James S. Carter and Justin A. Chiarodo
Representations and Warranties (“R&W”) insurance has burst into the market in the last five years and now plays a key role in mergers and acquisitions (“M&A”) involving government contractors. Both private equity and strategic buyers use R&W insurance to improve their competitive position, and sellers benefit by avoiding escrows and holdbacks. In short, it can help get deals done. R&W insurance continues to evolve, and government contracts deals present unique challenges.
Below we discuss the basic aspects of this important insurance product and provide 10 tips for potential R&W policyholders to consider when evaluating policies.
What Is It? R&W insurance protects a party to an M&A transaction against unintentional and unknown breaches of a seller’s representations and warranties in the transaction agreement. The policyholder can be either the buyer or the seller, but typically it is the buyer. A “buy side” policy protects the buyer against losses due to a breach or a third-party action that would result in loss due to a representation or warranty breach. A “sell side” policy covers a seller against claims by the buyer that the seller breached a representation or warranty made at the time of closing. R&W insurance typically involves a premium payment in the range of 2.25%–3.25% of the coverage limits purchase (plus applicable fees and taxes). Coverage generally lasts up to six years for fundamental reps and up to three for other than fundamental reps. There are more than 20 primary underwriters in the market as of this writing, with coverage limits in excess of $1 billion available. So there is a robust (and growing) market for this insurance product.
What It Is Not. R&W insurance is not a substitute for due diligence. Insurers in a government contracts transaction will expect thorough due diligence relating to compliance with government contracting rules and regulations, including (among other key areas) program eligibility, compliance practices, security clearance requirements, intellectual property, data privacy, and cybersecurity. Providing adequate responses to the underwriters’ inquiries can also help the policyholder negotiate improved policy language.
A Separate Contract. Although tied to the transaction agreement, an R&W policy is a separate contract between the insurance company and the policyholder. Like most insurance policies, R&W policies feature terms, definitions, conditions, exclusions, and other limitations. A careful review of this policy language is crucial to ensuring policy purchasers are getting what they are paying for.
10 AREAS TO CONSIDER WHEN EVALUATING R&W INSURANCE POLICIES
- Loss: R&W insurance typically covers loss from a breach of representations and warranties, as well as defense costs and other costs. Policy language can vary, and some policies have more favorable wording than others. “Loss” may be defined broadly (to include any loss arising out of a breach of representations and warranties), or it may be defined as an amount that the policyholder is entitled to recover under the transaction agreement. If the latter formulation is used, it may be necessary to specify that loss is determined without respect to any limitations in the transaction agreement on recovery against the seller. Another consideration is whether the policy follows a “materiality scrape” in the transaction agreement, not just for the purpose of determining a breach, but also for determining the amount of loss. The definition of Loss must be read in connection with any exclusions pertaining to Loss. For example, does the policy exclude multiplied or consequential damages?
- Indemnity Structure: R&W insurance is often used as a substitute for a seller indemnity. But it can also be used in combination with a seller indemnity. The parties should pay close attention to how the coverage under the policy will interact with any seller indemnity. For example, the parties may intend for the R&W insurance to apply in excess of the seller indemnity. It may be important that the policy contains language that clarifies that the seller’s payments erode the retention in the policy, and, in any event, coverage above the retention is not contingent upon obtaining recovery from the seller. Or the parties may intend for the seller indemnity to apply in excess of the R&W insurance. In that situation, the policy and the indemnity provision should be reviewed to eliminate any doubt that the indemnity is secondary and excess to the coverage.
- Subrogation: Related to the indemnity structure is the concept of subrogation. If an insurer pays a loss, it typically receives whatever rights the policyholder had against the party responsible for the loss unless the insurer agreed to waive them. Often, insurers of buy side policies retain subrogation rights against the seller for intentional breaches of representations and warranties. If a buy side policy is included in a deal as a benefit to the seller, for example, the seller should carefully review the policy and the transaction agreement to ensure that any recourse that the insurer may have against the seller is in line with the seller’s expectations. The buyer will want to review the subrogation language to determine whether the insurer may have rights against a vendor, or a member of the management team, or anyone else with whom the buyer may have a continuing relationship.
- Exclusions: R&W insurance policies often feature so-called “standard” exclusions. These are exclusions commonly seen in R&W policies (although the language of the exclusions is not necessarily standardized). For example, standard exclusions exclude coverage for issues known by the buyer’s deal team, pension underfunding, net operating losses, and transfer pricing. Polices may also include “deal-specific” exclusions intended to address underwriters’ concerns related to a particular transaction. Insurers may be willing to narrow or remove deal-specific exclusions and, sometimes, certain standard exclusions based on due diligence. If it is not possible to remove an exclusion, policyholders should attempt to narrow the scope of the exclusions by, for instance, limiting them to that portion of loss that implicates the exclusion.
- Professional Services Exclusion: In deals involving professional service contractors—which squarely impacts the Government Services marketplace—parties should be especially wary of professional services exclusions. Such exclusions, if broadly drafted, could be read to apply to virtually any aspect of a company that provides professional services. Policyholders should request that such exclusions be removed or narrowed.
- Cyber/Data Privacy Exclusion: Cyber/data privacy exclusions are increasingly common. For transactions involving contractors that provide cyber-related services or handle confidential information, such exclusions may be unavoidable. But insurers may be willing to narrow such exclusions in response to thorough and careful due diligence efforts. Parties should also consider to what extent any cyber, errors and omissions, and/or directors and officers coverage may apply to a cyber event discovered once the transaction is complete. The insurer may be willing to modify an exclusion on the condition that such other insurance applies first.
- Choice of Law and Arbitration Provisions: Many R&W insurance policies require arbitration to resolve coverage disputes under the policy between the insurance company and policyholder. Policyholders should consider whether a mandatory arbitration clause is in their interest. Some policies provide for arbitration but make it optional at the policyholder’s election. Any arbitration clauses should provide for a fair method of selecting arbitrators. The choice of law provisions in R&W insurance policies typically select New York law (regardless of what law applies to the transaction agreement). Policyholders should consider whether they would be better off with the selection of another state’s law or removing the choice of law provision altogether.
- Other Insurance: R&W policies contain other insurance clauses indicating that the coverage broadly provided under the policy applies in excess of any other applicable insurance. Such provisions could give rise to disputes over which insurer must pay, or pay first, while the policyholder waits for payment. It may be appropriate to ask the insurer to clarify that any disputes over which insurer must pay shall not serve as a basis to delay payment to the policyholder.
- Notice: Like other types of insurance policies, R&W policies require timely notice in order to perfect a claim. Most policies require notice as soon as practicable and/or within a certain number of days. Policies should feature no prejudice provisions to reduce the risk of losing coverage due to untimely notice. Such provisions preserve coverage in the event of late notice except when and to the extent that the insurer can demonstrate that it was actually prejudiced. In all events, policyholders should familiarize themselves with the notice provisions. Some R&W policies require notice when the policyholder, or one of its specified officers, gains actual knowledge of a breach of the representations or warranties, loss, or third-party claim. In other R&W policies, notice is triggered by knowledge of any matter that could give rise to a breach.
- Defense: Buy side and sell side policies provide coverage for third-party claims. Typically, the policyholder is responsible for defending the claim while the insurer agrees to pay defense costs. The defense provisions should specify that the insurer is required to pay defense cost invoices within a certain time period. Policies require the policyholder to obtain the insurer’s consent for defense costs. Consent requirements may give insurers some control over the selection of defense counsel, but some insurers may be willing to stipulate to the policyholder’s choice of defense counsel in the policy.
This article was originally published in the Professional Services Council’s 2018 Annual Conference Thought Leadership Compendium. Blank Rome is a proud member and sponsor of PSC.