Representations and Warranties Insurance FAQ, Part I

September 17, 2014

With increasing frequency, parties to merger and acquisition (M&A) transactions are using representations and warranties insurance policies as an element of their deals. Lewis Rice attorneys are aware of this general trend and also have seen it in the deal activity of our clients. We have seen that in some cases, these policies aid the deal parties with their negotiations.

Lewis Rice attorneys have a unique understanding of these policies. For more than a decade, we have represented a managing underwriter of such policies. During the past five years, we have worked on the underwriting side of more than 40 such policies. This underwriting experience, combined with our representation of buyers and sellers in M&A deals, allows us to efficiently and thoughtfully counsel our clients regarding these insurance policies.

Below is Part I of frequently asked questions regarding representations and warranties policies.

FAQ #1: How does a representations and warranties policy work?

The policy creates a pool of funds from which the insured can recover for loss arising from an inaccuracy in the seller's representations and warranties stated in the M&A deal's purchase agreement.

FAQ #2: Can't the same goal be achieved by placing a portion of the purchase price into escrow?

Although an escrow account establishes a pool of funds for the buyer's recovery, a seller is typically reluctant to hold back a significant portion of the purchase price in escrow. Contentious negotiations regarding the amount of the escrow, the terms of its release, and the terms of the underlying seller's indemnity sometimes result. Proponents of representations and warranties policies contend that using such policies—rather than solely relying upon an escrow—provides the deal parties a route around such contentious negotiations.

FAQ #3: What are the fundamental components of a policy?

The policy will have a coverage dollar limit, a coverage period, and a retention amount (which amount functions as a non-tipping basket). The policy will identify the representations and warranties that are the subject of coverage (by reference to one or more sections of the M&A deal's purchase agreement). Also, the policy will exclude from coverage, losses arising from certain matters. An example of a typical exclusion is loss arising from a matter of which the insured had knowledge.

FAQ #4: If the losses that are covered arise from an inaccuracy in the seller's representations and warranties, does that mean that only buyers obtain these policies?

No. These policies are purchased by buyers and by sellers. A common motivation for a seller who obtains a policy is to establish a pool from which that seller's indemnity obligations can be paid and to allow that seller to distribute a greater share (or all) of the purchase price to its owners in connection with the closing.

FAQ #5: How does a policy work in a deal where a portion of the purchase price is escrowed?

The policy terms can be tailored to work regardless of whether there's an escrow account. If there is no escrow account, then the policy provides coverage from the point after which the retention amount is depleted. If there is an escrow account, then typically the retention amount is set at the point at which the escrow account is depleted.