Posted In: Business Transactions & Corporate Counseling & Mergers, Acquisitions and Divestitures
Business Blog: Representation and Warranty Insurance in Corporate Transactions
on August 19, 2019
Often conflicts that arise from a transaction are commonly due to a seller’s breach, or alleged breach, of a representation or warranty contained in the purchase agreement. Typically, a seller will indemnify a buyer for any breach of the representations and warranties made by the seller. Depending on the transaction, the seller may be required to place a certain amount of the purchase price into escrow for a period of time to cover any of its indemnification obligations. However, in many transactions, this structure is being modified because the parties have purchased a representation and warranty insurance policy. These policies are growing in popularity, and individuals and businesses should understand them in order to assess if such a policy may be necessary in a future transaction.
What is Representation and Warranty Insurance?
Representation and warranty insurance is an insurance product which allows parties to recover for damages caused by a breach of a representation or warranty in a purchase agreement. The policies serve as added protection to the typical indemnification/escrow arrangements discussed above. Usually, parties do not completely do away with traditional indemnification/escrow arrangements and rely solely on the insurance policy, but the amount placed in escrow can be dramatically reduced if an insurance policy is purchased. Deductibles and liability caps under representation and warranty policies are typically a percentage of the purchase price of the transaction, and the term of policies can range from a few months to several years. Each policy is tailored to the specific transaction that it is being purchased for, so terms of policies can vary greatly from deal to deal.
Who Purchases the Policy?
Both buyers and sellers to a transaction can purchase representation and warranty insurance, but buyers more frequently purchase the policies. Policies purchased by buyers directly compensate the buyer for any actual or alleged breaches of a seller’s representations or warranties. Policies purchased by sellers cover a seller’s liability for claims of breach of a representation or warranty. Parties negotiate the need for an insurance policy and specific references to the policy are often added to the language of the purchase agreement. If the parties agree that a policy should be purchased, both solicit offers and the parties decide together what policy should be purchased and by whom.
What are the Pros and Cons of Representation and Warranty Insurance?
Advantages exist for both buyers and sellers in purchasing representation and warranty insurance. One major advantage for buyers is the assurance that if a breach occurs, damages for the breach will be collectible. It also allows a buyer to accept a low seller indemnification liability cap without assuming the extra risk because the excess amounts will be covered by the policy. Representation and warranty insurance limits the seller’s post-closing liability under the purchase agreement. Sellers have more certainty regarding the amount of proceeds from the purchase price they will receive.
Disadvantages still exist when purchasing representation and warranty insurance, some of which can draw out negotiations between parties. Insurers often exclude certain items or specific representations or warranties from coverage, which can lead to more difficult negotiations because indemnification language will have to conform to the policy. Also, these policies can be very expensive, and determining who pays for the premium or each party’s share of the premium, is yet another term that must be negotiated.
This blog is intended to provide information generally and to identify general legal requirements. It is not intended as a form of, or as a substitute for legal advice. Such advice should always come from in-house or retained counsel. Moreover, if this Blog in any way seems to contradict advice of counsel, counsel's opinion should control over anything written herein. No attorney client relationship is created or implied by this Blog. © 2024 Brouse McDowell. All rights reserved.