[Ajay Krishna is a 4th-year B.A. LL.B. (Hons.) Student at The National University of Advanced Legal Studies, Kochi]
Mergers and acquisitions (M&A) transactions have been steadily growing in India and some of the most highly negotiated provisions in these transactions are those of indemnities in case of breach of representations and warranties. Globally there has been a rapid growth in the use of representations and warranties insurance (RWI) in relation to these transactions. However, a majority of domestic market players entering into such transactions do not seem to take advantage of the numerous benefits offered by these instruments to both buyers and sellers. This post examines the benefits and limitations associated with the usage of these instruments.
Representations & Warranties
Representations and warranties are concepts so closely intertwined that some may assume these to be synonymous. But, there exists certain key distinctions. A representation is an assertion as to a fact, true on the date the representation, made with the intention to induce another party to enter into a contract or take some other action. A certain mis-representation made can go all the way into rendering the contract itself void. A warranty on the other hand is a promise to indemnify in case the assertion made is false.
The terms are not defined in the Indian Contract Act, 1872. But, section 18 of the Contract Act defines the term misrepresentation. Additionally, section 19 provides two remedies if an agreement has been entered into by misrepresentation: the contract shall be voidable at the option of the aggrieved party; or the aggrieved party may insist on performance of the contract, and that it be put in the position in which it would have been if the representations made had been true. Warranty on the other hand is defined in section 12(3) of the Sale of Goods Act, 1930.
A distinction between the two was laid down by the Madras High Court in All India General Insurance Co. Ltd. and Anr. v. S.P. Maheswari, A.I.R. 1960 Mad. 484 albeit in the context of insurance contracts as follows:
The duty of disclosure comes under two heads, viz. (i) representation and (ii) warranties: representations which are made the basis of the contract and those which do not constitute the basis of the contract of insurance. The former are known as warranties. A representation is not strictly speaking a part of the contract of insurance or of the essence of it, but rather something collateral or preliminary and in the nature of an inducement to it.
In a transaction, although legal and financial diligence is carried out by the parties entering into it, even then an agreement evidencing such transaction contains provisions for indemnity payments to be made.
Representations & Warranties Insurance
In case of breach of any of the representations or warranties, indemnity claims may arise. Generally, the source for funding the indemnity is pre-negotiated. The traditionally used methods of funding the indemnity are:
i. Holdback of purchase price;
ii. Indemnification escrow account;
iii. Set-off against future payments; and
iv. Unconditional bank guarantees.
Amongst the ones mentioned above, maintenance of an indemnification escrow account is the most preferred. A latest trend is the parties to a transaction buying out an RWI in lieu of or in addition to any other means for funding the indemnity.
The earliest usage of such policies was seen in the 1990s. Most of these policies were generally a last resort arrangement where the seller would enter into an insurance contract through which the buyer’s claims would be met. The main drawback of these seemingly simple policy structures was that the seller could not have a “clean exit”. The other limitations were that most of these products were underwritten by underwriters who viewed these products from a broad “one size fits all” insurance angle rather than tailored to the requirements of a specific transaction. This generally meant broad exclusions and terms not customised to the transaction. An additional disadvantage was the high policy premiums due to limited number of players offering such products.
The modern day RWI policy terms are highly specialized and specific to each transaction. Since their benefits to both parties to a negotiation are now clearly identified, it is not uncommon to see buyer side insurance policies in addition to the traditional seller side policies. Typically, the policy covers financial statement warranties, inventory levels, vendor contracts, environmental law compliance and undisclosed litigation or tax liabilities.
In a buy side policy, it is the buyer who is the insured and claims directly from the insurer when a claim arises without resorting to contractual action against the seller. On the other hand, in a sell side policy, the seller claims reimbursement from the insurer for any costs incurred as a result of the claims brought by the buyer against the seller. Anecdotally, it has been seen that the buyer side policy has become more popular than the seller side policies. Globally, the retention amounts generally vary from 1% to 2% of the transaction value and premium varies between 2% to 3.5% of the insurance limit.
Some legal issues surrounding these include that in a buy-side policy the buyer must have performed a thorough due diligence and at the same time the seller must have carried out a thorough disclosure exercise. Anything which suggests otherwise may result in a higher premium being charged, lowering the scope of coverage or even denial of policy. Further, the buyer’s knowledge of any circumstance during the due diligence or as a result of any disclosure made by the seller may be exempted from a claim later. Similarly, in a sell-side policy there may be provisions to the extent that a seller may not be reimbursed for any claims which may arise as a result of fraud by the seller.
Benefits for Buyers
A few of the risk management and strategic uses of an RWI for a buyer are as enumerated:
• In an auction process, using an RWI may act as a ‘‘sweetener’’ as it allows a bidder to reduce the seller’s indemnity obligations making the bid appear more favourable to the seller.
• In case of distressed assets or companies where there might not be a great expectation of successful recourse from the seller as well as in the case of public companies where limited representations and warranties are given, the comfort offered by an RWI is much desirable.
• RWI can ease collection concerns against vendors who are a high credit risk post-closing since most of the RWI insurers are AAA rated institutions.
• In certain instances, where management teams are acquired and retained, even if there is comfort that the vendor will be able to pay claims, buyers for the sake of preserving the relationship with their new management teams prefer meeting claims from the insurer.
Benefits for Sellers
• It helps reduce the contingent liabilities on the books of the selling party post-closing of the transaction.
• An RWI helps distribute almost all of the sale proceeds. This is particularly beneficial to private equity funds and venture capital firms who desire to give a ‘clean exit’ to their investors. For instance, in a typical transaction without an RWI, 10% of the sale proceeds is generally deposited in an escrow account which is inaccessible to the seller. Whereas, with an RWI, this amount can be significantly brought down. The seller would only incur the retention cost which is generally between 1% and 2% of the transaction value and the policy premium (2% to 3.5% of the insured amount). This is why it is economical only for deals above a certain size.
• In a transaction it can protect passive and minority sellers who are not comfortable in providing joint and several indemnity to the buyer.
• It gives the sellers the opportunity to attract the best offers by maximizing indemnification.
Limits of RWI
RWI as its name suggests only covers breaches of representations and warranties. It does not cover covenant breaches, purchase price adjustments, or other payment obligations that might arise under an acquisition agreement.
RWI generally seeks to mirror as closely the language in the transaction document. However, insurers seek to exclude certain representations and warranties that they might deem to be too risky. Typical warranties that insurers may not cover include bribery and corruption, certain environmental issues, certain regulatory issues and financial warranties and pensions underfunding etc. In addition, the policy will not provide coverage for certain tax risks such as those resulting from transfer pricing arrangements.
Although the feasibility of using an RWI has to be considered on a case to case basis, with the entry of newer players in the market, the cost of securing an RWI policy is no longer a hindrance to its usage in most deals. Foreign investors well versed with the concept in their jurisdictions have also induced domestic market players into giving serious consideration to the costs and benefits associated with the usage of this relatively untapped instrument which has gradually started finding takers.
– Ajay Krishna