As more money has crossed the border, so has the popularity of deal-making insurance
Five years ago, representations and warranties insurance was a once-in-a-blue-moon sort of challenge for McCarthy Tétrault LLP lawyer Jake Irwin. Last year, says Toronto-based Irwin, it was a factor in about eight of every 10 deals.
His hunch — that the insurance was really taking hold — was confirmed by the American Bar Association’s yearly Mergers & Acquisitions study, which this year was accompanied by an “Indemnification/RWI Cheat Sheet.”
“I've been at McCarthys for about seven years, and previously I was at an international firm. And, so, I've always taken an interest in what's happening abroad. And one of the things that's helpful to M&A lawyers is we have a great deal of literature and learnings out of the U.S. that we sometimes import up here in Canada,” he says.
As a deal unfolds for one company to buy another, parties, particularly sellers, will disclose information about the target: stocks, assets and liabilities being transferred. If these so-called representations turn out not to be true (say, financials are misstated, the company has improper permits or disputed intellectual property), some sort of warranty would be in place to reimburse the other party — or so one would hope, based on what the textbook definitions suggest.
The insurance — which protects buyers from losses resulting from breaches of warranties or claims on indemnities — can also protect sellers against liabilities such as defence costs and settlement. Clean vendor exits and management rollovers are some of the scenarios that can be eased by RWI, both in cross-border and domestic deals, says Rory ffrench, a partner at Blake Cassels & Graydon LLP.
“There are a variety of situations in which RWI can be beneficial in achieving the objectives of each side on a deal,” says ffrench.
It’s not a new product — nor is it surprising that it would gain popularity, given the alternative of escrow holdbacks, says Irwin. Not to mention that as the market has grown, premiums have dropped: Torys LLP estimated that in 2017 alone, premiums on deals with US$100 million to US$500 million enterprise value dropped from an upper range of 3.75 per cent to as low as 3 per cent.
“Right now, it's a very useful product. It's priced extremely inexpensively and is fairly easy to put in place,” says Irwin. “Instead of putting money in escrow for a period of time, clients are willing to purchase the insurance instead — it's just a better economic decision for them.”
As Canadian RWI brokers make a name for themselves — now fixtures at coffee meetings and conferences — there has been a “knock on effect” across the deals market, says Irwin.
“Previously, in Canada, we had indemnity caps that were 100 per cent of the purchase price or 50 per cent. And, so, even on deals in Canada that aren't using the insurance, we're seeing those cap numbers come down as a result of the market for insurance dictating that you only need a 10-per-cent or 20-per-cent liability limit. And, so, it's having an effect on M&A whether you use the product or not,” says Irwin.
“So, sellers are able to exit deals with, you know, only 10 or 20 per cent ongoing liability, and they can limit it to the insurance — or they can have that lesser exposure, post closing. And, so, that's been a bit of a big change in the last five years in Canada.”
Traditionally, as lawyers at Osler Hoskin & Harcourt LLP put it, U.S. deal terms are typically more “pro-seller” than Canadian terms. While Canadian deals remain “more favourable to buyers” on average, Osler noted that there has been a convergence, with RWI trends marking “the most significant shift in the North American market since the death of the financing in the mid-2000s.”
“The familiarity of Canadian clients with RWI is generally dependent on how active they are in the M&A market. Active Canadian buyers and sellers — e.g., private equity funds, pension plans — will be as knowledgeable about and as comfortable with RWI as their counterparts in the U.S.,” says ffrench. “Outside of financial sponsors and other active participants, very generally speaking, it would be fair to say that American buyers and sellers tend to be more familiar with and more readily willing to use RWI than their Canadian counterparts; but that is certainly changing with each passing year as the pros and cons of RWI become more widely understood in the Canadian market.”
Irwin says that, as the insurance becomes the norm, some of the time spent in negotiating representations and warranties has shifted toward time to allow underwriting.
“The insurance companies typically use the same lawyers each time and they're very efficient. It means you need to build about an extra week into your schedule in order to get the insurance company up to speed and allow them the opportunity to underwrite the insurance,” says Irwin.
“Usually, you have that week anyways. But it's another parallel track to undertake as you as you look to get a deal signed up.”
On the other hand, ffrench has found the efficiency of insurers works in his favour as far as deal timelines go. The allocation of time can change, though, he notes; for example, more time may be spent on due diligence activities to satisfy the underwriters’ concerns, while less time may be spent on purchase agreement negotiation as indemnification provisions become less significant in the context of the business deal.
“It typically would not alter the overall length of a deal,” says ffrench. “Brokers and underwriters are very responsive and adept at moving quickly, and counsel that is familiar with RWI can help steer its client through the process smoothly. “
As a lawyer, ffrench has found that clients sometimes look to counsel for guidance about how to conduct the RWI process — although some clients or their investment bankers already have relationships in the RWI industry.
“It is beneficial for M&A counsel to have good working knowledge of RWI policies and underwriting processes as well as established relationships with brokers to help facilitate a smooth process for clients,” says ffrench.
RWI should continue to gain ground, both in acquisitions by sponsor-backed and strategic buyers, ffrench says. Irwin notes that the product has a long history in the European market that can help guide Canadians as well.
Irwin estimates that, going forward, eyes will increasingly turn toward the claims patterns.
“All of these policies have now been underwritten; we’re coming to the end of the claims period for the first generation of these deals. And so that means that, if a claim is going to be made against the insurance company, now — instead of against the sellers — it's going to be made in the next in the next little while,” says Irwin.
“The experience has been that purchasers have been more likely to make a claim against these insurers than they previously were against sellers. And, so, there's been an increase in M&A litigation as a result, and we still haven't really seen that trend fully work itself through. Whether that's going to have a feedback effect on the actual insurance itself or on the way we do deals is still, I think, something that M&A practitioners are waiting to see.”
The 411 on representations and warranties insurance
50% - The estimated decrease in RWI cost between 2011 and 2016 (McCarthy Tétrault LLP)
100% - The yearly increase in RWI policy issuance in the U.S. from 2012 to 2014 (McCarthy Tétrault LLP)
$30 million to $5 billion - Deal size where RWI is typically used (McCarthy Tétrault LLP)
52 - Number of acquisition agreements between 2012 and 2015 that referenced RWI in Canada (Thomson Reuters Practical Law)
2% to 4% - Average premium amounts for those deals (Thomson Reuters Practical Law)
1 to 2 - Number of weeks needed to complete underwriting on the deals (Thomson Reuters Practical Law)
What’s market for RWI claims
19.4% - RWI policies that received a claim notification in 2018
33% - Claim notifications that are made within the first six months after policy inception
45% - Share of North American claims submitted after 12 months, due to escrow funds being released