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You closed the deal on an important acquisition. Now, a few weeks in, you’re slowly beginning to realize that the business you purchased is different from the business you diligenced. Liabilities related to the pre-closing period are popping up out of nowhere. A material customer just canceled its contract, seemingly out of the blue. Worst of all, your auditors are now telling you that the pre-deal company may not have been recognizing revenues and costs appropriately, thereby overstating the earnings before interest, taxes, depreciation, and amortization (EBITDA) for the business.

As this drama continues to unfold, you take comfort in the fact that you purchased a representation and warranties (R&W) insurance policy as part of the transaction. Now comes the hard part: you must begin to think about what potential claims you know about, how you are going to gather documentation sufficient to support those claims, and whether there are other claims still lurking out there that have not yet materialized.

In this article, we explore four areas where disputes may arise between the insurer and the insured, and examine ways to address those issues.

The Current Dispute Market

Purchase price disputes (PPDs) can be costly for all parties. Five years ago, most PPDs settled. Now disputes—even over small deals—are on the rise. Increasingly, buyers and sellers seem willing to invest in seeking a favorable resolution through engaging in such disputes.

Part of this growth is driven by a feverish M&A market, and a desire on the part of both parties to close deals quickly, sometimes without agreeing fully on valuations. Instead, these deals may embed working-capital and earn-out mechanisms to help true up, later, the differences in the valuations, with R&W policies in place as an added layer of protection. In the private equity market, dispute risk can even be seen as a source of strategic advantage, where buyers essentially arbitrage such risk against positive expected value.

Together, these practices and trends are shining a brighter spotlight on the growing market for representation and warranties (R&W) insurance. While such policies have been around for a while, we recently have seen an increase in R&W claims. With the stakes growing higher by the year, this particular dispute market is emerging as a hot topic for lawyers on all sides — buyers, sellers, and underwriters.

R&W Insurance: How Does It Work?

Typically, R&W insurance is acquired to cover purchasers for the breach of a representation or a warranty — such as for regulatory noncompliance, tax exposure, environmental conditions, accounting issues or other matters — contained in the sales and purchase agreement (SPA).

R&W insurance bridges negotiation gaps, while providing benefits to both buyers and sellers. Policies generally cover either buyers (a “buy-side” policy) or sellers (a “sell-side” policy). Sellers may also purchase a buy-side policy on behalf of a buyer or vice versa. Currently, buy-side policies make up the majority of policies underwritten.

An example of a seller’s representations and warranties that may be covered under a policy is that the financial statements—balance sheet and income statement—have been prepared and are presented in accordance with generally accepted accounting principles (GAAP). If, after the transaction closes, it is determined that the historical financial statements violate GAAP, the buyer may decide to file a R&W claim. However, the filing of such a claim may not result in a payout: the insurer may challenge or deny the claim based on the terms of the policy.

The inability to agree on the amount of damages related to such claims has led to an increase in dispute resolution provisions such as arbitration, a relatively new development. We expect to see many more R&W claims resolved through arbitration proceedings in the near term, as the claims mature and the parties fail to settle.

Four Critical Policy Terms                                                                                               

Given current market trends, the growth in R&W claims shows no sign of abating. Listed below are four key elements of policies that could influence the outcome of a dispute regarding R&W policy coverage:

Arbitration Clauses. Many insurance policies contain a provision appointing a three-arbitrator panel, with each party selecting an arbitrator, and those two arbitrators selecting the third arbitrator. From the start, it is useful for each party to do two things: (a) decide in advance on as much of the arbitration decision criteria as possible; and (b) think carefully about whether they would prefer an attorney or an accountant on the panel. Accountants and lawyers provide different perspectives when it comes to R&W policies.

If the dispute involves GAAP or valuation issues, it may benefit both parties to include an accountant or financial professional on the panel, along with attorneys to provide legal expertise.

Limitations on Claims. SPAs and R&W policies often include limitations on the types (and amounts) of claims that can be recovered. Following are some typical examples:

• Survival Period. A defined period for making a claim, usually between 12 and 18 months (for public transactions, the survival period ends at closing).

• De minimis. A limit on claims made for individual losses, usually between $25,000 and $75,000.

• Basket or Retention. A minimum amount of the aggregate of all claims that must be reached before a claim can be made. Once the limit is reached, claims can be either in excess of a limit (referred to as the deductible, or retention amount—either a fixed dollar amount or a percentage of the purchase price) or from the first dollar (referred to as a “tipping basket”). The basket is typically set at approximately 1 percent of purchase price.

• Cap or Policy Limits. The limit on the total of all claims made. Amounts vary based on the specifics of the policy, transaction, and the extent of diligence.

The dollar amounts for the cap and basket can be determined by applying an accepted percentage to the total purchase price.

Materiality Threshold. If the contract is silent regarding when and if a dispute is considered “material,” this may be a key area of conflict. Buyers and sellers can potentially reduce the risk of claims by agreeing to a de minimis limit or a definitive threshold for materiality in the sales and purchase agreement (e.g., by setting a dollar threshold that must be exceeded before claims can be asserted).

Materiality as defined by GAAP is not necessarily equivalent to the meaning of the term “materiality” in a purchase and sale agreement or policy; in other words, if a policy contains a so-called “materiality scrape,” it does not “scrape” the concept of materiality from GAAP. As a result there may be conflicting issues around the materiality standard—insurers may claim a disputed amount is not “material” to the financial statements because those financial statements are in accordance with GAAP in all “material” respects (i.e., the disputed amount is below a “rule of thumb” quantitative threshold). However, according to the U.S. Securities & Exchange Commission’s Staff Accounting Bulletin No. 99, qualitative assessments must be performed. To the buyer, who may suddenly be dealing with a liability it was not aware of pre-closing, a difference that could have changed relevant deal considerations would most definitely be “material.”

Contract Confusion and Moral Hazard. Inconsistencies or a lack of harmony between the terms of the insurance policy and the purchase agreement are often flashpoints leading to disputes. There could also be a “moral hazard” if a seller perceives that its risk and exposure are mitigated due to the existence of an R&W policy, resulting in potentially aggressive representations and warranties in the purchase agreement.

Conclusion

Given today’s dynamic deals market and the complex, high-stakes considerations involved in R&W claims, it is wise for all parties with an economic interest in the transaction—buyers, sellers, underwriters, and their counsel to consider in advance the possibility of a R&W dispute, and take steps to mitigate this risk through contract and policy negotiation and, if needed, an efficient and effective dispute resolution process.

Douglas Bloom is a director in PricewaterhouseCoopers’ cybersecurity and privacy practice and is a member of the firm’s Financial Crimes Unit. He is also an adjunct law professor at Fordham University.