What Representation and Warranty Insurance is and the protections it offers

Join Arjun Murthy, Managing Director at Cascade Partners, and special guest, Justin Hanna, Partner at Taft Law, for an engaging two-part Cascade Conversations!

Part 2: Discover the significance of Reps and Warranties Insurance (RWI) and its role in safeguarding all parties involved in a transaction. Don’t miss out on this informative continuation of our series.

For those who missed Part 1 of our discussion on Reps and Warranties, you can catch up by clicking here!

Transcript:

Welcome to Cascade Conversations! Join the team at Cascade Partners and their network of trusted advisors as they work to demystify details, terminology and strategies in the world of acquisitions, divestitures, financings, performance improvement and restructuring.

 

Arjun Murthy – Managing Director at Cascade Partners:
So, we’ve talked a lot about reps and warranties in the traditional sense, but we haven’t gotten to the reps and warranty insurance side. So, reps and warranty insurance is just as it sounds—it’s insurance for reps and warranties. It seems to be pretty commonplace now on the buyers’ and sellers’ side of the transaction world.

I typically see it from transactions that are typically $25 million of enterprise value up. It’s not something that has to be done, but it’s commonplace for a reason. Can you talk to us a little bit about reps and warranty insurance, some of the benefits of it and how it can streamline the negotiating process?

 

Justin Hanna – Partner at Taft Law:
Yeah. So, at its basic core, rep and warranty insurance is exactly what it sounds like. It is insurance that is provided to the parties—really to the benefit of the buyer—that if there is a breach of the statements in the purchase agreement, the reps and warranties, insurance company will step in and pay for those damages on behalf of the seller.

So, that’s more or less what it comes down to. It is a little bit more of a higher scrutiny when it comes to the due diligence process because now you have a third party coming in and insuring this company that it doesn’t know anything about. So, it’s had an opportunity to do this due diligence. So I would say that process is a little bit more scrutinized.

But in general, it means that from a sellers perspective, you don’t have to negotiate the reps and warranties as closely because you have some comfort that you’re not going to have to necessarily pay out of pocket in respect of a damages claim.

 

Arjun Murthy: Got it. So, let’s talk about this for a second. So, I’m a seller and we go through rep and warranty insurance. It makes it a bit more streamlined. Negotiate the purchase agreement, all things you mentioned above. Fast forward six months from now, I’m a buyer and I find something that I didn’t know about. So, how do I go through that process and what does that really look like and who am I going to?

 

Justin Hanna: The process of making the claim?

 

Arjun Murthy: Yeah.

 

Justin Hanna: So, hopefully that never arises, but typically the claim is made the same way as is required under the purchase agreement. The buyer—you have to follow indemnification procedures—but if there’s a direct claim, the buyer is sending an indemnification notice to the seller and to the insurance carrier. And then, that sort of triggers the process.

 

Arjun Murthy: The benefit is the liability, right? Is it as much of the seller as it is the provider. So, the seller is really on the hook for the deductible they’re splitting ideally at the beginning of the engagement or the closing of the engagement.

 

Justin Hanna: So, there is a retention amount with respect to RWI, and that’s typically around 1 percent of the coverage of the insurance itself. So, that retention amount, typically half of it will be put in escrow by a seller and the other half will be covered by the buyer.

So, it’s almost like a self insurance threshold. And then, once you’ve crossed that amount, then the seller has some comfort that they are no longer on the hook for making payments with respect these claims, other than in the case of fraud or specifically carved out exclusions from the policy.

 

Arjun Murthy: And let’s talk about that for a second. Some of these carved out inclusions, why would something be carved out? Is it because, as we’re going through diligence, it’s something that was known, so the insurance obviously doesn’t want to insure something that was a known issue. Or why else would something be carved out?

 

Justin Hanna: There are two different types of carve-outs, or at least put them in two specific buckets. There are standard exclusions, and those are things like losses resulting from a breach of a covenant from losses resulting from purchase price adjustments from forward looking statements, net operating losses, pension plan liabilities and fraud. Those are generally carved out for most policies.

And then beyond that, there are deal-specific carve-outs. Those typically are carve-outs for known issues or known liabilities. If they reach some level of materiality, the carrier is not going to cover it. I mean, if it’s something that’s de minimis or immaterial, you may still get coverage for that. But if there’s a known issue, that is typically carved out from the policy.

 

Arjun Murthy: Now, that makes sense. The last question on this has to do with broader reps and warranties and the RWI. How has the pandemic changed how some of these are being written? Has it changed material adverse effect clauses? Has it changed exclusions when it comes to RWI underwriting? Have you seen any big impacts from COVID in relation to underwriting these?

 

Justin Hanna: Yeah, I mean, I don’t know that it’s a direct result of COVID, but I would say it’s probably a direct result of the number of deals that have been in the market post-COVID. The number of carriers—a lot more carriers have gone into the market during that time—and, generally speaking, we’re seeing that the market is a lot softer. So, that means slightly lower premiums, slightly lower, potentially retention amounts, more negotiations around the exclusions. What the end result is, rather than RWI really only making sense from a financial perspective for deals that are $20 or $25 million in enterprise value; now, we’re seeing it actually can make sense for deals as low as $15 million. For a typical RWI policy, it still potentially makes sense.

Now, there’s going to be added costs, right? So, that’s the premium, oftentimes, that’s split between the buyer and the seller. And there’s also added cost of the due diligence. So, I would say, generally speaking in a typical transaction, a buyer is going to want to do a fair amount of due diligence. If it’s an asset deal, maybe slightly less than usual. An equity deal, maybe slightly more, because now they’re assuming all those liabilities when they’re acquiring a company. When there’s an RWI transaction, that level of scrutiny goes up.

That means more time on the part of both the buyer and the seller to make sure that they’ve really covered everything, including the kitchen sink. The process is typically similar to a normal M&A transaction. You know, a buyer does its due diligence, it passes along typically due diligence memorandum to the insurance company. The insurance company’s counsel then reviews that. There’s typically an underwriting call. So, they get on the phone with the business folks on the buy-side and legal counsel, and they walk through each area of scrutiny.

 

Arjun Murthy: That can be a two-day process.

 

Justin Hanna: Well, it can be a two-day process. Typically is probably a full afternoon phone call. And if you have good counsel, we try to be efficient about how quickly we get through that, but it is a process. And then they leave that call, not necessarily answering all of the questions; maybe most of them, but then they’ll pass along follow-up questions like, “We talked about this. We didn’t really have the complete picture. You didn’t give us the full answer. So, here are our follow-ups.” You respond to those follow-ups and then, eventually, you get to a point where they’ve gotten the information they need and they produce a policy, and that policy includes whatever the exclusions may be. Then, you negotiate the policy.

Once you negotiated the policy, if you’re ready to close on the business deal, you also then bind the policy at the closing. So, everyone would get on the phone—that’s buyer, seller, counsel for both sides, the underwriter and the underwriters counsel. So, everyone gets on the phone, they release signature pages and they bind the policy at the same time. And that’s how reps and warranties insurance gets implemented. But, as I was mentioning, there are slightly elevated costs during that negotiation period.

Oftentimes it’s worth it because at the end of the day, the seller gets comfort that there’s coverage for damages that occur post-closing. It can take its money and go use it as it wishes. And buyer gets comfort that there’s a collectible party on the other side. That someone is standing behind these and they’re not going to have to chase after the seller to try to recoup any of those losses.

 

Arjun Murthy: Right. And sellers are getting more of their money up front too, because it replaces that escrow, aside from whatever the deductible portion or the retention portion is.

 

Justin Hanna: Exactly.

 

Arjun Murthy: And so, it’s beneficial to both parties. We talk about as advisors, and especially talking to clients in the lower middle-market, there’s a lot of costs at the beginning of doing a transaction: attorneys, investment bankers, quality of earnings, reps and warranties insurance, etc. But all of these, there are strong rationales as to why we encourage it because, while it’s a little bit more upfront on the front end, it can save you a ton of money on the back end.

And also, every dollar in what you’re saving now, especially when it comes to things like equality of earnings, etc., there’s a multiple associated with that. And so, while transactions are expensive, I think the goal is for folks, especially on the sell-side, is to do only one in their lifetime and we want to make sure we’re setting them up for success—the best that’s possible—which includes having a great team of lawyers, accountants and investment bankers.

Justin, I appreciate your time today. This is really helpful. Sometimes, this can be a dull subject, but I think you made it very intriguing. So, thanks again.

 

Justin Hanna: Thanks, Arjun. I really appreciate you having me out.

 

Arjun Murthy: Yeah, likewise.

 

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