Representation and Warranty insurance (“R&W Insurance”) is becoming more prevalent in M&A transactions as buyers and sellers continue to seek ways to mitigate risk with respect to post-closing M&A disputes.  However, with the growing prevalence of R&W policies, parties must also become familiar with the often complex R&W Insurance claims process.

By way of background, a R&W Insurance policy shifts the post-closing risks associated with potential breaches of representations and warranties from the buyer and/or seller to a third party insurer.  Although R&W Insurance is available to both buyers and sellers, it is more common for buyers to purchase a R&W Insurance policy.  Buyers often consider a R&W policy to help mitigate unknown risks and to provide additional protection beyond the parties’ indemnification cap and survival limitations.  For sellers, a R&W policy can reduce the seller’s overall exposure for liability and reduce the amount of funds that are required to be held in escrow. Generally, R&W Insurance supplements or stands as a substitute to the parties’ indemnification structure and either substitutes or partially substitutes the funds being held in escrow. 

Given the increased frequency of R&W polices in M&A transactions, more information is becoming available with respect to R&W Insurance claims.  As reported by AIG, the vast majority of R&W Insurance claims arise out of transactions in the $100 million to $1 billion range, and the average successful R&W Insurance claim results in a settlement of $4 million.1 The most common R&W Insurance claims relate to financial statements (18%), tax (16%), compliance with laws (15%) and material contracts (14%).2  AIG found that parties asserted claims on R&W policies issued by AIG approximately 19.4% of the time during 2011-2016.3 

Thus, with the rising prevalence of R&W Insurance, more R&W Insurance claims are being asserted by buyers and sellers.  Given this trend, the following are some important considerations and pitfalls to keep in mind when considering a claim under a R&W policy. 

Understanding the Scope and Exclusions of the R&W Coverage

As an initial matter, it is essential to understand the scope of coverage in a R&W Insurance policy.  Although R&W policies are designed to indemnify a buyer or seller arising out of breaches of the representations and warranties in a transaction agreement, not all claims are likely to be covered.  For example, R&W policies often exclude:

  • claims for fraud or intentional criminal acts;
  • claims related to estimates, projections, forward-looking statements;
  • breaches of covenants;
  • known breaches (i.e., those discovered during due diligence);
  • breaches during the period between signing and closing; and
  • special indemnities.

Likewise, most R&W policies do not cover post-closing working capital adjustments or earn-out disputes.  As a result of the myriad of potential policy exclusions, it is important to engage sophisticated M&A litigation counsel early to navigate resolving the variety of issues that can arise after a transaction, including the R&W Insurance claims process.

The Interplay Between the R&W Policy and the Baskets, Caps and Survival Periods of the Transaction Agreement

It is also crucial to understand the interplay between the indemnity thresholds, such as baskets, caps and survival periods, of the transaction agreement and those of the R&W Insurance policy. For example, many transaction agreements include complex claims baskets, which include minimum monetary thresholds that must be met before a party can assert a claim for indemnification. The transaction agreement may also contain an indemnification cap that limits the total contractual liability for a seller or a buyer.  Similarly, transaction agreements also typically include various survival periods for different representations, which dictate the time by which a party can assert a claim for indemnification. 

A R&W policy often attempts to mirror these various thresholds. However, in certain instances, the R&W policy may be subject to different thresholds or survival periods, allowing either more or less flexibility with respect to a party’s ability to assert a claim. In fact, in many cases, the party purchasing the R&W policy may have negotiated different periods to avoid being completely bound by the transaction agreement’s limitations. Buyers and sellers must understand the interplay of these various thresholds and survival periods to understand when they have the ability to assert a claim under the R&W policy, and to ward off attempts to deny coverage. To ensure compliance with both the R&W policy and the transaction agreement, parties should engage litigation counsel familiar with both the traditional indemnity requirements and the claims requirements.

The Interplay between the Sellers’ Indemnity Obligations and Coverage Under the R&W Policy

Because R&W Insurance is often used as a substitute for or supplement to the parties’ indemnification structure, parties must understand the interplay between the R&W policy and the sellers’ indemnity obligations.  For example, the R&W policy may only apply to amounts in excess of the seller’s indemnity obligations.  The R&W policy, therefore, may only permit recovery once the indemnity is exhausted and may even require a buyer to assert and enforce its claim against a seller before providing coverage.  On the other hand, the seller’s indemnity may only apply in excess of the R&W Insurance policy.  As a result, it is crucial to understand the interplay between these provisions and litigation counsel can aid in this process.

Understanding “Materiality” for Purposes of Both the Transaction Agreement and the R&W Policy

Transaction agreements often contain materiality requirements with respect to whether a particular representation was breached or whether a party can recover damages for that breach.  Whether a breach is “material” is often fact-intensive and requires a detailed investigation of the underlying facts.   While R&W policies typically follow the materiality provisions in a transaction agreement, that is not always the case.  In fact, R&W policies may contain a “materiality scrape,” by which the R&W policy may disregard the materiality qualifications in a transaction agreement when determining whether any given representation is inaccurate or determining the amount of damages arising from any such inaccuracy, or both.  Again, litigation counsel can assist in understanding what qualifies as material and whether the R&W policy even requires materiality before triggering coverage.

Understanding What Constitutes a Loss under the Policy and When it is Covered

It is also imperative for buyers and sellers to understand what qualifies as a covered loss under a R&W policy. On the one hand, in a seller-side policy, the R&W policy will often cover the amount the seller is obligated to pay to the buyer for a breach as well as the costs of defense. On the other hand, in a buyer-side policy, the R&W policy will typically cover the damages or losses resulting from a seller’s breach or for third party claims. However, a R&W policy may exclude certain losses that may otherwise be covered under the purchase agreement, including consequential or special damages, damages relating to a purchase price adjustment or damages relating to a multiple of damages. It is also crucial to understand what showing must be made to demonstrate a covered loss under the R&W policy. For example, a R&W policy may require a party to demonstrate an “actual” loss before it can obtain coverage. What qualifies as a loss will likely vary by policy. Moreover, to demonstrate the amount of a loss, a party will be required to show the damages they suffered as a result of any breach of a representation and warranty. Claimants should retain M&A litigation counsel to help prepare a damages analysis that will be accepted by the carrier, or that would withstand scrutiny in an arbitration or court proceeding in the relevant jurisdiction in the event that a coverage dispute arises with the carrier.

Providing Proper Notice Under the R&W Policy

R&W Insurance policies also typically contain strict notice requirements. Some policies may require that claims be made as soon as practicable or within a specified period of days. In certain policies, a buyer or seller may be required to provide notice when they have actual knowledge of a claim, while in others, a buyer or seller may be required to provide notice when they have any knowledge of a potential claim. In addition, R&W policies may require differing levels of detail to be able to assert claim. For example, a R&W policy may require that a party provide “reasonable detail” when asserting a claim for coverage.  It is important to retain M&A litigation counsel to determine and comply with the proper notice requirements to ward off attempts to deny coverage.

Given the complexities of R&W coverage, parties should engage sophisticated litigation counsel familiar with the R&W claims process in the early stages to ensure that the various requirements of the R&W policy are met. For more information on asserting or prosecuting R&W claims, please contact the authors.

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  1. M&A Insurance - The new normal? AIG Global M&A Claims Study 2018 (June 21, 2018), https://www.aig.com/content/dam/aig/america-canada/us/documents/insights/aig-manda-claimsintelligence-2018-r-and-w.pdf

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