In recent years, the use of representations and warranties insurance (RWI) in mergers and acquisitions (M&A) transactions has experienced dramatic growth worldwide. Consequently, deal participants in Latin America are showing increasing interest in the product. This Holland & Knight alert is intended to outline the basics of RWI for those who are not yet familiar with it.
Introduction
RWI is a form of transactional insurance that is commonly used in many M&A transactions in the U.S. and Europe with the purpose of compensating the buyer for financial losses resulting from breaches of the representations and warranties made about the target company in the transaction’s purchase agreement or breaches of the seller’s obligation to pay for pre-closing taxes in lieu of a traditional seller indemnity. Once closing has occurred, the RWI policy protects the insured from unanticipated losses that are caused by such breaches.
The insurer will pay the insured for losses resulting from a breach of the representations or the pre-closing tax covenant in the purchase agreement that is in excess of the policy’s retention. A retention, similar to a traditional deductible, is the total amount of losses that parties other than the insurer must absorb before the policy provides any coverage to the insured.
Nuts and Bolts of RWI
What Is the Underwriting Process, and How Does It Work?
The initial step in obtaining a RWI policy is to secure quotes for coverage from one or more insurers. A buyer seeking to purchase a policy will typically use an insurance broker for this. Based on preliminary information about the deal – including the target’s financial statements, a draft of the purchase agreement and any information memorandum about the target – insurers will provide an initial non-binding indication of interest letter (NBIL) setting out the main terms on which they propose to offer coverage, including the premium, retention, possible exclusions and areas of heightened risk.
After analyzing and comparing the NBILs, the buyer will select an insurer and proceed to underwriting, which typically takes one to two weeks but can occur as quickly as necessary to accommodate the timing of the underlying transaction. The first step in the process is to pay the underwriters an upfront, nonrefundable underwriting fee that will depend on the transaction size, complexity and possibly other factors. Then, the underwriters and their counsel are given access to the deal’s data room, transaction documents and diligence reports, which they will review.
Once the abovementioned diligence materials are reviewed, an underwriting call will be scheduled. This call takes approximately two hours and requires the attendance of the buyer’s deal team members, its counsel and other third-party diligence providers, the underwriter and its counsel. The call will include sections devoted to the specialty areas of due diligence such as tax, financial, regulatory, environmental, corporate and labor and benefits. On this call, the underwriters and their counsel have the opportunity to ask questions about what diligence the buyer completed. Promptly after the call, the underwriter will provide the buyer with a draft policy and any follow-up questions, if needed. Negotiation of the policy (which is a standard form) and resolving any underwriting follow-ups are the final steps before coverage can be bound.
After the policy is in place, the insured can file a claim against the policy if a breach occurs. The frequent use of RWI in M&A transactions reflects its usefulness in making deal negotiations more efficient, and the market has developed a track record of paying valid claims.
Costs and Retentions of RWI Coverage
The cost of RWI varies depending on the transaction size and market conditions. The premium is a one-time lump sum paid at closing that is usually between 2 to 5 percent of the amount of coverage being purchased. RWI policies include a deductible, referred to as the retention, that is often around 1 percent of total deal value before the policy begins covering losses.
Common Coverage Limit and Exclusions for RWI
While coverage can usually be obtained for up to 100 percent of the purchase price, most buyers purchase coverage for 10 percent to 15 percent of the deal’s value, mirroring the amount of coverage they would receive under a typical seller indemnity. RWI will typically cover the full scope of the representations negotiated by the two parties, although it is standard for RWI policies to exclude coverage for losses that result from breaches about which the insured has actual knowledge, purchase price adjustments, breaches of covenants (other than the pre-closing tax indemnity), unfunded/underfunded pension plan liability, the use of net operating loss carryforwards and losses from “interim breaches,” which both arise and are discovered between signing and closing. There can also be additional exclusions in the Latin American context for corruption, expropriation and/or changes in law.
Why You Should Consider RWI for M&A Deals in Latin America
As explained above, RWI offers an important risk allocation solution and can bring significant benefits to both the buyer and seller. The primary benefit is that it aligns otherwise incompatible interests and expectations in the transactions, allowing a clean seller to exit from the target company, while providing the buyer with protection against unknown contingencies that might otherwise significantly reduce the target company’s value, absent recourse. The use of RWI also reduces transaction costs by streamlining and simplifying the negotiation of the purchase agreement between the parties, particularly with respect to the scope of the representations and warranties, and by potentially eliminating or significantly reducing indemnification and escrow discussions.
