In acquisitions, the seller’s representations and warranties — and its indemnification obligations in the event of a breach — are often the subject of intense negotiation. Buyers want protection against unknown liabilities and other surprises. Sellers, on the other hand, want a clean exit: They’d prefer not to place a portion of the purchase price in escrow and remain liable for post-closing contingencies.

Rather than fight over how post-closing risk will be allocated between them, an increasing number of buyers and sellers are using representations and warranties (R&W) insurance to shift some or all of this risk to a third party (the insurer).

Closing the Gap

R&W insurance can help close the gap between buyer and seller, resulting in better contractual terms for both. For example, it can:

Protect the buyer against breaches while minimizing the seller’s exposure to indemnification claims for unknown liabilities. In some transactions, the parties eliminate indemnification and rely exclusively on R&W insurance.

Eliminate the need for escrow, allowing the seller to distribute all of the proceeds to its shareholders or partners without delay. This is particularly attractive for private equity funds, which enjoy a higher internal rate of return (IRR) when escrow arrangements are avoided.

Provide the buyer with more coverage, over a longer period. R&W insurance can be a great option when the seller is unwilling to provide the level of protection the buyer desires. Some insurers offer coverage for as long as six years after closing; a typical indemnification obligation lasts only one or two years.

Allow the buyer to gain an advantage in a competitive bidding situation. Incorporating R&W insurance into its bid and offering the seller a clean exit can make a buyer more attractive.

Either party may purchase R&W insurance, but buyer-side policies offer several advantages. For example, with a seller-side policy, in the event of a breach of warranty, the buyer would first make a claim against the seller, and then the seller would file a claim with the insurer. With a buyer-side policy, the buyer deals directly with the insurer and, for the most part, the seller stays out of the process. Another advantage of buyer-side policies is that they cover breaches caused by the seller’s fraud; seller-side policies do not.

Shop Around

If you’re considering R&W insurance, keep in mind that coverage, exclusions, premiums and other terms vary significantly from policy to policy, so it pays to shop around. For more information on strategies for reducing risk in M&A transactions, please contact us.