Half of all merger and acquisition deals are subjected to post-closing price adjustment claims. Traditionally, these disputes were resolved through working capital adjustments, earn-outs or indemnification payouts — solutions that frequently cause unwelcome delay and increased contentiousness. Attorneys often found their requests for more diligence at odds with the clients’ desire to close the deal quickly.
Representations and warranties insurance policies were developed to address the dealmaker's need to leave no stone unturned while remaining nimble. Although early policies were costly and riddled with exclusions, the reps and warranties industry has evolved and expanded. Today, approximately 25% to 33% of private M&A deals provide for reps and warranties coverage as recourse for breaches of representations or warranties in purchase or merger agreements.
The policies can insure either the buyer or the seller, but most policies purchased insure the buyer against breaches by the seller. Often used in addition to or in place of indemnity, the coverage can attract better offers by offering greater indemnification, ease concerns regarding collection, and preserve relationships by shifting risk to a third party.
Seller-insureds might use a reps and warranties policy to manage their own risk or successor liability, whereas buyer-insureds might look to the coverage to distinguish a bid in a competitive auction or mitigate credit risk in a distressed asset setting.
The American Bar Association estimates that between 12% and 17% of policies purchased are subjected to claims. An American International Group Inc. 2016 study — What Happens After the Deal Closes? Representations and Warranties Insurance Global Claims Study — estimates that about 14% of reps and warranties policies issued between 2011 and 2014 reported a claim. And other sources put the number as high as 35%, depending on the year.
Representations and warranties related to financial statements, taxes, contracts and intellectual property are most the most common sources of claims, but claims can also cover unexpected events such as civil antitrust judgments — breach of representation that the seller complied with all laws — or fraud by a third party resulting in overpayment by the target company.
Many reps and warranties policies require claims to be resolved through confidential arbitration, resulting in a dearth of information on the outcome of these claims. But certainly, the proliferation of the coverage has led to a growing pool of claims to be resolved in relatively uncharted territory.
A few considerations policyholders navigating this process must consider include constraints on evidence, consistency when litigating parallel claims, and avoiding conflicts.
While reps and warranties policies are often tailored to a particular deal, the process for filing a claim is usually straightforward:
1. A breach is discovered, and proper notice is sent to the insurer.
2. The policyholder submits proof of loss, a calculation of damages and details on the facts and circumstances surrounding the breach.
3. The insurer conducts a comprehensive review to evaluate whether there is a breach covered by the policy, whether there are relevant exclusions and whether loss flows from the breach.
4. The insurer and policyholder endeavor to negotiate a settlement.
5. If no settlement is reached, the claim proceeds to the dispute resolution process in the agreement, often a confidential and closed arbitration.
Closed arbitrations limit admissible evidence to the parties’ submissions during the initial notice of claim and investigation process. But, as previously stated, buyer-side reps and warranties insurance is often used to entice sellers by relieving them from involvement in post-closing claims. Where the breaching seller is not a party to the claims process and cannot be relied upon to provide information and evidence on the alleged breach, presenting sufficient evidence can prove challenging.
Policyholders on the buyer side of transactions must therefore consider the constraints and limitations of a policies’ arbitration clause at the outset, resist a false sense of security and be diligent in gathering information from the seller prior to closing. Post-closing cooperation clauses are one possibility but unlikely to have much practical effect. This is particularly true where the insurer may seek to recover its payout from the breaching party, although the insurer typically has no subrogation rights against the seller under R&WI policies, except for instances of fraud.
Policyholders and their counsel must also maintain a consistent approach where both indemnity and insurance funds are available as recourse.
Some policies are structured to replace escrow and indemnification altogether (e.g. where an escrow is impossible, such as bankruptcy, public company transactions, etc.), whereas others are used to supplement those obligations (e.g. a buyer-side policy where the seller is responsible for paying a portion of the retention with escrowed funds). However, negotiating the settlement of indemnity claims in parallel with reps and warranties claims requires attention to consistency.
Policyholders seeking full damages from insurers must be just as diligent in pursuing indemnity funds, lest they arouse skepticism from the insurer.
Finally, insureds must carefully consider who will litigate R&WI claims submitted to dispute resolution. Naturally, when a deal dispute arises, transactional lawyers are quick to call a litigator in their own firm. And there can be efficiencies when the firm who “did the deal” handles the dispute: they have cleared conflicts with the client, built relationships, and become familiar with the diligence and events that led to the dispute at hand. However, if the firm’s underlying deal work becomes an issue in litigation of an R&WI claim or other dispute, the law firm’s work can be called into question.
Jennifer Oliver is counsel at MoginRubin L.L.P. in San Diego. She joined the firm in 2017 after nearly 10 years practicing as a complex business litigator in New York. Her practice is focused on antitrust and complex business and investment litigation. She can be reached at email@example.com and 619-687-6611.