2019 guide to Foreign Private Issuer status
A company organized outside the US subject to provisions of the US federal securities laws receives benefits if it qualifies as an FPI.
A representations and warranties insurance policy, or RWI, is insurance that covers the losses that arise from a breach by the seller of its representations and warranties in an acquisition agreement.
This type of insurance is becoming more common in mergers and acquisitions.
The policy itself may be issued to the buyer in an acquisition and thus be referred to as a buy-side policy, or it could be issued to the seller and be referred to as a sell-side policy. The vast majority of policies currently issued are buy-side policies.
Through RWI, the insured can recover directly from the insurer for losses rather than from a party in the transaction. Thus, the insurance policy shifts the risk of loss from the seller to an insurer. By using this product, the buyer and seller can limit, or even sometimes eliminate, the seller’s potential liability for breaches of representations and warranties, while at the same time protecting the buyer from the risk of loss.
There has been an increase in the last year or two in the use of this type of insurance.
Some sellers warn bidders in asset or company auctions that the seller will not give much in the way of indemnities and the buyer will have to rely on representations and warranties insurance.
The increase in interest in this type of insurance is due partly to the fact that the types of transactions that can be covered by representations and warranties insurance now have expanded beyond simple industrial or manufacturing targets to a broader range of targets, including those in the energy and project finance sectors.
As the scope of the coverage expands, buyers and sellers are finding the product a more useful tool to address deal issues like survival periods for representations.
Another factor in the growing use of the product is many new insurers are coming into the US market. This has increased competition and put downward pressure on the premiums the insurers charge.
Just a few years ago, RWI premiums ranged from 3% to 5% of coverage limits and the retention, which is another term for the deductible, ranged from 1.5% to 2% of deal value. More recently, premium and retention amounts have steadily decreased.
Buyers of RWI may now find premiums below 3% of coverage limits and retention amounts of 1% of deal value or even less for larger transactions.
Given that the buyer most often purchases the policy, one would expect that the buyer would pay the premium. However, this cost is almost always negotiated between the buyer and seller as a transaction expense. Sometimes the buyer and seller agree to split the cost 50-50.
In terms of who takes the first loss, the deductible is often split so that the buyer bears the first half of it and then the seller is at risk for the second half. In essence, the retention is split. The first dollar is at the buyer’s loss, but the seller will bear some of that exposure so that the seller has some “skin in the game” in terms of its exposure to breaches of the representations and warranties.
The process of buying RWI insurance has become more streamlined and efficient over the last couple years. Today an RWI policy can be bound in as little as a week, although two to three weeks is more common.
The process usually tracks the time it takes to negotiate a transaction agreement. The process starts typically with a broker who specializes in this type of insurance seeking quotes from insurers. Insurers will submit non-binding indication letters called NBILs that will include information about the amount of coverage, premium, retention amount, proposed exclusions and areas of heightened risk that will be focused on during the diligence process. Some insurers may offer pricing options: for example, the NBIL will explain the effect on the premium of having a limit on liability $10 million versus $20 million or a retention amount of 1% versus 2%. The broker then helps the buyer evaluate the quotes, both in terms of pricing and the proposed exclusions. The broker and buyer usually end up jointly selecting the preferred carrier.
Once the carrier has been selected, an underwriter will be assigned if one was not already involved in preparing a quote. The underwriter looks at the acquisition agreement, the disclosure schedules and all the due diligence reports. The majority of underwriters also engage outside legal counsel to assist with the review, but there are some that do everything in-house.
After the diligence is completed, the broker and underwriter will schedule an underwriting call, that typically runs for about two hours, to allow the underwriter and its counsel the opportunity to ask questions about how the deal negotiations went, the deal terms and the diligence performed, and probe into matters that are of potential concern. The persons buying the insurance should spend time preparing for the underwriting call.
The best way to prepare for the underwriting call is to review the agenda and questions, if provided ahead of time, and make sure that the right people are on the call to provide answers. Have someone from the deal team on the call to discuss the business of the target and rationale for the deal. Have someone from the operational team who performed any operational diligence. Have the legal counsel who negotiated the agreement and performed legal diligence. Have a financial adviser who did the financial and quality-of-earnings diligence. Have a tax adviser who did tax diligence and can speak to the structure of the transaction and tax history of the target. Finally, it may also be useful to have subject matter specialists, like an environmental or regulatory lawyer, depending on what questions the insurer has said it has about the transaction.
The underwriter is more likely to take comfort in the answers if the buyer exhibits a thorough understanding of the deal and shows that thorough diligence has been done.
The underwriter will send a list of written follow-up questions after the call. These are questions about things that could not be answered during the call as well as any transaction-specific exclusions from the policy that have resulted from the underwriting process and review. The underwriter will also provide a copy of the draft policy if it has not already done so.
From this point, the buyer will simply address all the remaining follow-up questions and negotiate the policy. It is worth noting that the underwriter will want to review all subsequent drafts of the agreements and disclosure schedules, and any other materials that are produced, until the point when the deal is ready to be signed and the policy is bound, which typically occur at the same time.
Underwriters will expect to have very substantial third-party due diligence in place. They will expect an outside law firm or multiple firms to have done a robust due diligence review of the legal matters. They will want to see that an accounting firm has done a quality financial and tax review.
If the transaction is in an area like the energy industry, where specialist knowledge is needed to understand the potential risks, then the underwriters may expect also to see an independent engineer, environmental and permitting expert and possibly other consultants. The diligence is usually done by third parties. It is not done by the buyer.
However, if the buyer is a large institution that can demonstrate it has the expertise in-house, then there will be less need to have third-party reviews. If the buyer is a financial investor like a private equity firm, then the insurer will want a full third-party diligence review. Even with a large institution that has the experience to evaluate the deal on its own, third-party reports are preferred.
RWI coverage is intended to cover the typical representations and warranties that would be given by a seller in an M&A transaction and be indemnified by the seller. The policy also covers liabilities for pre-closing taxes as a separate indemnity.
However, the policy does not cover everything that an indemnity in a transaction agreement would normally cover.
For example, it does not cover breaches of covenants. It does not usually cover any special indemnities that are agreed during negotiations outside the standard indemnities. Thus, in most deals, even though there is representation and warranties insurance coverage, the seller indemnity will still be part of the transaction because it needs to cover the deductible and needs to cover covenants, special indemnities, potential exclusions from the RWI policy and other matters.
The presence of an RWI policy affects the seller indemnity in a significant way, but it does not eliminate the need for a seller indemnity. That said, lately as RWI policies become more prevalent in transactions and also in an environment that is more seller friendly from a deal perspective, with seller leverage increasing and competitive auction processes, some transaction agreements have no seller indemnity, and the buyer relies exclusively on insurance.
In transactions without a seller indemnity, the representations and warranties will not survive past closing, and the buyer essentially bears all the risk that is not covered by the RWI policy. The only recourse the buyer has for a seller misrepresentation is against the policy above the retention amount and to the extent there is no exclusion in the policy.
The insurers try to write policies that cover all the representations and warranties in the acquisition agreement. That said, the insurers are expecting the representations to look like the normal representations one would get in any deal. They may not want to cover any representations that are off market.
There are some representations that are in a minority of deals that some might argue are market for that type of deal, but that the underwriters generally exclude as a matter of practice. An example is a representation that there has been full disclosure by the seller of all material information or a variant based on the Securities and Exchange Commission anti-fraud Rule 10b-5. These types of representations are almost always excluded by an underwriter.
Another representation that is usually excluded is any representation that the target company is not insolvent and will not be rendered insolvent by the transaction. Underwriters do not feel in a position to evaluate the solvency of the target. Another example of a representation that is not covered is collectability of accounts receivable.
In general, underwriters do not want to cover representations that are so broad that they could cause losses that are at the maximum limits of the policy. They prefer to cover representations that are specific and targeted, and for which the potential exposure can be understood and quantified.
An example where the exposure can be understood is a representation that the target has not paid bribes to foreign government officials or otherwise violated the US Foreign Corrupt Practices Act. That type of risk can be understood by doing diligence. If the target company is operating in a high-risk jurisdiction or is engaged in contracting with foreign governments, then there will be more focus placed on the diligence done to confirm that there are no real risks in that area.
The insurers are fairly flexible on the amount of coverage that can be purchased. There is no magic formula, although most buyers look to buy coverage for about 10% of the purchase price. They may go up to 20% if they want larger coverage.
Fundamental representations are subject to a policy limit, which might be 10% of the purchase price paid in the acquisition. In the acquisition agreement itself, it is customary to have caps on the indemnity the seller may be required to pay. The cap for loss due to a breach of a fundamental representation — for example, that the seller owns what it is purporting to sell or that it has authority to enter into the transaction — is typically the full purchase price, if there is a cap for breach of such a representation. Lower caps would usually apply to indemnities for breaches of representations that are not considered as fundamental.
The point is that by taking on an RWI policy and agreeing to look to the insurance rather than the seller for indemnification, you are losing any enhanced coverage for fundamental representations that you might otherwise have been offered in the acquisition agreement.
Getting coverage through insurance for fundamental representations, in a way that the buyer would expect from the seller absent insurance, has been a challenge. Fundamental representations are things that are so fundamental that if untrue, the deal really should be unwound. However, some new insurers coming into the market are offering a special coverage for fundamental representations only that give the policyholder coverage for up to 100% of the purchase price. It is a type of excess coverage above the normal policy limits. The buyer must pay extra, but it is available if the buyer wants to close that gap.
The policy will have a list of exclusions or risks that it does not cover. For example, it does not cover known issues. If there is a known litigation, it will not be covered by the policy. Matters that are disclosed on the seller disclosure schedule are not covered by the policy nor are material issues that are raised during due diligence.
Thus, if there are known risks, the buyer should be prepared to find another way to address those than relying on an RWI policy.
For example, the seller might agree to a special indemnity, sometimes supported by an escrowed holdback of part of the purchase price or other credit support. Alternatively, the parties might decide to reduce the purchase price to address a known risk.
There are some special considerations for RWI policies in the energy area. It is important to keep in mind that this type of insurance has historically covered transactions that involve manufacturing and other light industrial companies. Covering energy and project-type deals is a more recent development, and many underwriters are new to the area.
Anyone buying insurance for an energy project should be prepared to spend time educating the underwriters about the types of risks in such deals. The underwriter in these types of deals will almost certainly bring in an outside law firm to help evaluate the diligence and identify the risks. The underwriter might rely more heavily on counsel than usual.
In these situations, buyers need to take a more comprehensive approach and lay out the risks in diligence reports in a manner that someone who is new to the area can follow. The underwriter will take more comfort from a report that it can understand. The lawyers and others doing diligence should get advice from the broker at what level of comprehension to write a diligence report that is as much for the insurance underwriter as the buyer in the M&A transaction.
There has not been a long claims history because the product has not been offered in the volume that it is today. That said, there have been a lot of claims made. Claims are more likely to be made under an RWI policy than made against sellers in cases where there is no RWI policy in place.
The insurers are well prepared to deal with claims. That is part of their line of business. They have entire groups within the insurance company who deal with claims. They have processes in place to pay out claims, and they are used to paying out claims.
Buyers in the M&A market are getting more comfortable that insurers do indeed pay on these claims and are capable of assessing and making appropriate decisions on the payment amounts after claims are made.
This is an area to watch. If claims begin to exceed what insurers expect, then it will obviously affect pricing and availability of the product. This is all the more reason for buyers and sellers in the M&A market to do a serious negotiation, allocate risks appropriately and do thorough diligence as if they will not be able to rely on insurance because that is what is most likely to lead to a stable market going forward.
Sustainable finance is a key priority for the EU and is high on the regulatory agenda for asset managers and other financial institutions.