Representations and Warranties Insurance in the Purchase and Sale of a Business

Representations and warranties are common tools used in purchase and sale transactions to allocate risk between the parties and provide a foundation for parties to enforce remedies against each other.  A representation is an assertion that a fact, material to the transaction, is true as of a certain date, while a warranty is a promise to indemnify a false assertion.  Parties often disagree on representations and warranties, and particularly on the protection against breaches of such terms.  As a purchaser, you’re looking for maximum protection and ideally, as much of a holdback or a portion of the purchase price as possible.  As a vendor, you’re looking for minimum responsibility to indemnify and receipt of the purchase funds as fast as possible post-closing.  To avoid potential stalemate, parties in a transaction may wish to consider obtaining representations and warranties insurance (“RWI”).

What is RWI?

RWI is an alternative risk allocation method to protect the insured party from losses and liabilities incurred from inaccuracies of representations and warranties discovered post-closing.  Instead of using traditional methods of indemnities and holdbacks, RWI allows the parties to pass on such responsibilities to the RWI insurer.  You can purchase RWI either as the purchaser (buy-side policy) or the vendor (sell-side policy), and it is possible for both parties to share the RWI premium.  In most transactions, the parties opt for a buy-side policy as it is the purchaser who is generally seeking the protection.  Both RWI policies likely have a deductible, and they will not cover breaches known to the insured prior to purchasing the RWI.   While RWI is generally a blanket policy, you must be aware of the exclusions.

Why is RWI Useful?

RWI provides additional flexibility for parties to negotiate on terms of the transaction which promotes confidence and efficiency in closing the transaction.  If you’re a purchaser, RWI can enhance your bid and may provide against potential financial loss through the enhanced survival period and coverage of the representations and warranties.  It may also provide greater comfort to any third party lender who is funding the purchase.  If you’re a vendor, RWI can reduce your indemnity obligations, limit subsequent exposure to potential liabilities, and promote faster access to the funds.

When to use RWI

RWI is useful when traditional security measures over representations and warranties (ie. indemnification and holdback) are insufficient or cannot be negotiated successfully. The benefits of RWI are particularly useful in certain transactions:

  • Purchaser wanting greater and longer duration of coverage than what the vendor is willing to indemnify for;
  • Vendor continuing to be part of the business post-closing and a continued, healthy business relationship between the parties is desired;
  • Vendor having significant interest/need to secure a clean closing without any holdback;
  • The transaction is time-sensitive and needs to be closed without lengthy negotiation.

RWI may not be appropriate in other transactions:

  • Certain known liabilities (ie. environmental liabilities) are not covered by RWI and are essential to the transaction;
  • Transactions that are either too small to justify the cost of the premium and the deductible, or too large where the premium may be too high and the coverage may be insufficient.

In summary, RWI can be an effective tool for parties to have to resolve issues that might otherwise impede a transaction.  It is important for you to review your transaction with your lawyers, advisors and insurance advisors/brokers to determine if RWI can be helpful.

 In our next article, we will discuss anti-sandbagging clauses in a purchase and sale agreement.