M&A Transaction Insurance: An Overview

November 2016 Follow @Paul_Hastings M&A Transaction Insurance: An Overview By Neil A. Torpey, Sean P. Murphy & Lu Wang As a result of falling costs, faster underwriting, and improving policy terms, M&A transaction insurance has become increasingly popular as a means of allocating, to a third-party insurer, deal risk in privatetarget M&A deals. Consequently, deal practitioners are increasingly utilizing various forms of M&A transaction insurance. Such forms include Representations and Warranties Insurance ( RWI ) as well as specialized policies that cover risks excluded from RWI, such as those associated with taxes, litigation, and other contingent liabilities. I. Transaction Insurance Overview A. Every M&A deal is shaped by risk allocation. B. Transaction risks can be 1. Retained by the acquiring company (the Buyer ); 2. Allocated to the selling security holders (the Sellers ) through escrows or holdbacks; 3. Assigned to an insurer through M&A transaction insurance; or 4. A combination of the above. C. When the Buyer is the insured, insurance can reduce or eliminate the need for the Sellers to fund a general indemnification escrow, although escrows for heightened risk (e.g., a known, pending lawsuit) or purchase price adjustments may still be needed. D. When the Sellers are the insured, typically they remain liable to the Buyer under the M&A sale and purchase agreement (the SPA ) for losses involving breaches by the Sellers of provisions of the SPA, but insurance serves to compensate the Sellers against covered losses. E. Common forms of M&A transaction insurance include: 1. Representations and Warranties Insurance; 2. Tax Insurance; 3. Specific Litigation Insurance; 4. Other Contingent Liability Insurance. 1

II. Quantifying Transaction Risk: Data on Post-Closing Claims 1 A. Deals with claims: Approximately 60% of deals have at least one post-closing claim. B. Approximately 25% of deals have more than one post-closing claim. C. Average number of claims per deal: Deals with claims: 2.9 In all deals: 1.3 D. Average claimed amount per deal: Deals with claims: $4.25M In all deals: $1.75M E. Percent of deals with claims that resulted in arbitration or litigation: 9% F. Percent of claims against policies written for transaction sizes of $100M or less during the 2011 2014 period 2 : 15% III. Representations & Warranties Insurance: Fast Facts A. Premium: The premium is typically 3 5% of the insured amount. 3 B. Deductible: The policy deductible, or the retention, is often 1 3% of the deal s purchase price when the Buyer is the insured, or the escrow amount when the Sellers are the insured. 4 C. Policy Forms: Policies are tailored to each transaction, and repeat policyholders can often start with a previously negotiated form if engaging the same insurer. D. Process: The premium, coverage, and underwriting process each differ slightly depending on which party is insured. E. Alternatives to RWI: Uninsurable risks can be collateralized with special escrows. F. Insurers expect the parties to share costs involved in RWI, to ensure incentives for thorough diligence and active negotiations. 2

IV. Why Do Buyers and Sellers Use RWI? The allocation of risk shapes every acquisition, and the backbone of risk allocation is the right of the Buyer to be indemnified for breaches of the Sellers representations and warranties. In a standard acquisition of a non-public selling company, the Sellers bear the indemnification risk. The risk has traditionally been managed using a two-tiered structure: (i) an escrow funded from proceeds due to the Sellers, and (ii) in the event of a claim beyond the escrow, the right of the Buyer to clawback proceeds from the Sellers directly. In the 1990s, RWI emerged as a niche tool to shift some or all indemnification risks from the Sellers to an insurer. Due to falling costs, faster underwriting, and improving policy terms, RWI has risen in popularity in recent years. However, it still remains a specialized product penetration of RWI in U.S. private-target deals remained less than 10% in 2015. An RWI policy can be either buy-side or sellside. When the Buyer is the insured (a buy-side policy), RWI can reduce or eliminate the need for an escrow because an insurer, rather than the Sellers, indemnifies the Buyer for covered losses. 5 When the Sellers are the insured (a sell-side policy), they remain liable to the Buyer for breaches typically through the two-tiered structure but RWI compensates the Sellers for covered losses. Buy-side policies are the dominant form of RWI today, comprising at least 80% of policies issued annually in the U.S., according to major insurers and market data. A. Buy-Side Policies Buy-side policies allow the Buyer to seek indemnification from an insurer for losses covered by the policy. Buy-side RWI is often used to: 1. Enhance the Buyer s bid for a Seller. In an auction scenario, a Buyer s ability to reduce or eliminate the Sellers indemnification risk through buy-side RWI can make the Buyer s bid more competitive. 2. Protect deal relationships. Where a Buyer desires to protect Seller relationships postclosing (such as key employees or investors), buy-side RWI can avoid the need to sue Sellers in the event of a breach. 3

3. Maximize Sellers IRR. Where buy-side RWI reduces or replaces the use of escrows, proportionally more proceeds are available to Sellers at closing. Institutional Sellers can therefore boost IRR by distributing such proceeds to investors at closing. 4. Cover Seller fraud. Buy-side RWI generally insures the Buyer against Seller fraud, whereas Sellers are not insured against Seller fraud in sell-side RWI. In a buy-side policy, the insurer often retains the right to pursue a Seller fraud claim against the Sellers (i.e., fraud claims are subrogated). 5. Bridge the gap in indemnification terms. Buy-side RWI can be used to supplement the Sellers indemnification obligations where the Buyer desires greater protection than that provided by the SPA. 6. Facilitate acquisition lending. Funds paid out under a buy-side RWI policy are assignable to acquisition lenders. This can be an important term for acquisition lenders, especially in highly leveraged transactions. B. Sell-Side Policies Sell-side policies insure the Sellers against losses to the escrow and/or clawback risk from claims above the escrow. Sellers defense costs are also generally covered. Sell-side RWI is often used to: 1. Add certainty to the purchase price. Sell-side RWI compensates Sellers for indemnification-related losses, adding certainty to the purchase price that Sellers receive. 2. Make a clean exit. Where sell-side RWI covers liabilities above the escrow, Sellers can distribute the closing proceeds to investors with little or no risk of a clawback. 3. Maximize IRR. Sell-side RWI can eliminate the need of institutional Sellers to set aside internal reserves for contingent liabilities, allowing earlier distribution of closing proceeds to investors. 4. Close quickly. With RWI backstopping Sellers risk, Sellers may be able to negotiate and close a deal more quickly. 5. Protect passive and minority Sellers. Sell-side RWI binds at the deal level and protects all Sellers, including passive and minority Sellers. 6. Reduce credit risk borne by the Buyer. In the event of a claim above the escrow, sellside RWI allows a highly-rated insurer to backstop the Sellers credit risk at the time of the clawback (where sell-side RWI covers losses above the escrow). Often, the point at which the prospect of RWI is raised in the deal process can determine what kind of associated benefits are available. For example, RWI could impact purchase price negotiations if raised in the early stages of a deal; whereas RWI could effectively facilitate closing a deal if raised towards the end of deal negotiations when parties cannot agree on specific representations and warranties language or the scope of Sellers indemnifications. 4

V. What s the Buying Process Like? A. Three Phases. RWI typically proceeds in three phases and usually involves the interested party, an insurance agency, and one or more underwriters. The process may take two to three weeks. Where time is of the essence, underwriters may be able to complete the underwriting process in several days. Phase 1: Solicit Bids The party interested in RWI approaches an RWI broker. Because RWI policies are transaction-specific and highly specialized, the interested party s regular insurance broker (e.g., for D&O or standard business liability lines) may not have the product experience to broker RWI. Therefore, RWI is generally sold to clients through specialized insurance brokers. The interested party initially provides the broker with the latest draft of the SPA, disclosure schedules, and Seller financials. The broker uses such materials to solicit preliminary bids from RWI underwriters, who represent carriers and are authorized to underwrite the insurance on their behalf. Phase 2: Negotiate Preliminary Terms Underwriters review the information, request further diligence if needed, and issue nonbinding quotes that include the likely premium, limits, retention, and possible exclusions. This usually takes approximately one week. The interested party and its counsel (which often includes specialized insurance counsel), along with assistance from the broker, analyze the bids and negotiate additions and changes to optimize coverage. Phase 3: Underwrite and Bind the Policy Once a policy is chosen, the interested party executes an agreement with the underwriter that sets forth the underwriting process and a non-refundable underwriting fee (which is typically credited toward the premium when the policy is bound). Repeat policyholders can often start with a previously negotiated form if engaging the same insurer. Because changes in deal terms can affect the underwriting process and pricing, parties often wait to begin full underwriting until the primary deal terms are near-final. The deal team and data room are then made available to the underwriter. Within one to two weeks, binding terms are issued and the policy forms are finalized. Final policies can be made available at transaction signing if needed, and the policy is bound and paid for at closing. 6 B. Differences in Buy-Side vs. Sell-Side Underwriting The underwriting process differs between buy- and sell-side policies. In a buy-side policy, the underwriter evaluates the thoroughness of the Buyer s due diligence. The underwriter will examine the list of documents that the Buyer requested, the data room, and the Buyer s external and internal due diligence reports. The underwriter will also interview the team in charge of the due diligence process. In a sell-side policy, the underwriter evaluates the reasonableness of the scope and depth of the Seller s representations and warranties, as well as the processes by which the Seller assessed the accuracy of each statement. Because of these differences, the coverage terms and premium may also differ depending on the insured party. VI. What Are Typical Policy Terms and Exclusions? A. Typical Terms While each policy is tailored to the specific transaction, typical terms include: 5

1. Pricing. The policy premium is calculated as a percentage of the insured amount, generally 3 5%. Relevant factors in policy pricing include, but are not limited to, transaction value, deductible size, Seller industry and business line, scope and depth of indemnification obligations, time gap between signing and closing, quality of the transaction diligence, identity of transaction principals and their advisors, and insurance market dynamics. Pricing also includes an underwriting fee (typically about $25,000) that is due at the time of underwriting review and that is typically credited toward the premium when the policy is bound. 2. Deductible. The deal parties bear a portion of the risk in the form of a deductible (also known as a retention ) before a claim can be made under the policy. The deductible is typically 1 3% of the deal s transaction value; it can be borne by the Buyer or the Sellers or shared by both. 3. Coverage. The policy generally covers the Seller s representations and warranties as set forth in the SPA, but policies often have exclusions for high-risk areas or risks that an insurer is not willing to cover (e.g., environmental liability). Exclusions are discussed below. 4. Duration. The policy period usually mirrors the period of survival of representations and warranties and, in a buy-side policy, can be extended further. For example, it may be possible for the Buyer to extend general coverage to include a full audit period after the expiration of representations and warranties under the SPA. The policy period for tax claims usually matches the period stated in the SPA (typically six or seven years). 5. No claims declaration. Policies typically require a no claims declaration from the insured stating that it is not aware of any potential claims arising from a breach of the SPA at the time of the policy s inception. The declaration is typically limited to actual knowledge of a breach. 6. Subrogation. In buy-side policies, insurers may retain the right to stand in the Buyer s shoes to seek redress from Sellers for claims that the insurer has paid. This can be a delicate issue. Sellers may be prepared to negotiate with the Buyer in the event of a breach but may be wary of being pursued by an insurer. It may be possible to secure a waiver of the insurer s subrogation right, but waivers are typically negotiated on a policy-by-policy basis (and potentially claim-by-claim). B. Typical Exclusions RWI typically does not cover the risks described below. Such exclusions may be addressed outside of the policy by separate escrows and other risk-allocation methods. 1. Known or heightened risks. Such risks (e.g., those arising from matters disclosed in the disclosure schedules or matters that may be inherently difficult to diligence, such as net operating losses) are typically excluded from coverage. Other high-risk areas include environmental exposure, health-care regulation, and intellectual property rights in tech-centric deals. However, special escrows or specialty insurance products such as tax insurance, litigation insurance, and special situation insurance may be available to properly hedge such risks. 6

2. Post-closing working capital or purchase price adjustments. These are typically excluded, as well as other matters where the insured has recourse through a mechanism other than standard indemnification for breaches of representations and warranties. 3. Fraud, if the policy is sell-side. Insurers are unwilling to insure Sellers against Seller fraud in sell-side policies. Coverage for Seller fraud is generally available in buy-side policies, but the insurer may retain the right to sue the Sellers when such a claim is paid. 7

VII. What Are the Benefits and Drawbacks of Escrows vs. RWI? 8

VIII. Allocating Transaction Risk: Other Forms of M&A Transaction Insurance Solutions to M&A risk allocation continue to evolve rapidly. As discussed above, RWI generally covers breaches of the selling company s representations and warranties. However, RWI typically does not cover (1) known or heightened risks, or (2) risks that are not the subject of representations but are the subject of a special indemnity (e.g., successor liability on an asset sale or a reverse break-up fee triggered by CFIUS blockage). Products such as tax insurance, specific litigation insurance, and contingent liability insurance complement RWI by covering these risks via specially tailored policies. Below is a breakdown of the frequency of breaches encountered by some insurers who participate in the RWI market, and a brief introduction to certain additional insurance products. A. Breaches of Specified Representations & Warranties As a % of All Breaches Tax: 32% Undisclosed liabilities: 13% Intellectual Property: 11% Employee-related: 10% Financial Statement: 8% Capitalization: 8% Other: 7% Customer Contracts: 7% Regulatory Compliance: 4% B. Tax Insurance Approximately one-third of all breaches of representations and warranties involve taxes. Tax insurance may be appropriate to cover this risk, especially where selling companies have complex or uncertain tax positions. Sellers may secure tax insurance early in the M&A sale process to reduce risk ahead of the Buyer s due diligence. Buyers may purchase it to transfer downside risk to an insurer, have access to the insurer s tax expertise if the tax position is challenged, and/or enhance the Buyer s bid for the Seller by removing the matter from the scope of indemnification. In particular, M&A transactions are often enhanced by tax insurance covering: Issues concerning historic net operating losses Issues concerning Subchapter S status Issues concerning REIT status Issues concerning spin-offs, corporate restructurings, recapitalizations (e.g., valuation of basis/gain, tax-free status, cancellation of debt income, etc.) Issues concerning transfer pricing, related-party transactions/fees, etc. Issues concerning nexus Issues concerning tax credits C. Specific Litigation Insurance The risk of pending or threatened litigation can be difficult for deal parties to allocate. To underwrite this risk, an insurer will review the schedule of pending and threatened litigation in the SPA disclosure schedules to determine whether claims against the Seller are insured under existing insurance. When they are not (or when they are not adequately insured), Specific Litigation Insurance may be available. 9

Insurers may insure pending litigation involving: Alleged breach of contract (not typically covered by other insurance); Alleged patent, trademark, or copyright infringement; and Threatened litigation that appears to have solid legal (as opposed to factual) defenses. D. Other Contingent Liability Insurance This is a catch-all category to cover risks not discussed above. The underwriting process will depend on the specifics of the risks to be insured. It has been used to cover, for example: The risk of successor liability in the context of an asset sale; and The risk of regulatory disapproval blocking the transaction and requiring a break-up fee (e.g., CFIUS blockage of transaction). IX. Conclusion RWI is a tool which may be useful in efficiently allocating risk and increasing deal value, and it may even be the key to winning a competitive bid. Whether RWI or an escrow is the right tool for a particular deal ultimately depends on the circumstances. In making this decision, it is critical to engage a neutral, experienced advisor that the parties can trust because the optimal tool may change as the deal evolves. If you have any questions concerning these developing issues, please do not hesitate to contact any of the following Paul Hastings New York lawyers: Neil A. Torpey 1.212.318.6034 neiltorpey@paulhastings.com Sean P. Murphy 1.212.318.6664 seanmurphy@paulhastings.com 1 Data from SRS Acquiom. 2 Data from AIG. Claim rates were only slightly lower for transaction sizes above this threshold. Most frequent sources are financial statement issues, followed by taxes, contract matters, and IP. 3 Other sources have presented similar ranges. PLC reports ranges of 2 4% as of 2015, and AIG points to 2 5%. 4 This rate is generally determined by the particular deal size. For example, 1 1.5% may be typical for enterprises above $50M, but transactions around $25M should expect rates around 2 3%. Further, a step-down is possible after 12 18 months. 5 Whether the Sellers remain liable for excluded matters or for clawbacks above the buy-side RWI limit is negotiated dealby-deal. Buy-side RWI is often used as a tool to eliminate the post-closing liability of Sellers entirely (except for Seller fraud), with the Seller s representations and warranties not surviving past closing. 6 RWI is typically obtained during deal negotiations and binds at closing because binding after closing can leave deal parties uninsured during the interim. Occasionally, however, parties obtain RWI after closing. Paul Hastings LLP PH Perspectives is published solely for the interests of friends and clients of Paul Hastings LLP and should in no way be relied upon or construed as legal advice. The views expressed in this publication reflect those of the authors and not necessarily the views of Paul Hastings. For specific information on recent developments or particular factual situations, the opinion of legal counsel should be sought. These materials may be considered ATTORNEY ADVERTISING in some jurisdictions. Paul Hastings is a limited liability partnership. Copyright 2016 Paul Hastings LLP. 10