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Representations and warranties insurance use on the rise

Increase in M&A transactions has caused buyers and sellers to protect themselves from transactional mishaps.

January 25, 2019
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West Michigan’s uptick in mergers and acquisitions has buyers and sellers gravitating toward a particular type of insurance.

Ryan Isaacs, regional executive vice president of Arthur J. Gallagher & Co., said representations and warranties (R&W) insurance has grown in popularity as an increasing number of businesses in a variety of industries, including manufacturing, life science, distribution, and wholesale food processing and food growing, pursue M&A transactions.

Michael Greengard, president of Grand Rapids-based Praxis Business Brokers, said M&A activity involving the service industry has grown faster year after year. Along with the service industry, he said the manufacturing and distribution industries account for 90 percent of his company’s sales commission.

Both agree that’s a positive trend.

“The growth of those industries (is because of) access to capital in the marketplace and also generational ownership is changing,” Isaacs said. “The demographics of company owners are set up for the likelihood of a potential transaction. The age of company ownership is at a place where they want to monetize their assets.”

The M&A bump has caused buyers and sellers to protect themselves from transactional mishaps by increasingly using representations and warranties insurance. The insurance can be modified as either a buyer policy or a seller policy.

According to Arthur J. Gallagher & Co., a seller policy provides indemnification to the sellers for defense costs and losses stemming from actions against them by the buyers for alleged breaches within the transaction agreement.

A buyer policy allows the buyers to recover loss from a breach directly from the insurance carrier versus seeking recovery from the seller and also provides defense coverage to mitigate expenses incurred in defending third-party claims associated with a seller breach of representations and warranties.

Although every M&A negotiation and purchase agreement is different, Isaacs said some of the breaches that can be insured are ownership structure, accuracy in financial statements, no undisclosed liabilities, status of known litigation and liabilities, relationship status with consumers and suppliers, compliance with laws, titled shares, taxes, intellectual properties and environmental matters. He said all of those elements have to be represented and are warrantied in a purchase agreement.

According to Arthur J. Gallagher & Co., R&W insurance can be used for multiple reasons, such as to supplement seller indemnity, to reduce or replace escrow requirements, and to extend duration of representations. It also can help to facilitate transactions, reduce counterparty risk, safeguard investment returns, safeguard sale proceeds, protect against seller fraud, enhance bids and assist with resale opportunities.

  • Supplement seller indemnity — Buyer can supplement seller indemnity obligation by purchasing policy limits above agreed seller indemnity within the transaction agreement. Enables buyer to accept a lower level of indemnity than they would otherwise be comfortable with.
  • Reduce or replace escrow requirement — R&W insurance can supplement seller escrow requirements, thereby agreeing to a lower acceptable holdback amount, or substituting for an escrow when such a holdback is not feasible due to the deal structure or seller attributes.
  • Extend duration of representations — R&W insurance can be structured to extend the duration or survival period of the representations and warranties agreed to in the transaction agreement.
  • Facilitates transactions — R&W insurance can help consummate deals when agreements cannot be reached between buyer and seller regarding certain risks.
  • Reduced counterparty risk — Buyers often will find the counterparty risk of an insurance carrier significantly more tolerable than that of the sellers.
  • Safeguard investment returns — A buyer can help ensure a successful investment by mitigating the financial risk of unforeseen liabilities.
  • Safeguard sale proceeds — Enables sellers to enjoy sale proceeds without fear of potential clawback due to unintentional breaches.
  • Protection against seller fraud — A buyer policy can respond to seller fraud assuming the buyer and their due diligence did not have knowledge of the fraud prior to close.
  • Facilitates resale opportunities — R&W policies are generally transferable, enabling a buyer to facilitate a subsequent transaction to another party seeking similar business assurances.

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