Over the past decade, there has been a fairly rapid adoption of transactional risk insurance by parties to corporate transactions. They are regularly seeking insurance solutions through representations and warranties insurance (RWI) (or, as it is sometimes referred to outside the U.S., “warranty and indemnity insurance”) to minimize potential downside risks they face should any promises the transaction parties made to each other turn out not to be true. Relatedly, with post-transaction shareholder disputes continuing at a solid pace in the U.S., companies are considering if and how their directors’ and officers’ (D&O) insurance may provide coverage in the event of a post-closing dispute, including disputes over the valuation of a transaction.
Given the rapid adoption of RWI policies and ongoing litigation under D&O policies for post-transaction events, the authors have kept a close eye on how coverage disputes under these two policies have developed. Many of the coverage disputes that have reached public litigation under these policies involve the “bumping up” of share prices and valuation “multipliers.” These coverage disputes, plus the mergers and acquisitions (M&A) market generally and policyholder interest in insuring post-transaction events, have each affected how underwriters are “weighing” the risks of the companies and transactions they insure.
This two-part article—the first on RWI and the second on D&O insurance—assesses what’s on the horizon for transactional insurance in light of recent developments in underwriting, claims, and coverage disputes.
In 2023, M&A activity fell to a 10-year low, reflecting a broad global decline in deal-making activity and a sharp decrease in initial public offering activity. For the deals that did occur, there was an increase in minority transactions and secondary exits (wherein company shares are sold by individual shareholders rather than the company).
Despite last year’s decline in M&A activity, RWI has never been more popular. According the 2023 Private Target M&A Deal Points Study published by the ABA Section of Business Law, from 2016 to 2023, the percentage of private company transaction agreements in the United States that referred to RWI grew from 29 percent to 55 percent.
For companies contemplating a transaction, RWI is often viewed as an integral tool to enable smoother negotiations, reduce friction between buyers and sellers, and safeguard against unforeseen risks that might arise post-transaction. In general, these policies protect against unforeseen liabilities or financial losses that may arise or be discovered post-transaction that result in breaches of representations and warranties. RWI policies are primarily “buyer-side” policies, issued to the buyers to protect against the downside risk of breaches by the seller, but there are also “seller-side” policies to cover the seller should the buyer later claim a breach. By transferring the risks of a loss due to a breach of representations and warranties from the buyer and seller to the insurer, these policies not only protect against the subject risk but also facilitate deals by enabling buyers and sellers to close transactions with the assurance that a reliable safety net exists to address risks that may materialize later, essentially lowering the transaction costs of M&A deals. Unlike the traditional indemnification provisions in transaction agreements, which would rely on the financial stability of the seller or the liquidity of escrow arrangements that lock up a portion of the purchase price, RWI offers a risk-management tool that has a fundamentally different security and dispute-resolution profile. Such policies also promote deal efficiency by allowing sellers to walk away with less exposure to potential claims, which, in turn, facilitates cleaner exits and quicker settlements. By shifting risks to an insurer, transaction parties can better allocate resources and focus on their core business objectives.
RWI typically covers the insured party’s (either the buyer’s or seller’s) loss due to breaches of representations and warranties that are specified in the underlying deal document. Those representations and warranties encompass a range of areas such as financial statements, legal compliance, litigation, taxes, and other material aspects of the business. An RWI policy generally covers a specified period, often mirroring the survival period of the representations and warranties agreed upon in the underlying deal documents. Coverage often includes defense costs and indemnity payments, subject to the policy’s terms and conditions. While RWI policy language varies, one example of a common claims-made and reported insuring agreement provides that, subject to the terms and conditions of the policy, the insurer will indemnify, reimburse, or pay on the insured’s behalf the covered loss (due to breaches of the underlying agreement) under the policy as reported within the policy term or other specified terms. The terms “loss” and “breach” are often defined terms in RWI policies. “Loss” may be defined to include “any loss, liability, claim, or action arising out of, in connection with, relating to, or resulting from a Breach.” “Breach” may be defined to mean “any breach of, or inaccuracy in, the representations and warranties set forth in Articles X and Y of the Acquisition Agreement as of the date of the Acquisition Agreement.” RWI policies contain many other terms and conditions, including both standard and bespoke provisions drafted during the underwriting process, as discussed below.
As with any other form of insurance, the underwriting of an RWI policy is viewed by insurers and underwriters as an exercise in reducing information asymmetry between insurer and insured. From the insurer/underwriting perspective, left unaddressed, “information asymmetry gives rise to problems of adverse selection and moral hazard, problems that cannot be solved by pooling and pricing.” As a result, RWI underwriters act with similar goals as underwriters for any other type of insurance policy—to minimize information asymmetry and thereby minimize the potential resulting outcomes of adverse selection and moral hazard. The distinguishing feature of the RWI underwriting process is that the buyer of the target company also suffers from information asymmetry as compared with the seller of the target company, and therefore the underwriter also acquires access to transaction due diligence and is focused on understanding the buyer’s due diligence process in underwriting the RWI policy.
The RWI underwriting process can be viewed as consisting of three stages: risk selection, the underwriting call, and policy negotiation. Of these, the initial stage of risk selection is when the underwriters are most concerned about and are most susceptible to information asymmetry as they do not yet have access to the buyer’s diligence reports. A typical request for RWI coverage can include a confidential information memorandum detailing the target company’s operations, financial statements, and, depending on the stage of the deal timeline, a letter of intent or a draft of the transaction agreement (or both). Using this initial information, the underwriter then chooses whether or not to quote coverage for transactions that fit within the risk appetite of the carrier. The underwriter’s quote will include premium pricing, retention thresholds, exclusions limiting the scope of coverage, “heightened concerns” that will be subject to enhanced diligence expectations, and “synthetic” comments to the acquisition agreement. Each of these areas is subject to competitive pressures and can shift dramatically depending on whether RWI is placed during an insured-friendly soft market when M&A deal activity is low, as in 2023, or a carrier-friendly hard market.
Once the insured selects a carrier from among those that quoted coverage, a formal underwriting agreement is entered between the insurer and insured, and the parties begin preparing for the second stage of the process: an underwriting call held between the carrier, the buyer, and the buyer’s advisors. The underwriter requests and is typically provided the buyer’s diligence reports and access to the seller’s virtual data room, which the underwriter reviews in conjunction with the underwriter’s legal counsel and accounting advisors. This stage is the meat and potatoes of the underwriting process, when the underwriter can assess the underlying transaction. Underwriters from different insurers will approach the underwriting call differently to conduct their own due diligence, which is based on the parties, underlying transactions, and underwriting approach.
Having completed the underwriting call, the underwriter may propose to negotiate policy terms with the insured. This stage generally addresses general business terms (i.e., notice periods and due dates for the payment of premiums), for which the underwriters often seek to follow broad market trends, in addition to the deal-specific terms that respond to the findings of the underwriting process, including exclusions.
Deal-specific policy terms are also viewed by underwriters as safeguards against “moral hazard” or protection against “adverse selection.”
“Moral hazard” can be defined as the risk that the parties will change their behavior as a result of the availability of insurance coverage. In the RWI context, the concern is that the deal process will not be conducted as rigorously as it would have been in the absence of the RWI policy. For example, when there is no RWI placed for a deal, but losses from the seller’s breaches of representations and warranties are paid by the seller through an escrow or hold back, sellers have the incentive to negotiate narrowly tailored representations and broadly disclose against those representations in the disclosure schedules. The seller’s incentive may not be the same with the presence of RWI. Underwriters may address the removal of the seller’s incentive by proposing synthetic comments to the underlying deal agreement (i.e., adding knowledge qualifiers to seller representations in the transaction document) or deemed disclosures of known, material risks that have not made it into the deal document schedules.
“Adverse selection” in the RWI context can be defined as a situation where insureds seek coverage for riskier transactions. Underwriters may address their concerns of adverse selection in a particular transaction by adding exclusions, which sometimes take the form of bespoke categories. For example, a bespoke exclusion could be added for losses relating to common claims for a target in the particular industry the target is in. Such exclusions are proposed and negotiated between the parties and are tailored to known and material risks that were identified during the buyer’s diligence.
Underwriting for RWI insurance is unique in many ways because the underwriter becomes acquainted with the due diligence of the deal with the buyer through access to due diligence reports and data rooms. Therefore, the underwriting and due diligence processes may become relevant to how an RWI claim is later developed and resolved.
Due to the increased interest in RWI policies in the market, insurers and brokers alike have published reports in recent years summarizing RWI claim trends, noting among other things how many claims are made on the total RWI claims placed, the values of the underlying deals, and frequent categories of representations and warranties that are raised in RWI claims. The historical rule of thumb was that about one in five policies resulted in a claim, but more recent data from certain insurers suggest this frequency has declined to about one in six, though the percentage of claims resulting in payments has increased. For example, one broker claims that over the past five years, 22 percent of claims resulted in payment net of the retention. In addition, AIG, in its 2023 study, noted that loss payouts meaningfully exceeded premiums for transactions with enterprise value below $250 million, perhaps suggesting that more disputes are associated with smaller transactions.
Year-over-year, there is variance in what general categories of representations and warranties in the underlying deal documents result in claims of loss. The top three categories, as noted in AIG’s 2023 study, were financial statements, legal compliance, and material contracts. The quantity of claims understates the true significance of these areas, however, because the results are even more dramatic when looking at the number of claims paid or the amount of loss paid. For example, one carrier claims that 65.7 percent of its paid loss was attributable to financial statements and material contracts representations, while legal compliance was a distant third at 9.5 percent of loss paid.
Despite fairly consistent data of the claims being made and some upward trends in RWI policies paying out on a greater percentage of claims being made, each RWI claim is as individual as the underlying transaction itself, leading to varied disputes.
Once the policyholder establishes a claim for a breach of a representation or warranty of the underlying transaction document triggering the RWI policy, the insurer may raise barriers to coverage in the form of exclusions and loss valuation concerns. Exclusions, loss valuation, subrogation to the seller, and other insurance are common sources of friction in RWI claims.
Exclusions. RWI insurers have sought to disclaim coverage or limit their obligations for breaches of representations of warranties through exclusions that are considered more standard in RWI polices, as well as exclusions that are bespoke to the RWI policy. As with other coverage claims, the RWI insurer typically bears the burden to prove the application of exclusions, which are, as directed by state-specific case law, construed narrowly and in favor of coverage.
Some exclusions are commonly found in RWI policies. For example, one standard RWI exclusion addresses losses arising from breaches of representations and warranties about which the buyer’s key figures involved in the deal had actual knowledge prior to the deal closing. There is of course some tension in applying these exclusions due to the unique nature of the underwriting process, wherein the underwriters often have complete access to the due diligence that the insured buyer does and have a similar opportunity to discover potential issues in the transaction. The underwriters’ due diligence, and the information learned during the underwriting process, therefore may have a bearing on the application of these types of exclusions. Nonetheless, during the claims adjudication process, RWI insurers may request information from the buyer as to when the breach was discovered to confirm that the buyer did not have actual, subjective knowledge before the policy incepted. Though the “prior knowledge” exclusion has not been fully litigated to the authors’ knowledge, the United Kingdom court in Finsbury Foods Group indicated in its 2023 decision that a “prior knowledge” exclusion may apply given the involvement of deal team members in issues later raised as part of the RWI claim, indicating that RWI insurers may continue to rely on these types of exclusions in future RWI claims.
RWI policies may also contain bespoke exclusions relating to specific representations and warranties in the underlying deal document. As discussed above, RWI underwriters sometimes identify areas that will require bespoke exclusions. To date, these exclusions do not yet seem to be the subject of extensive RWI litigation; however, that may change as underwriters continue to negotiate unique policy language to address perceived information asymmetry, moral hazard, or adverse selection in the underlying deal.
Loss valuation. Loss valuation is a hot topic for RWI claims. The loss due to a breach of a particular representation or warranty may be not only the economic impact on the insured to indemnify or defend a third-party claim or the damages for first-party losses, but also the value associated with the purchase price of the acquired asset or company. In other words, had the seller truthfully and fully represented or warranted a particular fact, then the asset or company would not have been valued so high and the buyer would not have paid the amount it did to purchase the asset or company. How the purchase price is valued has been subject to debate in RWI claims that have reached litigation.
For example, in pH Beauty Holdings, the buyer alleged that the seller had artificially overstated the profits of the company it was selling and had failed to account for millions of dollars in promotional expenses for beauty products, which the buyer contended led to an inflated purchase price. The purchase price was based on the 2018 earnings of the sold company, multiplied by 13.66. Therefore, the buyer argued that the seller’s failure to account for promotional expenses resulted in an overpayment of the purchase price of nearly $33 million and submitted that amount to its RWI insurer as its loss. While the insurer agreed that there was a breach of the deal document and loss under the RWI policy, it disagreed with the valuation of the loss. Hiring an outside forensic accountant, the insurer argued that the purchase price value—and the insured’s claimed loss—was significantly offset by a net working capital adjustment, among other accounting bases. The case was settled before motions had been decided; however, the lesson of this case and others is that earnings multipliers and the deal valuation can translate into the “loss” calculation under the policy. In such a case, RWI policyholders should assess not only the impact of a breach of a representation or warranty on their business, but also whether and how such a representation was incorporated into the purchase price and how the purchase price was calculated (by earnings multipliers, fair valuation, or otherwise). That, in turn, could indicate the policyholder’s loss” under the RWI policy. Policyholders and insurers alike may find it useful to understand “loss” by retaining accounting experts or even relying on reports and analysis provided by accountants during the deal process.
Subrogation to the seller. Typically, in either the deal document or the RWI policy (or both), the parties agree that the RWI insurer and the buyer are contractually barred from seeking subrogation against the seller entity for loss arising from breaches of representations and warranties except in cases of willful breach, fraud, or intentional misrepresentation. The rationale behind this rule is that the buyer is encouraged to purchase RWI in the first place to remove the risk from the seller that accidental, unintentional, or negligent breaches of representations and warranties will lead to costly indemnification obligations to the buyer. Conversely, the seller is motivated to provide truthful and complete representations and warranties to the buyer to avoid later risks that the buyer or the RWI insurer will later seek payment from the seller. Therefore, RWI insurers may be looking for potential subrogation opportunities against the seller should any questions of intentional breaches of representations and warranties arise. Courts have affirmed the RWI carriers’ right to do so. For example, in the case of Jude McColgan, the court confirmed that the RWI insurer may seek subrogation directly against the sellers in cases of fraud pursuant to the RWI policy’s provisions.
Other insurance. Particularly with third-party claims, the buyer may have third-party insurance policies at its disposal other than its RWI policy. For example, a seller may fail to disclose ongoing third-party bodily injury litigation in the course of the deal transaction. The buyer would argue that the RWI policy is triggered by a breach of a representation or warranty concerning known but undisclosed third-party claims, but the buyer may also have commercial general liability or other policies that could provide coverage for the third-party claim. It is beneficial for policyholders to understand what other insurance may be available relating to their claims, even if those claims trigger RWI insurance, and conversely, RWI insurers may be particularly keen to seek other insured information for third-party claims for this reason.
If the RWI claim is not paid or resolved through negotiation, the parties to an RWI claim may pursue traditional litigation or alternative dispute resolution. For some time, RWI claims were not frequently litigated due to arbitration provisions. Some RWI policies may also require that the parties first seek resolution through nonbinding mediation or other alternative dispute resolution and, afterwards, allow for a “cool-down” period before arbitration is commenced.
However, RWI policies in recent years do not always require arbitration, and the authors have noted over a dozen litigated cases addressing substantive RWI claims in the U.S. and the United Kingdom, where RWI policies originated. While exhibiting a variety of fact patterns, many of these cases involve underlying transactions or breaches relating to purported failures of sellers to properly disclose material contracts or financial liabilities that are accounted for in the purchase price of the transaction, causing loss to the insured buyer. Rarely do the cases result in substantive rulings, though that reality may begin to change with the January 2024 summary judgment decision in Novolex Holdings. In Novolex, the Supreme Court of New York County denied summary judgment sought by the policyholder that there were breaches of certain representations and warranties relating to material contracts of the target company, though the court held that there was a fact issue as to whether another representation and warranty for “adverse effects” were implicated by the reduction of business by a key customer of the target company. Also, in July 2024, a San Francisco jury in the Wing Inflatables case ordered certain RWI insurers to pay damages for breaches of contract and the covenant of good faith and fair dealing in a 2019 acquisition relating to the insured’s claim under RWI, though at least some RWI insurers have indicated their intent to seek a new trial. However, both the Wing Inflatables and Novolex cases demonstrate that courts have delved, and likely will continue to delve, into RWI policy language and the underlying transaction to adjudicate coverage disputes under RWI policies.
The trends in RWI placement, claims, and disputes are a product of the M&A market, underwriting appetite for insuring potential transactional risks, and policyholder interest in pursuing coverage for a variety of breaches of representations and warranties. Each of these variables will affect the use and development of RWI in the coming years.
Stay tuned for Part II to find out what’s on the horizon for D&O coverage for post-transaction claims.
