Feb 20, 2020
Representation and warranty insurance expanding in Canada
Wednesday, February 19, 2020 The Lawyer's Daily
In M&A transactions, the representations and warranties, as well as the related indemnity and holdback provisions, are major points of negotiation. The purpose of these provisions is to allocate the risk of liability between the seller and buyer. However, the required due diligence and the negotiation process can be enormously costly and ultimately the deal may fall apart as the risk cannot be allocated in a manner that is satisfactory to both parties.
How, then, can the parties reduce this burden and complete the transaction?
Depending on the transaction, representation and warranty insurance (RWI) may be the solution. Generally speaking, representation and warranty insurance will respond to and protect against losses suffered by an insured party as a result of a breach of a representation and warranty.
The prevalence of RWI in private M&A transactions has been increasing over the years, particularly in transactions involving private equity firms. Here’s a primer on representation and warranty insurance.
While RWI is not a new product in the Canadian insurance market, its use in Canadian private M&A transactions has been steadily increasing. Parties to M&A transactions in Canada are realizing the benefits of RWI in allowing them to efficiently close deals that may otherwise be bogged down in strenuous negotiations over risk allocation and costly due diligence. Insurance companies have taken note of the increased use of RWI in Canada, which has led to faster underwriting and a more competitive marketplace in terms of pricing.
What is usual risk allocation arrangement?
In a commercial transaction, the parties will look to allocate the risk of loss arising out of a breach of a representation and warranty. In allocating such risk, the parties often agree to an indemnity from the seller to the buyer secured by a holdback of a percentage of the purchase price for a period of time. The holdback provides a source of recourse in the event a loss is incurred by the buyer.
The indemnity exposure to the seller is often capped at a percentage of the purchase price. In a survey of private market deals in 2018 by Practical Law Canada, the median cap was 36 per cent of the deal value. The indemnity will also survive for a set period of time, generally between 12 and 24 months, following closing of the transaction. While these are market figures, there is no set standard and the actual indemnity and survival period will fluctuate based on the particularities of the deal.
What is standard, however, is that this point is subject to intense negotiation and can in some cases lead to a stall or breakdown of the transaction. On one hand, the seller wants to minimize the amount of capital which is held back, and on the other, the buyer needs protection for potential future losses and certainty of recourse. RWI may be useful to bridge gaps between the parties on these issues.
Benefits of RWI
This type of policy, and the protection it provides, may be beneficial to both the buyer and seller.
For the seller, RWI can replace the need to render a potentially significant amount of capital illiquid for a long period of time and allow for a clean and timely exit from a business venture.
Essentially, the policy takes the place of all or some of the purchase price which would otherwise be held back to cover potential losses. The result is that the seller can confidently use the proceeds of the sale for future investment, to pay off existing debts or distribute funds to investors.
In transactions where RWI is purchased, it is common for the indemnity cap and the survival period of the indemnity to be significantly lower than it would be where RWI is not obtained. Although there is a deductible which may be paid by the seller, that cost may be significantly less than the indemnity cap on a typical transaction.
Additionally, the seller may be a group of shareholders who may have differing levels of involvement in the business and therefore a differing knowledge regarding the accuracy of the representations and warranties. If this is the case, these passive shareholders can obtain protection from exposure to a joint and several indemnity from the seller group to the buyer by negotiating a RWI requirement.
Conversely from a buyer’s perspective, the policy provides protection for breaches of representations and warranties, which may be particularly important when engaging in transactions with notable risk. For example, the most common breach in the health sector is compliance with laws and the most common breach in the technology sector is intellectual property. Overall, the most common breach types are with financial statements, tax, compliance with laws and breaches of material contracts.
In a typical transaction, the size and duration of the holdback is merely a current prediction of future risk and potential loss, but there is no certainty. As well, while the holdback funds provide certainty of recourse to a degree, it is not always a given that the funds will be made available without dispute from the seller. Likewise, if the holdback is insufficient or there is simply an unsecured indemnity, the buyer may not be able to recover against the seller for losses in excess of the holdback, or at all, if the seller has distributed the remainder of the purchase price or has disposed of its assets.
Additionally, RWI can help a buyer distinguish its bid (while benefiting the seller) where the seller has received or expects to receive competing bids by allowing the buyer to seek less burdensome indemnity and holdback terms.
For both parties, this type of policy can also play a significant role in getting the deal done quickly and with confidence. The policy can be used to bridge gaps in the desired holdback amount and duration because RWI can extend both the duration for recourse and the available funds.
As well, a RWI policy can protect relationships between the seller and buyer. Where, for example, a passive investor purchases a significant interest in a business, the buyer and seller must maintain a working relationship and any breach of the representations or warranties could damage that relationship. Likewise, where the seller is being retained by the buyer as an employee or consultant, a RWI policy could be a useful tool to mitigate the strain on the relationship if an indemnification obligation were to arise.
This is the first of a two-part series. Up next, how RWI works, limitations of an RWI policy, where to buy a RWI policy, and for what types of M&A deals it is good for.
This article was originally published by The Lawyer’s Daily (www.thelawyersdaily.ca
), part of LexisNexis Canada Inc.
Representation and warranty insurance expanding in Canada