Representations and warranties insurance (“R&W Insurance”) has been increasingly used in corporate transactions to facilitate successful negotiations. R&W Insurance is an insurance policy purchased by a party to a corporate transaction to indemnify against unknown risks and breaches by Seller of its representations and warranties made in the acquisition agreement. The following are key points to note about R&W Insurance:
R&W Insurance offers various benefits to both Buyers and Sellers in corporate transactions.
Benefits to Buyer: R&W Insurance affords a Buyer flexibility in that it allows the Buyer to offer a reduced escrow or holdback, which may be more attractive to a Seller. A Buyer can purchase higher amounts of insurance with longer coverage durations than Buyer might otherwise be able to negotiate with Seller. R&W Insurance also typically covers Seller fraud, with the insurer maintaining subrogation rights. Finally, a Seller may be more willing to agree to more extensive representations and warranties knowing that its liability may be limited to the escrow or holdback in certain respects.
Benefits to Seller: A Seller benefits from R&W Insurance in that it can allow for reduction of an escrow or holdback, allowing Seller’s shareholders to receive more proceeds of the transaction up-front. R&W Insurance can also allow a Seller to have fewer contingent liabilities post-closing, and may make a Seller feel more comfortable agreeing to broader representations and warranties, making for smoother negotiations between the parties.
R&W Insurance is not a perfect solution for either a Buyer or a Seller because its coverage may be less broad and it does not cover known breaches of Seller’s representations and warranties, breaches of covenants or special indemnities and may have various exclusions.
For known risks that are not covered by R&W Insurance or risks with liability potential of a greater magnitude than an agreed upon escrow or holdback would cover, parties to a corporate transaction can obtain contingent liability insurance, also known as contingent risk insurance (“Contingent Risk Insurance”). Unlike R&W Insurance, which insures against unknown risks, Contingent Risk Insurance is purchased by parties to cover certain contingent, known risks. Contingent Risk Insurance may be purchased alone or in addition to R&W Insurance. Contingent Risk Insurance transfers a known or uncertain contingent liability, often identified during the due diligence process of a transaction, from a company’s balance sheet to an insurance company. Contingent Risk Insurance might also be purchased by a company in the context of a financing transaction to quell concerns of investors or lenders concerning a specified known risk faced by the company. Types of known risks for which Contingent Risk Insurance coverage may be offered are the following:
The following are key points to note about Contingent Risk Insurance:
The central benefit of Contingent Risk Insurance is that it can be used to eliminate obstacles to consummation of a transaction because the risks covered by Contingent Risk Insurance are often issues that might otherwise cause a Buyer to cease negotiations or request a purchase price adjustment or special indemnity to compensate for material issues discovered in due diligence. With Contingent Risk Insurance, neither Buyer nor Seller assume the potential risk, facilitating successful negotiations and consummation of transactions.
While it is most time-efficient to obtain Contingent Risk Insurance prior to entering into negotiations, as discussed below, a contingent risk may arise while negotiations are ongoing. For instance, if a Seller is named as a plaintiff in litigation in the midst of negotiating a transaction, Contingent Risk Insurance may be an option to cover a potential adverse verdict that may exceed Seller’s existing liability insurance policy limits. Contingent Risk Insurance can be used to salvage a transaction that might otherwise be put on hold or abandoned altogether due to unforeseen circumstances.
While R&W Insurance policies can usually be obtained fairly quickly, Contingent Risk Insurance policies may take more time to acquire as insurance companies must evaluate various aspects of the specific risk to be insured. Given this lead time, insurance companies suggest beginning the process of obtaining a Contingent Risk Insurance policy as early as possible.
Ideally, for known risks that Sellers believe may adversely affect their abilities to negotiate transactions with potential Buyers, Sellers would anticipate what aspects of their businesses may present known risks and obtain Contingent Risk Insurance in advance of potential transactions to insure that closings will not be held up by Buyers’ concerns. Having Contingent Risk Insurance for certain known risks prior to initiating negotiations may make negotiations proceed more smoothly.
Michele Kloeppel and Allyson Coyne are members of Thompson Coburn’s Corporate Finance & Securities practice.
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