The representations and warranty insurance in M&A deals – How does it work ?

Representations and Warranty Insurance

 

A. Purpose

1. The purpose of the representations and warranty insurance is to cover the financial consequences of claims resulting from a breach of any representations and warranties made by the Seller.

2. The common goal of parties is to ensure that the commitments contained in the Acquisition Agreement matches with the provisions of the insurance contract as accurately as possible. If this condition is satisfied, the contract serves its purpose for both parties: for the guarantor, it transfers the risk of the representations and warranty insurance to a third party; for the beneficiary, it ensures effective coverage of the insolvency risk of the guarantor.

B. How does it work

1. There are two types of representations and warranty insurance: one subscribed by the Seller (a sell-side policy) which purpose is to operate as a civil liability insurance (indemnification of the Seller should the buyer be called as collateral; the other subscribed by the buyer (buy-side policy) which operates as a damage insurance (indemnification of the buyer for the financial consequences of the Seller’s breach of representations and warranties).

a. If the insurance is subscribed by the Seller,

i. When carrying out the insured risk, the insurer shall indemnify the Seller up to the amount of the indemnities owed to it in respect of the implementation of the liability guarantee. For the sake of efficiency, the Seller may stipulate in the insurance contract a direct payment of indemnities to the beneficiary of the guarantee (this is a stipulation for others).

ii. As the contract of insurance is a random contract, only uncertain events for the parties may be covered (article 1108 section 2 of the French civil Code); the policy cannot be put at stake in the event of deceptive or fraudulent behavior of the Seller at the time of the negotiation and execution of the liability guarantee since the hazard would be lacking here

b. If the insurance is subscribed by the buyer,

i. Unlike the policy subscribed by the Seller, the policy subscribed by the buyer allows the insurer to finance the indemnities due by the Seller before any recourse. Hence in case of claim under the warranty, the buyer files a claim directly with the insurer.

ii. As regards the scope of the insurance policy, it is more extensive than that of the policy subscribed by the Seller since the fraudulent behavior of the Seller cannot be automatically attributed to the buyer so that the damage remains covered by the guarantee.

2. The insurance premium, which generally ranges between 2% and 5% of the total coverage amount, is paid on the date of completion of the transaction and its payment constitutes a condition precedent for the insurance coverage to become effective.

3. By its very nature, certain risks are excluded from the insurance coverage. These typical exclusions include the following:

i. Claims with a triggering event which took place after the effective date of the sale / capital increase;

ii. Claims triggered by a willful dissimulation or fraudulent behavior of the insurance subscriber;

iii. Claims already covered by other insurance policies usually subscribed by a company, such as, for example, disputes arising from the sale of goods or services covered by product liability insurance contracts or professional indemnity insurance contracts, or dubious debts covered by credit insurance policies;

C. Advantages of the representations and warranty insurance

1. Whatever the party concerned

a. Propensity to pacify the relations between Seller and buyer.

b. In the specific case of private equity transactions, the guarantee given by the warrantor to the investor can quickly alter their relationship. The intercession of a third party, the insurer, as guarantor to resolve conflicts resulting from the enforcement of the liability guarantee, is likely to facilitate the maintenance of good relationships, the latter being an absolute condition to the success of a capital investment operation.

c. Utility for capital increases: the representations and warranty insurance is particularly suitable for equity-taking operations by capital increase. Indeed, in such operations granting a guarantee (cautionnement) or a first demand guarantee (garantie à première demande) can reveal difficult. Since the proceeds of the capital increase are paid to the company and not to the guarantor, the latter, except to dispose of other personal assets, will not have resources that can be made available to the benefit of a bank in return for the grant of a security or an independent guarantee to the investor...

d. Flexibility of the mechanism, since it can be subscribed indifferently by the buyer or the Seller.

e. Efficiency since the guarantor (insurance company) is solvent.

2. From the Seller’s point of view

a. Contrary to traditional counter-guarantees, the insurance allows that the transfer price be fully apprehended by the Seller at the closing, with lesser or no amounts having to be immobilized in anticipation of a performance of the security (whether in the form of an escrow or of a guarantee of a first-demand bank guarantee for example). This therefore allows the Seller to secure its offer without being compelled to freeze the proceeds of the sale.

b. Insurance allows the Seller not to be exposed on a long-term basis.

c. Insurance may allow the Seller to organize its personal and patrimonial foresight without waiting for the end of the guarantee period; isolating the proceeds of the sale from all future claims is an efficient way to allow him to organize its inheritance through donations for instance.

d. Insurance can allow the protection of key relationships.

e. Insurance can enable strategic positioning in the context of an acquisition bidding process: by incorporating liability insurance coverage, the Seller can expect higher bids.

f. Insurance may be useful to compensate for the inability to make guarantee commitments (e.g. for funds or for a Seller who bought the company only recently): the Seller may be required to resell a business acquired just one year before and may therefore not be prepared to grant guarantees for a period prior to his date of acquisition.

g. During the period of validity of the liability guarantee, the insurance policy covers not only the financial consequences derived from the enforcement of the liability guarantee, but also the costs of expertise and litigation

3. From the Buyer’s point of view

a. The insurance contract allows the buyer to turn directly to the insurer in the event of a breach, without having to turn first to the Seller.

b. The transferor's credit is strengthened by a more effective risk coverage and such coverage can possibly be granted for a longer period of time.

c. The contract of insurance may allow a strategic positioning of the buyer in the context of a bidding process for acquisition: The buyer who opted for the insurance may differ from the other buyers by requesting a guarantee ceiling which is lower than its competitors and by offering to the Seller less a safer exit (clean exit).

d. The contract of insurance may allow the avoidance of contentious negotiations and legal proceedings (the Seller can be in possession of key skills or have a network which the buyer wishes to benefit of after the sale, or the buyer may be dependent on its future business relationship with the Seller once the deal is signed). This allows the Buyer to avoid jeopardizing his relationship with the Seller.

e. In the case of multiple Sellers, the contract of insurance can simplifies the management of the liability guarantee and the process of filing of claims under such guarantee (e.g., in case of sale of a family business with several generations of Sellers, or in case of sale of a business partly owned by natural persons (managers or family shareholders) and partly owned by financial investors).

f. The contract of insurance can allow for the "rapatriation" of the jurisdiction in the place that suits the buyer better. Indeed, international legal proceedings are much more complex and costly than domestic ones. If, at the buyer’s request, the Seller subscribes to a contract of insurance governed by the law of the buyer and issued by an insurance company located in the same jurisdiction as the buyer, this will facilitate legal actions by the buyer.

D. Disadvantages

1. High cost of this technique (2 to 7% of the amount of the guarantee sought) compared to the traditional techniques of guarantee of the representations and warranty insurance (this insurance is applicable to operations of transfer of a certain volume: 50 million of €).

2. The subscription of a representations and warranty insurance is part of a complex mechanism. Particular attention should be paid to the harmonization and the proper articulation of the stipulations of the Acquisition Agreement and the insurance policy.

Dominique Dumas - Partner - Corporate / M&A / Business

Courtois Lebel, Attorneys at law, 13 Ter Bd Berthier, 75017 Paris. Tel. 01 58 44 92 92