usual types of exclusions are:
- Known or disclosed events that have been identified during due diligence, or for which specific indemnities have been included in the contract itself.
- Uninsurable fines and penalties.
- Damage where there is fraud on the part of the insured.
- Obligations that do not have to do with the representations and guarantees granted by the seller.
- Representations and guarantees that have to do with environmental matters.
- Tax risks arising from corporate reorganisations or restructurings.
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