Deal Points Volume XXIV, Issue 3
The Newsletter of the Mergers and Acquisitions Committee
American Bar AssociationFall 2019
Required Accuracy of Seller’s Representations as a Condition of Closing in Transactions Involving Representation and Warranty Insurance
Buyers and sellers of businesses increasingly are structuring their transactions in order to transfer to insurance companies some of the responsibility to reimburse the buyer for its losses arising out of the seller’s breach of its representations and warranties in the purchase agreement. However, even in this increasingly favorable marketplace for insureds, representations and warranties insurance (RWI) policies are not a panacea for all risks that may exist for a buyer in an M&A transaction. A common exclusion from coverage are breaches of representations and warranties that first occur after the purchase agreement is executed and that are known to the buyer prior to the Closing, which exclusion is commonly defined in RWI policies as an “interim breach”. While parties are more frequently requesting and obtaining additional RWI coverage for interim breaches, losses arising out of an interim breach remain a standard exclusion from coverage. Given this common exclusion from coverage for an interim breach, this article comments on the importance of properly considering the materiality thresholds used in certain closing conditions in transactions involving RWI where the closing date will occur after the purchase agreement is executed.
In M&A transactions involving a purchase agreement that is executed prior to the closing date, two questions that need to be addressed by the purchase agreement include: (1) When must the seller’s representations and warranties be true in order for buyer to have a claim for breach (for example, when the purchase agreement is signed and/or when the transaction is closed); and (2) how true must the seller’s representations and warranties be in order for the buyer to be obligated to close? In order to address the second question, a seller typically is obligated to certify, as a condition to buyer’s obligation to close, that the seller’s representations and warranties made in the purchase agreement remain true at closing, subject to negotiated materiality qualifications. This certification is commonly referred to as a “bring down certificate,” and is intended to give the buyer some comfort (again, subject to negotiated materiality qualifications) that the target business has not materially degraded during the period between the signing of the purchase agreement and closing.1
Adding significant materiality qualifiers to the closing condition requiring the seller’s representations and warranties to be true and correct at closing can cause the buyer to incur substantially more risk than the buyer expected and its purchase price assumed.
In a typical purchase agreement involving RWI, the seller’s liability for a breach of the representations and warranties is capped at a portion of the retention under the RWI policy. For example, a typical allocation of risk between the buyer and the seller for the seller’s breach of non-fundamental representations and warranties would involve the buyer being responsible for losses up to .5% of the purchase price, and the seller then being responsible for losses up to the next .5% of the purchase price, at which point the retention under the RWI policy would be satisfied and the insurer would be responsible for the remaining losses up to the policy limit.
However, in the event of an interim breach, the seller’s share of the losses would remain at .5% of the purchase price, but there would be no insurance coverage to cover the excess because losses arising out of an interim breach are excluded from coverage. Unless the buyer is able to insert into the purchase agreement a line-item indemnity for all matters excluded from coverage, which few sellers would accept, the buyer’s primary protection in the event of an interim breach involving significant losses would be to refuse to close. But if the seller has succeeded in adding significant materiality qualifiers into the bring-down closing condition (such as a “material adverse effect” qualifier) in order to increase the likelihood of closing, the buyer may be forced to close in the face of significant losses (as long as they do not constitute a “material adverse effect,” for example) with no recovery from the insurer and limited recovery from the seller. 2
So given the seller’s justifiable desire for “deal certainty” after the purchase agreement is signed, as well as the buyer’s justifiable desire to maintain limited exposure for losses arising out of a breach of a representation and warranty by the seller, how should sellers and buyers address the issue of an interim breach in the context of the buyer’s condition to closing? One obvious way to address this issue would be to purchase coverage for interim breach under the RWI policy. Assuming that coverage for interim breach is not available or otherwise not purchased, then there appears to be no “silver bullet” that would address this issue satisfactorily for all buyers and sellers in all transactions.
While factors including the relative leverage of the parties, the anticipated time between signing and closing, and required publicity of the transaction pre-closing must be considered, at least one perspective that may be helpful to address this issue is to consider how the risks would be allocated for the interim breach between the buyer and the seller in a transaction without RWI. If one assumes for purposes of illustration that a “market” indemnification basket would be a deductible basket equal to 1% of the purchase price in a non-RWI transaction, the buyer would be taking the risk of incurring losses up to 1% of the purchase price in the case of an interim breach. Accordingly, one may argue that the buyer should still be required to close as long as an interim breach does not involve potential losses to the buyer in excess of 1% of the purchase price. If the purchase agreement requires the seller to pay losses for an interim breach up to .5% of the purchase price (after the buyer pays its share up to .5% of the purchase price), then buyer’s exposure for an interim breach involving losses equalling 1.5% of the purchase price would be limited to 1% of the purchase price. As a result, from this perspective, the buyer should have to close as long as the interim breach does not involve potential losses in excess of 1.5% of the purchase price.
This approach certainly would not be ideal for the buyer or the seller. The seller may want the ability to force a buyer to close even if an interim breach involves potential losses exceeding 1.5% of the purchase price, a very low threshold when compared with typical materiality qualifiers on closing conditions. If so, in the event of losses that can be easily quantified, the closing condition could provide the seller with the option to elect to force the buyer to close as long as the seller is willing to indemnify the buyer against any losses exceeding 1.5% of the purchase price (potentially subject to a market cap).
On the other hand, the buyer may not like the idea of closing the transaction knowing that it will immediately incur an unreimbursed loss equal to 1% of the purchase price. In addition, in order to recover under the RWI policy for other breaches of representations and warranties, the buyer would have to incur losses of .5% of the purchase price (or more likely 1% of the purchase price if the retention does not step-down to .5% of the purchase price after the seller pays losses for the uncovered interim breach equal to its .5% cap) arising out of breaches of representations and warranties covered by the RWI policy before the insurance company would pay for losses arising out of those breaches.
However, while not perfect and certainly not the only potential approach, this approach could prevent any unexpectedly large risks from being incurred by either party while still providing some assurance to the seller of closing. Regardless of how buyer’s counsel chooses to address an interim breach in its closing conditions in a transaction involving RWI with no coverage for interim breach, it is important to make sure the buyer is aware of the interplay between the closing conditions and an interim breach, and willing to accept the risks to closing and/or incurred losses that the chosen approach presents.
1 Counsel for the buyer sometimes may rely on the bring-down certificate (as qualified by the negotiated level of materiality) to address the first question stated, above (i.e., when must the representations and warranties be true in order for the buyer to have a claim for breach). However, the bring-down certificate may be drafted to answer only the second question (i.e., the accuracy required as a condition to closing). When the bring-down certificate is used to address the first question, any negotiated materiality qualifiers used for purposes of defining the accuracy of the representations and warranties required as a closing condition (such as material adverse effect) would add a second (and potentially significant) filter of materiality (beyond negotiated baskets, claim thresholds, etc.) to any ability of the buyer to recover for a breach of representation or warranty that first arose after the purchase agreement was signed. This result may be contrary to the expectations of the buyer’s client regarding allocation of the pre-closing date (not only pre-signing date) risks of the business.
2 The lack of coverage for interim breach under most RWI policies, combined with the chosen materiality threshold for the closing condition relating to the accuracy of the seller’s representations and warranties at closing, can create strange incentives for the seller and the buyer regarding any obligation of the seller under the purchase agreement to update the buyer after the signing date regarding new developments in the business that could constitute a breach of representation or warranty. For example, given the absence of RWI coverage for these new developments, the buyer may not want to know about them unless and until they would give rise to the right not to close.