The impact of representation and warranty insurance in indemnification provisions of M&A purchase agreements
Blog Post
In our blog post titled “Representation and Warranty Insurance 101” we provided an introductory summary to the concept of representation and warranty insurance as it relates to the use of such insurance policy in M&A transactions. This blog post further elaborates on the impact of such product on the various indemnification provisions of a purchase agreement.
By way of example only, if you assume a purchase price equal to $100 million, retention is likely to be $1 million and policy cap is likely to be $10 million. Thus, if there is a breach of a representation, the buyer would have the right to recoup from the policy those losses that exceed the retention of $1 million up to the cap of $10 million. This begs the question of where and how is the buyer supposed to recover the dollars before their losses reach the retention threshold and (to the extent applicable) losses that exceed the cap of $10 million. As the rest of the article points out, the result is different depending on whether there is a breach of an ordinary representation or a fundamental representation.
As it relates to losses incurred from breaches of ordinary representations up to the threshold of the policy retention amount, the typical way to handle it in the purchase agreement is by splitting the retention amount in half between the buyer and seller. Practically speaking this means that, with respect to ordinary representations, parties impose a deductible equal to 50 percent of the retention amount and a cap on the seller’s exposure with respect to such losses equal to the other 50 percent, which will be paid through an indemnity escrow amount that the parties will negotiate. Note that the deductible referenced here is the deductible under the purchase agreement. This is different from the retention amount, which is the deductible of the insurance policy.
Going back to our example from above, the deductible would be $0.5 million and the seller’s cap on losses the buyer incurs as a result of a breach of an ordinary representation would be comprised of the other $0.5 million. Hence, if there is a breach of an ordinary representation and the buyer’s losses related to such breach equal $4 million, the buyer would have to incur the first $0.5 million of losses due to the deductible, recover $0.5 million from seller’s indemnity escrow, at which point the retention of the policy would have been met and the policy would pay the buyer the remaining $3 million.
Another (buyer favorable) way to deal with losses incurred up to the retention amount is to provide that the first $0.5 million threshold will be a tipping basket as opposed to a true deductible. If the parties agree to a tipping basket, the outcome in our $4 million example would change dramatically: the buyer would recover the first $1 million of losses from seller’s indemnity escrow amount, at which point the retention of the policy would have been met and the policy would pay to buyer the remaining $3 million.
Depending on the leverage of the parties, instead of “splitting the retention in half”, sometimes parties agree to a retention split of 75 percent deductible and 25 percent seller cap, which is a seller favorable treatment due to the higher deductible. If this is how the purchase agreement is negotiated, then the outcome in our $4 million example would be that the buyer incurs the first $0.75 million of losses, recovers $0.25 million from seller’s indemnity escrow, and then recoups the remaining $3 million from the insurance policy.
Note that in all examples provided above, including the one with the tipping basket, if the buyer’s losses stemming from a breach of an ordinary representation do not rise to the level of the specified threshold in the purchase agreement (whether that is $0.5 million or $0.75 million or somewhere in between), then buyer would have to simply incur such loss. For example, if an ordinary representation was breached and the buyer incurred $0.3 million of losses for such breach, then it is most likely that buyer would just have to incur such loss because neither the deductible nor the tipping basket would have been triggered, and the insurance policy does not apply until losses reach the retention amount. This is the reason why, in certain instances, buyers ask that all first dollar damages related to ordinary representations under the purchase agreement should be split 50 percent by buyer and 50 percent to be paid by seller’s escrow, regardless of the amount of such losses. Under such circumstances, assuming that buyer’s losses for breach of an ordinary representation amount to $0.3 million, buyer can recover $0.15 million from seller’s escrow and not be out of pocket for the entire $0.3 million.
It is difficult (and arguably unreasonable) to ask that the deductible should apply to fundamental representations such as ownership of shares, authority to sign the agreement and other representations or similar importance. Therefore, buyers ask and usually receive a seller indemnity escrow amount equal to the policy retention amount. In our example where the purchase price is $100 million, such indemnity escrow amount is likely to be $1 million. If buyer suffers $4 million of losses due to a breach of a fundamental representation, then buyer would be able to recover the first $1 million from the indemnity escrow amount, and the remaining balance of $3 million from the insurance policy. Even though the indemnity escrow amount in this hypothetical transaction would be equal to $1 million, it is still a lot better than a standard M&A transaction that does not use representation and warranty insurance where the amount of seller’s indemnity escrow is typically equal to 10 percent of the purchase price. This is one of the great benefits of using representation and warranty insurance (i.e., as a seller, you are unlocking value for your shareholders by distributing more proceeds at closing than you would be able to do otherwise).
On the flip side, buyers usually ask that their ability to recover losses stemming from breaches of fundamental representations should not be limited by the coverage limit of the policy. Instead, they should be able to have recourse against seller after such policy limit is exhausted up to the amount of the purchase price received by seller.
Going back to our example where the purchase price is $100 million, and assuming that the buyer suffers $60 million of losses due to a breach of a fundamental representation, buyers frequently argue that they should receive the first million from the indemnity escrow amount, then go after the policy up to its cap, and the remaining difference would be paid by seller. Obviously, sellers are prone to push back on this point by arguing for a “true hard cap” equal to the policy limit, and arguing that buyer controls the terms of the policy it procures and buyer should purchase a policy with a high enough coverage limit. Some sellers agree to a “purchase price cap” but the buyer still remains concerned if seller is a fund that will distribute the proceeds to its investors and have no assets after the closing. The solution to this dilemma also depends on the negotiation power of each side and the level of due diligence performed before closing. More often than not, parties find a middle ground solution that involves the use of holdback provisions, additional or special escrows, earn-out and promissory note set-off provisions, guaranties from ultimate owners of the business, or simply an unsecured contractual right to sue seller if losses for fundamental representations exceed the coverage limit of the policy.
The foregoing points represent mere examples of issues that need be negotiated between parties when representation and warranty insurance is utilized in an M&A deal. For information on whether R&W insurance is appropriate for your deal and to assist you in obtaining a policy for your M&A transaction, contact the attorney listed below.
What is representation and warranty insurance?
Representation and warranty insurance is an insurance product used to “complement” traditional escrow and indemnification measures. I note the word “complement” because it is atypical for the policy to serve as the sole source of recovery if losses are suffered due to a breach of a representation in the purchase agreement. Insurers want the parties to have some “skin in the game” in order to ensure the integrity of the diligence process, and this is usually accomplished by providing for a small indemnity escrow in the purchase agreement and other means. In essence, the policy serves the purpose of shifting risk to the insurance provider, as opposed to allocating that same risk to a buyer or seller. There are buyer and seller side policies in the marketplace but the most common ones are buyer side policies because they offer better terms. In such policies, the buyer is the insured party and, if the buyer suffers a loss that is covered under the policy, the buyer would have the right to file a proof of loss claim directly with the insurance provider.What is covered by representation and warranty insurance?
A representation and warranty insurance policy covers losses stemming from breach of a representation that are in excess of the retention and up to the coverage limit of the policy. Retention refers to the deductible under the policy (usually 1-2 percent of purchase price), and the coverage limit refers to the cap of the policy (usually in the range of 10-25 percent of the purchase price). Note that the lower the retention and the higher the coverage limit, the higher the premium will be, which is the price that you have to pay to procure the policy (usually in the 2-4 percent range of the coverage limit). The coverage period under the policy varies from three years for ordinary representations to 6 years for fundamental representations.By way of example only, if you assume a purchase price equal to $100 million, retention is likely to be $1 million and policy cap is likely to be $10 million. Thus, if there is a breach of a representation, the buyer would have the right to recoup from the policy those losses that exceed the retention of $1 million up to the cap of $10 million. This begs the question of where and how is the buyer supposed to recover the dollars before their losses reach the retention threshold and (to the extent applicable) losses that exceed the cap of $10 million. As the rest of the article points out, the result is different depending on whether there is a breach of an ordinary representation or a fundamental representation.
Losses Stemming from Breaches of Ordinary Representations
As it relates to losses incurred from breaches of ordinary representations up to the threshold of the policy retention amount, the typical way to handle it in the purchase agreement is by splitting the retention amount in half between the buyer and seller. Practically speaking this means that, with respect to ordinary representations, parties impose a deductible equal to 50 percent of the retention amount and a cap on the seller’s exposure with respect to such losses equal to the other 50 percent, which will be paid through an indemnity escrow amount that the parties will negotiate. Note that the deductible referenced here is the deductible under the purchase agreement. This is different from the retention amount, which is the deductible of the insurance policy.
Going back to our example from above, the deductible would be $0.5 million and the seller’s cap on losses the buyer incurs as a result of a breach of an ordinary representation would be comprised of the other $0.5 million. Hence, if there is a breach of an ordinary representation and the buyer’s losses related to such breach equal $4 million, the buyer would have to incur the first $0.5 million of losses due to the deductible, recover $0.5 million from seller’s indemnity escrow, at which point the retention of the policy would have been met and the policy would pay the buyer the remaining $3 million.
Another (buyer favorable) way to deal with losses incurred up to the retention amount is to provide that the first $0.5 million threshold will be a tipping basket as opposed to a true deductible. If the parties agree to a tipping basket, the outcome in our $4 million example would change dramatically: the buyer would recover the first $1 million of losses from seller’s indemnity escrow amount, at which point the retention of the policy would have been met and the policy would pay to buyer the remaining $3 million.
Depending on the leverage of the parties, instead of “splitting the retention in half”, sometimes parties agree to a retention split of 75 percent deductible and 25 percent seller cap, which is a seller favorable treatment due to the higher deductible. If this is how the purchase agreement is negotiated, then the outcome in our $4 million example would be that the buyer incurs the first $0.75 million of losses, recovers $0.25 million from seller’s indemnity escrow, and then recoups the remaining $3 million from the insurance policy.
Note that in all examples provided above, including the one with the tipping basket, if the buyer’s losses stemming from a breach of an ordinary representation do not rise to the level of the specified threshold in the purchase agreement (whether that is $0.5 million or $0.75 million or somewhere in between), then buyer would have to simply incur such loss. For example, if an ordinary representation was breached and the buyer incurred $0.3 million of losses for such breach, then it is most likely that buyer would just have to incur such loss because neither the deductible nor the tipping basket would have been triggered, and the insurance policy does not apply until losses reach the retention amount. This is the reason why, in certain instances, buyers ask that all first dollar damages related to ordinary representations under the purchase agreement should be split 50 percent by buyer and 50 percent to be paid by seller’s escrow, regardless of the amount of such losses. Under such circumstances, assuming that buyer’s losses for breach of an ordinary representation amount to $0.3 million, buyer can recover $0.15 million from seller’s escrow and not be out of pocket for the entire $0.3 million.
Losses Stemming from Breaches of Fundamental Representations
Fundamental representations are treated differently because of two main reasons: the deductible does not usually apply to such representations, and buyers argue that they should be able to recover losses exceeding the policy coverage limit.It is difficult (and arguably unreasonable) to ask that the deductible should apply to fundamental representations such as ownership of shares, authority to sign the agreement and other representations or similar importance. Therefore, buyers ask and usually receive a seller indemnity escrow amount equal to the policy retention amount. In our example where the purchase price is $100 million, such indemnity escrow amount is likely to be $1 million. If buyer suffers $4 million of losses due to a breach of a fundamental representation, then buyer would be able to recover the first $1 million from the indemnity escrow amount, and the remaining balance of $3 million from the insurance policy. Even though the indemnity escrow amount in this hypothetical transaction would be equal to $1 million, it is still a lot better than a standard M&A transaction that does not use representation and warranty insurance where the amount of seller’s indemnity escrow is typically equal to 10 percent of the purchase price. This is one of the great benefits of using representation and warranty insurance (i.e., as a seller, you are unlocking value for your shareholders by distributing more proceeds at closing than you would be able to do otherwise).
On the flip side, buyers usually ask that their ability to recover losses stemming from breaches of fundamental representations should not be limited by the coverage limit of the policy. Instead, they should be able to have recourse against seller after such policy limit is exhausted up to the amount of the purchase price received by seller.
Going back to our example where the purchase price is $100 million, and assuming that the buyer suffers $60 million of losses due to a breach of a fundamental representation, buyers frequently argue that they should receive the first million from the indemnity escrow amount, then go after the policy up to its cap, and the remaining difference would be paid by seller. Obviously, sellers are prone to push back on this point by arguing for a “true hard cap” equal to the policy limit, and arguing that buyer controls the terms of the policy it procures and buyer should purchase a policy with a high enough coverage limit. Some sellers agree to a “purchase price cap” but the buyer still remains concerned if seller is a fund that will distribute the proceeds to its investors and have no assets after the closing. The solution to this dilemma also depends on the negotiation power of each side and the level of due diligence performed before closing. More often than not, parties find a middle ground solution that involves the use of holdback provisions, additional or special escrows, earn-out and promissory note set-off provisions, guaranties from ultimate owners of the business, or simply an unsecured contractual right to sue seller if losses for fundamental representations exceed the coverage limit of the policy.
Other Indemnification Implications
Many other indemnification provisions of a purchase agreement need to be scrutinized if the parties decide to use representation and warranty insurance in a transaction. For example, it is advisable that the parties negotiate an “order of recovery” section that clearly sets forth the sources of recovery that buyer has available, including the insurance policy, and the exact order in which buyer has to pursue such sources. Moreover, if you are a buyer using insurance in your transaction, make sure that your attorneys are paying close attention to the definition of “losses” in the purchase agreement, and whether such term is defined to include consequential damages. Consequential damages (such as lost profits and multiple of earnings damages) are tricky because if you specifically enumerate them as allowed damages in the purchase agreement, underwriters are likely to exclude them as recoverable damages in the insurance policy. In addition, the outcome on how consequential damages are treated depends on an analysis of the applicable state law that governs your purchase agreement. Next, because the seller has less liability exposure when an insurance policy is used, buyer should generally seek favorable terms in the indemnification section. The goal should be to remove as many hurdles to recovery under the policy as possible. Examples include no reduction for tax benefits received, no broad duty on buyer to mitigate losses, negotiate pro-sandbagging language and try to limit seller’s ability to assume defense of claims if the amount of the claim is in excess of the amount of the seller’s indemnity escrow.The foregoing points represent mere examples of issues that need be negotiated between parties when representation and warranty insurance is utilized in an M&A deal. For information on whether R&W insurance is appropriate for your deal and to assist you in obtaining a policy for your M&A transaction, contact the attorney listed below.