With the increase in deal activity worldwide RWI has exploded over the last decade.
According to SRS Acquiom out of the 1900 private deals surveyed in its 2022 report 44% of those deals contained RWI.
Usually for targets with an enterprise value in excess of $20m, RWI is available for deals of smaller values though much less common. It has not traditionally been used when the target is a public company, however this is changing and more public M&A deals are utilizing RWI.
With the increase in the number and size of M&A deals in Israel over the last few years, RWI is now featuring more regularly on the Israeli scene. There are currently several insurers in the market who provide coverage.
The purpose of this update is to provide a brief overview of the principal terms of an RWI policy, the problems it comes to solve and the benefits to buyers and sellers.
Information Imbalance in M&A-Buyer beware
In law school the first thing you are taught is “caveat emptor” – “buyer beware”.
What lies behind this warning is an inherent information imbalance between a buyer and seller. In the case of an acquisition of a company, the seller will always know more about the company being sold than the buyer. This issue drives the many conventions that have come to allocate risk in M&A deals.
The buyer will attempt to redress this imbalance in two ways[1].
- Due diligence. Through conducting a due diligence review – during which buyer gets to ask questions of the company’s employees and advisors, review documentation and initiate searches of public databases.
- Indemnification. The purchase agreement will include an indemnity provision under which seller will indemnify buyer for “losses” to buyer resulting from a breach of a representation or warranty.
RWI provides an additional option for solving this problem. If the deal contains RWI and there is a breach of a representation covered by the policy, the insurer will pay out the claim to the buyer. Indemnification is a very close cousin to insurance. However, while indemnification shifts risk to the seller for a breach of a representation, rep and warranty insurance shifts the risk to the insurer.
Use of RWI & Key Features
The parties agree on the application and terms of the RWI at the LOI stage. Below you can find some of the key features of RWI[2].
- Who is covered? – (Almost always) the buyer. There are some policies available at lower deal values that maybe attractive to sellers. Even though it’s the buyer named in the policy, the process is often instigated by the seller who will line-up the insurance solution (for no cost) and then ‘flip’ this across to the buyer to finalize and put in place.
- Policy limit – According to most surveys – 10-20% of enterprise value. One way to think of this is as a replacement to an escrow or holdback – which is also often around 10-20% but may be substantially more in certain cases. In theory, buyers can take limit under the policy of up to 100% of EV.
- What is not covered? – The insurer may exclude certain specific items based on the due diligence and risk profile of certain aspects of the target (e.g. cyber loss where there are historic cyber breaches). Importantly, the actual knowledge (not constructive or implied knowledge) of the buyer’s internal team on the deal (i.e. the 2-3 key deal executives) will be excluded.
- Premium – 1-4% of the policy limit. Depending on negotiating posture will be paid by buyer or split between buyer and seller. US is at the higher end of the range. Israel is circa 2% and UK closer to 1%.
- Due Diligence – The insurer will review the due diligence report prepared by the buyer on a ‘non-reliance basis’, supplementing with specific questions. Generally the insurer will not make changes to the reps and warranties. But may request that certain disclosures in the disclosure schedule are clarified or supplemented.
- Seller’s liability – The standard position in the UK and US is to have zero or a nominal amount (i.e. $1) cap on liability. In the event of a claim, the sole recourse of the buyer will be under the RWI policy. In Israel, it’s typical to see a combination of indemnity and RWI policy as Israeli buyers prefer that sellers retain some ‘skin in the game’. Most common structures include sellers remaining liable under the SPA up to the deductible amount in the policy and/or sellers remaining liable for certain areas expressly excluded under the policy.
Note: if the deal contains a purchase price adjustment clause it is not unusual for there to be an escrow or holdback for this purpose that is separate from the escrow for the RWI policy mentioned below.
- Deductibles (retentions) – 0.5%-1% of enterprise value. This works like the deductible on your home or car insurance policy. This may be allocated between buyer and seller in different proportions.
- Escrow – In order to cover the deductible, the parties will often negotiate for there to be an escrow established for covering the deductible. This will typically be released 18-24 months from closing.
- Periods of cover – 7 years for fundamental and tax reps and for the pre-closing tax indemnity. 3 years for other reps.
- Claims – Brokers and insurers have been collecting claims data for over 15 years. Data collected by Willis Towers Watson (WTW) shows that claims are made on 19% of all policies placed, which is significantly higher than the number of claims made under the traditional SPA indemnity structure. This is not a surprise given it is easier to claim under a policy and you avoid the need to bring claims against existing management teams. According to WTW, 84% of claims made result in some form of insurer payment/settlement.
The Benefits
Seller
- Reduced liability risk, providing a ‘clean exit’ and peace of mind that buyers cannot make a claim years after a transaction.
- Expedited deal process – less negotiation around language of the reps, indemnities, etc.
- No or limited escrow, therefore releasing funds which can be utilized elsewhere.
- Solves joint liability issues for passive sellers (eg. VC funds), peace of mind – especially for older “owner” shareholders
- Removes need to apportion liability across sellers and management.
Buyer
- Greater coverage scope (more buyer friendly reps, etc. can be agreed under the policy) allowing the buyer to agree to more seller friendly/competitive terms under the SPA.
- No credit risk.
- Protection of ongoing relationship (if the seller is continuing in the business – eg. a rollover-seller in a private equity deal) – less “disruptive” to claim against the policy than the manager-seller.
- Avoidance of costly post-closing litigation proceedings.
- Genuine source of recourse against A-rated global insurers who have strong records of paying claims.
The elephants in the room
In most discussions regarding the merits of RWI you will encounter two reservations:
- In practice – do the insurance companies pay out?
- The seller has no skin in the game!
Taking the first issue, while there seems to be a lack of independent data on this question, reports produced by some insurers are useful in identifying certain trends. In its 2020 report AON provides the following data:
- of 340 claims made on more than 2,450 representations and warranties insurance policies placed by Aon in North America between 2013 and 2019:
- “30% of claims have been resolved
- 4% have been denied
- 54% are active; and
- 12% are inactive to date (ones in which no correspondence has been provided in over a year).”
A more recent report from WTW 2021 analyzing more than 200 claims, provides that 85% of claims were covered within the policy terms, with 15% of payments not covered by insurance. It cites the primary reasons for this as being to the amount claimed not exceeding the policy’s de minimis level and the matter claimed being disclosed during the sale process. The report discloses most claim events as coming from reps relating to tax and financial statement/accounting – with financial statement accounts constituting the highest average claim events. Next in line are the reps relating to commercial/customer, employment and compliance with laws/legal issues.
It’s hard to draw a conclusion from this data. However, overall, based on both reports, the number of claims made was only between 14%-19%. Other than from individual experience it is also difficult to ascertain if the buyer would have fared better by pursuing the seller directly with all of the uncertainty that a contested indemnification claim would involve. You have to assume that a buyer is more likely than not to make a claim if they have RWI than if they were relying on indemnification. That being the case, if affordability is not an issue, there seems to be a compelling case for RWI.
As for “skin in the game”. This is a phrase heard a lot from buyers’ representatives in the course of negotiations on indemnification provisions. Some argue that when a deal includes RWI – since the risk is shifted to a third party (the insurance company) – the seller will be less exacting or forthcoming in its disclosure. Intuitively, this concern makes sense. In practice, however, most sellers will still be incentivized to “do the right thing” – whether that is due to fear of being accused of fraud, the importance of the continuing relationship with the buyer, and (believe it or not) common decency. In Israel, this concern is less relevant, where deals are structured for sellers to still have some skin in the game.
It will be interesting to see the development of RWI market over the next couple of years – with a cooling in valuations and the perception of a buyer’s market. From personal experience, the peace of mind for both buyer and seller (whether perceived or real), and the more streamlined negotiations allow the parties to focus on other (perhaps) more critical commercial terms. I have not come across any cases of a buyer regretting taking out RWI, nor of a seller who would have rather been subject to an escrow holdback!
James Raanan, Adv. is a partner in APM’s Hi-tech and Venture Capital Practice, as well as head of its Telecoms practice. He has over 25 years’ experience as counsel to private and public companies globally, specializing in M&A and complex B2B commercial transactions. He is admitted to the bar in Israel and New York. He can be reached as jamesr@apm.law
DISCLAIMER: THE VIEWS AND INFORMATION CONTAINED HEREIN DO NOT CONSTITUTE LEGAL ADVICE.
[1] There are other tools also at the buyer’s disposal such as deferring payment of consideration in the form of an earnout, but the purpose of this article is to focus on seller’s representations about the company’s history and current state of affairs.
[2] This list is not exhaustive or applicable in all cases. There will be differences based on jurisdiction, risk profile, the size of the transaction and respective negotiating leverage. The above table is more reflective of terms in US deals.
