Acquisitions of companies can be simultaneously challenging and fascinating, given the gamut of issues one needs to take care of. Regardless of how clean and well-governed a target can be, the scope of any diligence will always be confined by the level of information provided to the buyer and its advisers. Consequently, while executing the transaction documents, the seller(s) have to provide customary and deal-specific representations and warranties which, in turn, are backed by indemnities that protect a buyer for loss suffered pursuant to their breach. Known colloquially as reps, they are material facts, statements and assertions by a party about itself and about the target being acquired. An indemnity obligation can be secured in by either putting an agreed sum which is a certain percentage of the total consideration in escrow, or permit the buyer to hold back this amount for a defined period or, as is increasingly common, by obtaining insurance to secure the payment of the indemnity claim. The last is representation and warranty insurance or RWI. It is no surprise that negotiations around them are the toughest since the primary share-purchase agreement allocates risks among the parties while the reps, warranties and indemnification provisions are tools for allocating those risks.
This newsletter examines the necessity of RWI and what parties need to be mindful of.
2. The RWI Parameters
Any indemnity is meaningful provided the indemnifier has the financial capacity to pay should the need arise. In a post-pandemic universe, financial strengths have diminished and seller(s) ability to provide enforceable indemnities in the event of a breach have declined. Enter RWI which can actually protect investments and have a meaningful impact to facilitate M&A activity. The key objective of such insurance is to provide financial protection to the insured, which is either buyer or seller, against unknown financial losses arising out of seller(s) breach of reps or warranties and which are covered by the insurance policy. RWI can reduce the negotiation time, and has the potential to permit an acquirer to claim beyond contract limitations. While either party can buy an insurance, but frequently buyers want seller(s) to do so. Nonetheless, a buyer too can buy where they do not have sufficient comfort from the seller(s) indemnity or financial ability. When seller(s) buy RWI, they aim to limit their potential losses from future indemnity claims and reallocate the risks of reps and warranty breaches.
2.1 Buyer & Seller Perspectives: Parties may elect to avail RWI for several reasons. For a seller, it may (a) help speed the deal process since there will be no need to place a large cash amount in escrow as security for its indemnity obligations; (b) it may attract higher offers because RWI could offer broader indemnification rights, particularly true in private equity transactions; (c) by purchasing a fixed cost RWI, contingent indemnification obligations may be reduced or eliminated. This is particularly important for minority seller(s) with minimal knowledge or lack of control over a target.
Viewing from the vantage point of a buyer, apart from drastically reducing the time taken for negotiations RWI (a) is a great tool to mitigate the risk of inability to enforce indemnity provisions, especially where legal processes may complicate matters; (b) policies can be customized so they can provide protection beyond a limited indemnity cap; (c) can also help in price conversations, since seller(s) often factor their post-transaction risks into the consideration; (d) enable an acquirer to claim beyond limitations in the contract. Some seller(s) warranties may be capped for a short duration because the seller(s) is unwilling to take a longer duration liability and, in this case, a buy-side policy can provide extended duration of warranties coverage, which works in the buyer’s favor; or (e) substituteindemnity and provide a sole remedy for reps and warranties breach. And, where the seller(s) is keen to structure the transaction as an auction, the potential buyers/bidders who possess RWI may actually have significant competitive leverage since it will enhance their proposal versus those that require either a holdback or an escrow mechanism to guarantee a post-closing indemnity obligation. A majority of policies are buy-side policies as the buyer can bypass going after a seller and, instead, claim under the policy directly. This is particularly useful if seller(s) are still involved in the business post-closing and goes a long way to preserve relationships.
2.2 Types: Insurance policies can be recourse or non-recourse based. Parties may commercially determine the recourse/non-recourse-based nature of the insurance obtained. For a buyer recourse-based policy, the insurance company may proceed against the seller(s) to recover the payment from them. In a non-recourse case, insurers cannot recover from the seller(s) except in exceptional and limited situations which include fraud, gross negligence and wilful misconduct. Currently, we are not delving into the details of the actual insurance policies, which will be the subject of another article. It is, however, necessary to explain briefly what is covered and excluded.
2.3 Coverage and exclusions: RWI does not cover either breach of covenants or issues within the knowledge of the buyer. Specifically, it covers losses from unintentional and unknown breaches regarding a target, its business, or its assets. If there is a breach of reps and warranties, an insured party can assert a claim directly against the insurance company for the portion of losses suffered that exceed the deductible under the policy. Therefore, while executing these insurance contracts, it is of paramount importance to ensure the liability of the insurer remains sacrosanct and no facts should be withheld or distorted etc. by the insured. Every seller will do well to remember that confession is good for the soul and, to that end, feel obligated to make as many disclosures as possible so it can claim the insurance. For the buyer, non-disclosure should not be fraudulent which will suffice. Needless to say, the insurance company would need to conduct a detailed diligence at its own level too to assess their risks.
If a situation arises post-closing, the first step is to determine whether there is a “loss” in terms of the policy definition. It sometimes incorporates one or more provisions within the definitive transaction agreement. If there is no “loss’ then the claim is not within the policy. But, if it is there, then the next step is to determine whether any policy exclusions apply. Exclusions too are negotiated and defined within the policy and cannot be de-hors the main contract. They generally include covenant breaches, those breaches which arise between signature and closing; adjustment obligations including purchase price or working capital, other payment obligations for which there is a specific indemnity, any exemplary or punitive loss or damages, criminal fines or penalties; environment and tax matters. Deal specific exclusions are determined based on the transaction specifics, which are dependent on the level of diligence and the disclosures. If any issue has been raised during the diligence or identified under the transaction documents, any loss arising from such issue would not be covered under the RWI. Thus, insurers expend significant efforts to understand the extent of a buyer’s knowledge pre-closing.
3. Regulatory Considerations
In India, often the seller(s) call the shots and insist on capping their liabilities and those beyond agreed thresholds become the buyer’s problem. Further, there are restrictions placed by the Reserve Bank of India or RBI on securing and payment of indemnities to persons not resident in India. Previously, any holdback from the consideration and payment of any indemnity required the prior approval of the RBI, which would be granted on a case-by-case basis. Effective May 20, 2016, the RBI amended the Foreign Exchange Management Act or FEMA and imposed a requirement to obtain prior RBI approval if an Indian seller’s indemnity obligations to a non-resident buyer exceeded the prescribed limits. In other words, pursuant to this amendment of FEMA regulations, RBI mandated that
- the parties could escrow or holdback a maximum of 25% of the consideration for up to 18 months from the date of the definitive transaction document;
- parties to ensure that there is no non-compliance with the pricing guidelines i.e., a seller must receive and retain at least the fair value of the shares sold after excluding the holdback, or escrow or payment in respect of an indemnity;
- if the parties wanted to and agreed to a holdback, or escrow or payment made in respect of an indemnity outside parameters which exceed the prescribed cap of 25% beyond 18 months, they could only do so after securing prior RBI approval.
Practically, this has meant that if the full consideration is paid, the seller can give an indemnity for 25% of the total consideration and for 18 months from the date of payment of the full consideration. With the aim to protect domestic industry, RBI’s approval is not easy to secure in such situations. Assuming such approval does not come through for the indemnity payment, the buyer would only have to rely on contractual remedies, like damages, to recover. Prior to this amendment, there was no such restriction and parties could negotiate and contractually agree monetary and time limits. The net effect for buyers is they will navigate through uncharted waters with exposure to pre-closing period claims.
While RWI is almost a necessity in UK and US acquisitions, the India market is hindered by the regulations coupled with a limited insurers market which has, most certainly, not kept abreast with the global markets and investor needs. Perhaps, it is time to permit Indian residents to buy RWI from foreign insurers and Indian insurers should have capacity to provide RWI in foreign currency, freely i.e., without securing prior RBI approval.
In an uncertain economic environment, it has now become more important than ever for dealmakers to protect their investments. RWI can be an effective and a valuable tool to supplement the seller(s) indemnification obligations under a share purchase agreement. This market has continued to evolve in the last few years. Strategically, PE investors opt for it vigorously in order to avoid long-term indemnity obligations, which is driven by lenders to the fund to secure investments and which would allow them to recover, even after the expiry of the fund life. As can be inferred from the above, seller(s) can use RWI to maximize closing proceeds and exit smoothly. Buyers use it to obtain additional protection beyond the indemnity cap and survival limitations negotiated with the seller(s) and improve their bid in auctions. Of course, there is no one-size that fits all and the terms of the policy must be negotiated to fit the dynamics of a particular deal.
It is almost unanimous that RWI can aid in risk mitigation and management, even though it is not a complete solution given the numerous exclusions. For parties to ensure risk is minimized, it is imperative, more than ever, that the due diligence exercise is exhaustive, with clear conclusions and recommendations and risks classified into high, medium, low so that RWI does not remain a stop-gap solution.