Reps and Warranties Insurance
Below are considerations of coverage for potential losses resulting from COVID-19 under representations and warranties insurance (RWI) policies:
- RWI is effectively “tail” insurance coverage, whereby a breach of a sale and purchase agreement (SPA) representation or the pre-closing tax indemnity (collectively representations) is discovered by the insured and notified to the insurer after the signing or closing of a corporate merger or acquisition, but where the breach relates to an event or issue that occurred prior to the signing or closing. RWI does not cover post-closing operational risks or events that first occur after policy inception.
- SPA representations are statements made by the seller or the target company itself, and relate to the condition of the business or asset being sold as of the date of the signing and closing of the acquisition. Examples of such representations include the accuracy of the financial statements or filed tax returns, the seller’s ownership of the shares or assets being sold, or the target company’s historical compliance with laws.
- The buyer is almost always the insured party under an RWI policy, and the policy indemnifies (or pays on behalf of for third-party claims) the buyer for losses resulting from sellers’ or the target company’s breaches of the SPA representations.
- More than 50% of US M&A transactions above $25M in value overall, and substantially more than 50% of private equity sponsored deals, used RWI in 2019.
- For private equity investment into certain industries, where coronavirus-related distress is already present and will grow considerably during Q2 of 2020, we are likely to see more insured buyers attempting to pursue claims under RWI policies for underperforming or nonperforming businesses in those sectors. These sectors include B2B and B2C, which were more than 25% of value and nearly 40% of volume of private equity deals in 2019. Representations on (re)insurance company transactions, which were also up in volume and value in 2019, are also potential targets of RWI policy claims.
RWI Coverage Considerations:
Does COVID-19 generally create exposure and potential losses under RWI policies?
Because RWI policies provide coverage for breaches of SPA representations, and those representations relate to historical periods of the target business or assets, most of the representations would simply not be implicated by COVID-19 exposure.
Representations likely to be explored for coverage could be compliance with law (including worker health and safety rules, like OSHA), material contract representations regarding contingencies (though contract counterparty credit or performance risk is generally excluded in any event), representations regarding material suppliers and customers, and representations going to adequacy of underlying insurance (including coverage for business interruption losses).
A separate set of representations more likely to be explored for coverage is for not-yet-audited financial statements (or management accounts) and related “no undisclosed liabilities” representations regarding Q1 2020. It seems likely that buyers would have stronger arguments for coverage under management account representations for January or February of 2020, once the impact on revenues (or necessity for reserving) became more apparent. We believe insurers will be very focused on the scope of these representations during their underwriting reviews.
Are insurers seeking to put coronavirus/COVID-19 exclusions on RWI policies?
We are currently seeing three approaches around limiting potential coronavirus exposure:
- Full policy exclusions: We are seeing around 60% of RWI insurers propose broad, policy-wide exclusions for coronavirus exposure. Below are examples of proposed exclusions we’ve seen to date:
- “Losses arising out of or resulting from any outbreak, including any pandemic or epidemic disease outbreak, relating to the COVID-19 virus (or evolution thereof).”
- “Losses arising from or relating to any business interruption or other business downturn solely to the extent such interruption or downturn arises out of the coronavirus (including any resulting COVID-19 sickness) or any government or other regulatory sanctioned response thereto).”
- “Any business interruption or other losses arising out of, or resulting from, COVID-19.”
- Others (around 20%) have taken the approach to specifically underwrite the exposure, potentially resulting in either full policy exclusions, or representation-specific exclusions – which would be preferable to a full policy exclusion.
- The third approach (taken by 20%) has been not to reference coronavirus exclusions. Several RWI insurers have, to date, taken the position that RWI as a class of business is not implicated by coronavirus exposure. It seems likely that this position will change, and that exclusions will be added, as US and global COVID-19 exposure matures.
Under a full policy exclusion, coverage would be defeated for all coronavirus related losses, including latent loss events not anticipated at underwriting – the “unknown” that RWI policies are typically designed to cover.
Are there other remedies for COVID-19 exposure under SPAs available to sellers and buyers?
Given that approximately 75% of private equity and other M&A transaction have a split signing and closing with an interim period, the following are examples of remedies that protect one of the parties against assuming COVID-19 exposure risk.
Closing Condition Examples:
- Seller protection: buyers are unable to secure financing or authorization to complete the transaction. Credit markets supplying acquisition financing have become very tight since the onset of the COVID-19 pandemic. Break fees payable to sellers may exist in addition to walk away rights.
- Buyer protection: interim financial or other target company performance covenants will likely be specified with a walk away or repricing right.
Material Adverse Change or Effect:
- Buyers will also have a general protection, in the form of a walk away right, in case there has been a material adverse change (MAC) at the target company’s business during the interim period.
- Notably, we are seeing coronavirus carveouts to MAC provisions on some deals, so that a material coronavirus event or exposure will not trigger the MAC walk away right for buyers.
Specific Indemnities, Earn-Outs and Purchase Price Adjustments:
- Post-closing, buyers and sellers can rely on specific indemnities, earn-outs and purchase price adjustments to manage target company performance risk, whether coronavirus exposure related or otherwise.