Representations and warranties insurance (RWI) has become more common in Texas mergers and acquisitions over the past few years. During a negotiation, sellers and buyers make specific representations and warranties about past and existing facts. Both sides rely heavily on this information for deciding to close the sale.
Traditionally, the common practice to protect against breaches of a representation or warranty has been to establish a holdback or escrow account and to provide indemnification from the seller. These funds are used to cover liabilities or losses when a breach occurs. RWI is often used to supplement or replace escrow and holdback arrangements and can also replace many indemnification obligations.
How does RWI help facilitate closings?
Either the seller or buyer can purchase RWI, but buyers procure policies in 90% of transactions to protect against sellers’ potential breaches. Having it in place can aid in closing a transaction in several ways:
- Reducing or eliminating a seller’s indemnity obligations and other liabilities.
- RWI can reduce holdback or escrow requirements that otherwise reduce proceeds sellers receive at closing.
- As a result, buyers can gain an advantage over other bidders as purchasing RWI puts money in the seller’s pockets.
- Buyers may also be better protected as purchasing RWI typically provides greater coverage against losses than holdback or escrow accounts.
RWI can also alleviate buyer concerns about a seller’s financial solvency after closing.
Key points for RWI policies
Generally, insurance companies charge a fee (premium) at closing based on a percentage of the coverage limits. Recently these have been in the 2-4% range. If the policy is $20 million, the premium can run from $400,000 to $800,000. Insurers also charge underwriting fees upon signing which may be in the $50,000 range.
Dollar amounts for policies typically equal 10% of the total enterprise value, with deductibles set at 1%. Standard exclusions apply as well as particular exclusions based on each deal, and not all seller representations and warranties are covered. Parties negotiate the policy’s term, which usually runs three to six years.
RWI should not replace due diligence
The benefits of purchasing RWI have become better understood, but these policies can be hazardous when treated as a substitute for comprehensive due diligence by buyers and sellers. Too often, one or both parties become fixated on the notion that the insurance company bears the risk instead of themselves.
This can be hazardous when all the potential pitfalls are not identified upfront. That is why it is advisable to consult with a mergers and acquisitions attorney with extensive experience guiding buyers and sellers through transactions ranging from tens to hundreds of millions of dollars. While RWI can help facilitate these transactions, it is not a substitute for proper diligence.