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In most acquisition agreements, the seller makes various representations and warranties to the buyer about the assets, liabilities, and business being purchased. The value to the buyer of such representations and warranties depends on the financial recourse that the buyer will have if they prove to be inaccurate. One relatively new option for protecting the buyer from a seller’s inaccuracies is representation and warranty insurance. Although representation and warranty insurance has been offered in the global insurance market (particularly in the United Kingdom) for many years, the U.S. market for this product is still in the early stages of development. Over the last five years, the use of this insurance in the United States has increased substantially as U.S. dealmakers have become more knowledgeable about the product. While it is not a “one size fits all” solution, representation and warranty insurance can have substantial utility in appropriate circumstances. PRODUCTS AND PRICING Insurance companies in the United States offer both buyers and sellers policies. Under a buyer’s policy, the insurer reimburses the buyer for losses due to inaccuracies in the seller’s representations. Under a seller’s policy, the insurer reimburses the seller for losses resulting from inaccuracies in the seller’s representations. Representation and warranty insurance is generally designed for acquisitions where the purchase price is between $25 million and $500 million. Insurers will typically provide up to $50 million in coverage for any one transaction. Policy periods match the “survival period” for the representations and warranties set forth in an acquisition agreement, though a three-year policy period is generally the longest available. Premiums are generally 4 percent to 6 percent of the amount of coverage purchased in the case of a buyer’s policy, and 3 percent to 5 percent of the amount of coverage purchased with a seller’s policy. BETTER THAN ESCROW Representation and warranty insurance can be particularly useful in circumstances in which the seller is unwilling to establish an adequate indemnification escrow account, which is the traditional alternative. This alternative requires the seller to indemnify the buyer for any inaccuracies, most commonly by depositing a portion of the purchase price in an escrow account. But in a typical acquisition, the objectives of the buyer and the seller with respect to the size (or even existence) of an indemnification escrow are in direct conflict. A buyer is concerned about its ability to realize the benefit it sought to obtain from the seller’s representations. Accordingly, it wants a large escrow account. In contrast, a seller wants at most a small escrow account. Sellers may be concerned about potential reductions in net sales proceeds, as well as having money tied up in the escrow account. Sellers may also need the money because of obligations to apply the sale proceeds to debt repayment or distributions to investors. With private equity funds or similar investment vehicles, a large indemnification escrow can negatively affect calculations of return on investment, as well as investor relations. Accommodations made by either party on the indemnification escrow arrangements may involve considerable pain. The failure of one or both parties to make sufficient accommodations may result in a deal-breaking impasse. In appropriate circumstances, representation and warranty insurance may offer a mutually acceptable solution. Assume, for example, that the buyer desires an indemnification escrow equal to 15 percent of the purchase price, but the seller desires to limit the indemnification escrow to 5 percent of the purchase price. A combination of an indemnification escrow equal to 5 percent of the purchase price and “excess” representation and warranty insurance providing coverage equal to 10 percent of the purchase price might reasonably accommodate both parties. Which party actually pays for the policy is, of course, subject to negotiation. STILL ON THE HOOK Insurance underwriters will generally require that one or both of the parties to an acquisition agreement still bear meaningful risk regarding potential inaccurate representations. Consequently, although stand-alone representation and warranty insurance can be purchased, the parties (particularly the buyer) may find it cheaper to buy a policy as a supplement to an indemnification escrow. When both an indemnification escrow and a representation and warranty insurance policy are utilized, the buyer would seek to recover any loss resulting from an inaccuracy first from the indemnification escrow (after satisfying any applicable deductible) and thereafter under the insurance policy. The policy typically would not cover losses until they were equal to the sum of the indemnification deductible and the indemnification escrow amount. ACQUISITION AGREEMENT The use of a buyer’s insurance policy to supplement an indemnification escrow raises a number of practical considerations that, from a buyer’s perspective, require careful analysis and treatment. Seller’s representation regarding the policy. If the seller is responsible for furnishing the insurance policy, the buyer may want to require the seller to warrant that, as of the closing, the policy is in full force and is binding against the insurer. The buyer may also want to require the seller to warrant that the obligations of the insurer under the policy are not subject to any defense based on fraudulent inducement or any other misrepresentations by the seller that would void or otherwise impair coverage under the policy. In general, the buyer may want to insist that the seller’s indemnification obligations in respect of this warranty not be subject to any deductible or cap. Because the utility of these warranties is limited by the buyer’s practical ability to recover from the seller, a buyer should carefully consider this issue before agreeing to accept an insurance policy in exchange for a smaller indemnification escrow. Survival of seller’s representations and warranties. It is important to ensure that the representations and warranties do not terminate before the end of the policy period. The better way to approach any agreed-upon time limits is to specify an outside date for the assertion of claims, rather than a date as of which representations and warranties terminate. For similar reasons, customary language limiting the buyer’s recourse for inaccuracies in the seller’s representations and warranties will need to be expanded to refer also to the insurance policy. Indemnification cap. To ensure the intended interplay between the indemnification escrow and the insurance policy, it may be appropriate to provide that the buyer’s losses arising from inaccuracies in the seller’s representations and warranties are to be (1) applied first to satisfy any deductible applicable to claims against the indemnification escrow, (2) then recovered from the indemnification escrow (with such losses also being applied against the retention set forth in the insurance policy), and (3) recovered from the insurance policy to the extent possible. MODIFYING THE POLICY To harmonize the provisions of the insurance policy with those of the acquisition agreement and otherwise to address the particulars of a specific transaction, substantial modifications to the insurer’s basic policy form may be required. The following issues may warrant particular attention. Scope of coverage. The insurer typically agrees to indemnify the insureds against any loss in excess of an agreed retention amount arising out of a breach of the seller’s representations and warranties set forth in the acquisition agreement (or a specified subset thereof). • Definitions. The definition of “insureds” in the policy should conform to the definition of “indemnified parties” (or the equivalent) set forth in the acquisition agreement (e.g., the buyer and its affiliates, officers, directors, employees, agents, successors, and assigns), and the definitions of “loss” and “breach” should conform to the corresponding or comparable definitions in the acquisition agreement. • Retention. A policy will typically provide that the insurer will be liable for losses only in excess of a specified “retention amount.” For obvious reasons, the retention amount should be no greater than the sum of the deductible set forth in the acquisition agreement and the indemnification escrow amount. Coverage exclusions. The buyer should request that the insurer cover defense costs associated with any third-party claim related to the acquisition seeking or resulting in criminal fines or penalties (or other losses that themselves are excluded from coverage). The buyer also should consider the scope of the exclusions when negotiating the amount of the indemnification escrow, since the escrow will generally constitute its sole source of recovery with respect to losses excluded under the policy. Coverage determinations. To have as seamless protection as possible, the buyer will want determinations as to which losses justify dipping into the escrow account to be binding on the insurer. This is so that these losses count toward satisfying the retention amount. Conversely, the insurer will want to make coverage determinations independently. While the interplay between coverage determinations relative to the indemnification escrow and the insurance policy is subject to negotiation, it may be possible to provide that escrow-related determinations will be binding on the insurer at least when the entire amount of the loss is payable from the indemnification escrow. This type of solution ensures that the party with the greatest economic incentive to get it right makes the coverage determination. Perhaps more important, it prevents an insurer from rejecting a claim that has been approved by the seller and is payable from the indemnification escrow solely to prevent the loss from reducing the retention set forth in the insurance policy. Choice of law. Most insurers will propose that the policy be governed by the laws of a jurisdiction favorable to insurers. The buyer may want to insist on a jurisdiction more favorable to insureds. In sum, although not appropriate for all situations, representation and warranty insurance may have substantial utility when a buyer and seller have irreconcilable differences relative to the size or existence of an indemnification escrow. Although representation and warranty insurance now appears to be used most frequently in the United States when the seller is a private equity fund or similar investment vehicle, its use will likely expand as the business and legal communities become more knowledgeable about it. Mark E. Betzen is a partner and Mark T. Goglia is an associate in the Dallas office of Jones Day. They both practice in the area of mergers and acquisitions. They may be reached at [email protected] and [email protected], respectively.

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