What is Representations and Warranties Insurance?
By Daniel S. Hughes, Managing Director, CPA/CFF, CGMA, CVA
Representations and warranties insurance (RWI) is becoming an increasingly common and required tool to expedite M&A transactions, bridge gaps in deal negotiations and reduce buyers’ and sellers’ risks of financial losses after deals close.
At the most basic level, representations are the assertions sellers make about their companies, those entities’ financial positions and past and present operations that buyers can rely upon as statements of fact to assess and value those businesses. Sellers also provide buyers with supporting documentation and business records to warrant their representations, including, but not limited to, financial statements, tax returns, customer and vendor lists, sales contracts, product inventory, copyrights and intellectual property. In this sense, reps and warranties form the basis of a buyer’s due diligence process and are critical for minimizing risks of post-transaction disputes.
Sellers historically assume the responsibility of this risk by withholding a portion of their sales proceeds in an escrow account to indemnify buyers from any claims of losses they sustain as a result of sellers’ misrepresentations or failure to disclose material information. However, the traditional escrow holdback can be costly for sellers who are either reluctant to aside a portion of the sale’s proceeds or who may need immediate access to those funds now or in the future. Under these circumstances, RWI replaces or partially replaces an escrow to help facilitate a deal. The policy shifts the indemnification risk to a third-party insurer and provides sellers with a cleaner exit without weakening buyers’ opportunities for full recovery.
The reps and warranties made by a seller and covered in an RWI policy are detailed in the purchase agreement along with coverage limitations, exclusions and requirements claimants must meet to demonstrate a breach and recover damages. It is important to note that there is no one-size-fits-all RWI policy. Rather, each policy is dependent on the language and provisions contained in the purchase agreement. This makes it critical for buyers and sellers to ensure the terms and conditions detailed in the purchase agreement are written to suit their unique goals and needs.
Current Trends in RWI
As the use of RWI has increased, so too have the number of claims. According to AIG’s most recent M&A Claims Intelligence Series for Representations and Warranties Insurance, 38 percent of all claim notifications for breaches are related to accounting issues, including financial statement and tax breaches. The frequency of these claims increases to 46 percent when covered losses are greater than $1 million and continues to rise along with higher valued delas.
Uncovering and potentially alleviating these financial concerns before a deal closes is possible with the benefit of a well-planned and thorough due-diligence process. Unfortunately, this requires a significant investment of time and money, which are scarce resources in the ultra-competitive deal market. All-too-often, buyers shortcut the due diligence process in a rush to close deals, leaving many issues undetected until post-merger.
RWI can be considered a safety net should adverse, post-merger issues arise. However, as is the case with most types of insurance, RWI is only as good as the insured party’s ability to collect on claims that result from a specific and verifiable breach or misrepresentation of information by another party.
While insurers may have deep pockets, they also have policies and procedures for filing claims and demonstrating a breach of covered representations and warranties. The claim verification process requires demonstration that a misrepresentation occurred that is directly linked to a specific type and amount of loss covered in the insurance policy. In general, this analysis is dependent on case-specific facts and documentation, including adherence with policy language and exclusions for filing claims related to an alleged breach. Under most circumstances, quantification of specific losses must be supported by accepted methodologies and accompanied by underlying documentation, which necessitates the expertise of experienced forensic professionals.
As it relates to RWI claims due to alleged financial statement and tax misrepresentations, forensic accountants can help analyze and evaluate the correct applications of accounting principles and tax codes over periods of time and determine whether restatement of financial reporting is required based on errors or non-application of generally accepted accounting principles (GAAP). They possess the skills require to analyze multiple-based valuations and investigate the causality between value and purchase price, including the extent a change in earnings could have impacted the negotiated purchase price.
For this reason, insurance companies, transactional attorneys and their clients involved in M&A transactions are well-served to engage forensic accountants who can play a vital role to not only demonstrate proof of a breach of representations and warranties in accordance with RWI policy language, but also that an alleged breach resulted in recoverable damages.
For more information contact:
Daniel S. Hughes, CPA/CFF, CGMA, CVA