Mooting the utility of Representations & Warranties Insurance Policies in exit deals for a PE and VC Investor

M&As and Investment transactions have been growing rapidly in India and there is no doubt that in such transactions allocating the risk of a breach is extremely important. In the recent past, we are witnessing detailed indemnification clauses including the “loss” related clauses covering grossing up of tax and grossing up of shareholding.

In the secondary sale of shares, venture capital investors are reluctant to provide representations beyond their title in the shares that they hold. Traditionally, such investors will be hesitant in providing any indemnity to potential acquirers because the traditional method of indemnification involves the carry forward of payment rule, wherein the VC investor may be required to indemnify the party beyond a certain time frame as well. Moreover, VC investors have a limited fund life and hence prefer not to have indemnity obligations beyond the life of a fund.

The most common way in which a buyer protects itself is by incorporating provisions of indemnity in the contract which requires the seller to indemnify the buyer for any breach of representation or warranty. Traditionally, indemnification is the most common method of safeguarding one’s interest in a transaction but there were many limitations to this approach, like risks for seller wherein he is not able to receive the remainder of the purchase price, risks for buyer wherein the buyer fears that the fund held back would be insufficient to cover all indemnity claims.

Traditionally used methods to secure the promises of indemnification are:

  1. A holdback of purchase price
  2. Escrow account for indemnification
  3. Unconditional bank guarantees
  4. Set-off against future payments

Representations and Warranties Insurance (“RWI”) could be a substitute or augment the traditional indemnification mechanisms.

There are benefits of an RWI policy for both buyers and sellers in a deal/transaction. For sellers, it eliminates any requirement for escrow or holdback that would otherwise reduce the money received by the seller at closing, provide a cleaner exit with fewer contingent liabilities incident to the sale. For the buyers, the bid looks much more attractive as indemnification is protected by a third-party insurer, they can also increase the indemnity amount which otherwise would have been highly-negotiated by the seller. For both parties, the process for negotiation and finalizing of the transaction document is expedited and as the insurance covers all losses, sellers might not be resistant to agreeing to post-closing indemnities in the deal as well.

What are Representations and Warranties?

In case of breach of any representations or warranties in the transaction document, the rise of indemnity claims is almost always provided for. For the uninitiated, a ‘Representation’ is a statement of fact about the current state of the business made by a seller to the buyer or by a buyer to the seller in a purchase agreement[1]. A ‘Warranty’ in simple words, guarantees the accuracy of the representation[2] and ensures compensation in case the representation so made is false. Representations and warranties are negotiated clauses of the transaction and the scope of representations and warranties depends greatly on the nature of transactions.

The terms ‘Representation’ and ‘Warranty’ are not defined in the Indian Contract Act, 1972, however the Madras High Court in the case of All India General Insurance Co. Ltd. and Anr. v. S.P. Maheswari[3] made a distinction between the two terms. The High Court said that those representations which are made the basis of the contract are known as warranties, and otherwise a representation simpliciter is rather something collateral which only has a tendency to induce the other party.

Even after an exhaustive due diligence process, it is difficult for a buyer to know everything relevant to the purchase, so these representations and warranties fill in gaps in the buyer’s knowledge of a company.

RWI Policies for transactions, an Introduction

It is important to know that there are no “one size fits all” RWI policies offered by insurance companies. Typically, parties go for tax insurance or a transaction-based insurance policy, we will concern ourselves with the latter for this discussion.

An RWI is thus an insurance policy used in deals to protest losses arising due to the breach of representations made in the transaction documents. Every transaction is a different transaction and thus, every RWI policy is tailored according to the specific transaction. Each RWI policy is negotiated to match up with the terms and language of each transaction.

What are the types of R&W Insurance available for transactions?

Typically, transaction insurance policies cover either the ‘buy-side’ or ‘sell-side’, however in terms of practice a buy-side policy is more prevalent. The distinct features of them both are discussed below:

  1. Buy-side policy: In this the RWI policy is acquired by the buyer in the transaction. The advantage of this type of policy is that a direct claim can be made against the insurer without pursuing the seller for the same. The purchaser is able to recover its losses while at the same time ensuring a clean exit for the seller. It is important the transaction documents require a recourse-based buy-side insurance policy, wherein the seller is liable to indemnify the counterparty in case the insurer does not make a payment under the claim to the buyer. The buyer under this type of RWI policy gets additional time to detect and report problems and gets an effective indemnity in public deals as well where it will otherwise be difficult to recover such losses.
  2. Sell-side policy: These policies are acquired by the seller in order to limit their losses. A sell-side policy will typically cover the capped indemnity under the agreement along with any additional defense cost for related litigation. A sell-side policy also reduces the liabilities associated with post-closing breaches of representations and warranties such as claw-back liabilities wherein the seller is required to make good the losses if any breach with respect to representation and warranties occurs after the closure of the deal. A seller may also opt for RWI policy if he is a minority investor but bound to indemnify a buyer via a joint or several liability. A sell-side policy is typically preferred by PE and VC funds in order to give a ‘clean exit’ to its investors.

How to negotiate and obtain RWI policy during a transaction?

An RWI policy is typically completed in multiple stages, starting from the pre-indication strategy wherein the buyer or seller reach out to RWI broker for discussing the objective of the policy, then the broker submits important documents to RWI insurer specifying the details of the transaction as discussed in the pre-indication stage. Once the insurer is selected and paid an underwriting fee and provided with all the relevant documents, a diligence call is arranged between the insurer, the parties to the deal, and their legal representatives. A first draft of the insurance policy is soon provided by the insurer after the diligence call. It is important that the language of policy should be in line with the language in the transaction agreement. The final policy is generally negotiated in advance of the closing date of the transaction. The insurer then provides a ‘binder’ to the policyholder that legally obligates the insurer to bind coverage at the time of signing or closing. Once the binder is signed, the policy becomes binding.

Structure of an RWI policy should not be ambiguous and it should clearly mention what is covered and who is covered under the policy. As a general rule, a claim under the RWI policy is triggered only when there is a breach of covered representation and warranty. The RWI policy should also mention whether the insurance is provided on ‘first party’ (providing coverage to the policyholder) basis or ‘third party’ (providing coverage to another party based on policyholder’s liability to another party) basis.

Limitations

Though RWI policies are instrumental in limiting the liabilities of the seller and buyer but there are certain limitations to them, we shall list a few of them below:

  1. Unlike a typical promise of indemnity, RWI policies will always be limited to a cap based on the amount consideration in the deal/transaction, in developed jurisdictions, it is typically 10% of the purchase price.
  2. RWI policies only cover breaches of those representations and warranties that are explicitly mentioned in the agreement. It does not cover breaches that are ancillary to the covered representations and warranties.
  3. RWI policies tend to contain numerous exclusions which are common to many types of insurance policies. These exclusions are generally with respect to corruption, environment, and bribery.
  4. RWI policies exclude claims wherein the insured may have had knowledge prior to the effective date of the policy of certain facts which could give rise to the breach of representations or warranties.
  5. Transactional RWI policies will not provide coverage for tax risks that might result from transfer pricing agreements.
  6. RWI policies can totally exclude certain issues identified in the buyer’s due diligence process.
  7. Unlike indemnity payments, proceeds from an RWI policy may be considered as net taxable income in India.

Relevance of the Indemnity clause in transaction documents is still not diluted

Inclusion of RWI in the transaction agreement would still not cover every liability arising from breach of covered representations and warranties, thus there will be certain aspects where indemnity provision under the transaction document would still hold value.

  1. In determining the loss bearing capacity of parties till the payment retention amount for the RWI policy.
  2. In determining who will bear the loss arising from the items excluded from the coverage under the RWI policy.
  3. Provide for de-minimis amount i.e. the minimum loss to borne before making a claim under the indemnity provision.
  4. In cases where parties commercially agree to include a recourse-based insurance policy, an indemnity provision in the transaction document proves helpful to enable the buyer to enforce a claim against the seller.
  5. RWI policies will always have cap on the recoverable amount and typically have a life of 3-6 years post the closing of the deal. An indemnity provision however, can still cover a higher amount of indemnity or provide a longer time frame than what is provided under the RWI policy.

Conclusion

An RWI policy provides an option to parties involved in M&A/Investment transactions to allocate the risk associated with the transaction to a third-party, and thus proceed with the deal themselves spending less time on negotiating the indemnity clause. It has become an important tool in any restructuring process as it offers greater flexibility when compared to traditional methods for addressing the liabilities (such as holdback, escrows, etc.). As the Indian market matures further, it is important for RWI policies to get tailored as per the need of the Indian market. Inclusion of RWI in the transaction agreements proves instrumental in boosting the confidence of investors seeking to make exits in providing indemnities to potential buyers. However, an RWI policy too has certain limitations and a well-drafted indemnity clause in the transaction document is still needed to bring clarity on those aspects on which the RWI policy falls short.

[1] Marialuisa S. Gallozzi; Eric Phillips, Representations and Warranties Insurance, 14 Envtl. Cl. J. 455

(2002)

[2] Id.

[3] A.I.R.1960 Mad. 484

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