According to the 2019 ABA Private Target M&A Deal Points Study, in the US 52% of purchase agreements examined included references to representation and warranty insurance ("RWI")1. While this trend seems less pervasive in Canada, we are witnessing a growing trend where buyers and sellers are turning to RWI as an additional coverage to standard indemnity mechanisms. This trend, combined with a reduction in M&A activity in light of the COVID-19 pandemic, has led to growing competition among insurers and increased negotiation power for parties seeking RWI. While some companies may struggle with a significant loss in share value, assets may still be valuable to potential buyers, resulting in an anticipated increase in asset-based transactions. In addition, the pandemic will surely give rise to an increase in distressed transactions with buyers turning to RWI as a source of protection for breaches in representations and warranties, including possibly fundamental representations and warranties. We have summarized below key insights and takeaways regarding the current RWI market in Canada to help parties when deciding which policy best fits their needs.
Understanding insurers' positions
In today's environment, COVID-19 exclusions from coverage under RWI policies is generally the norm as RWI does not cover known issues. However the RWI market is quickly and continuously evolving and three main trends have emerged in exclusions to date:
- Full exclusions for losses arising out of the COVID-19 pandemic, which may include language such as: "arising out of", "resulting from" or "to the extent it is increased by" COVID-19 or even the "threat" of COVID-19, namely in sectors more directly affected by COVID-19 such as public transport, healthcare, hospitality, travel and supply-chain dependent business;
- Initial broader exclusions which are subsequently tailored based on the due diligence conducted by the insurer and the bring down call, on a case-by-case basis;
- No initial exclusions and subsequent tailored exclusions added to the policy based on the insurer's level of comfort following due diligence, again on a on a case-by-case basis.
This said, information gathered to date suggests that insurers are moving away from the first approach to avoid cutting themselves out of an already crowded and competitive market. The current growing trend is in line with the second approach, whereby exclusions will be tailored following insurers' due diligence. Insurers will evaluate risks depending on the business of the target, considering certain sectors present more liabilities than others. RWI for transactions in such affected industries may be subject to increased premiums.
Heightened due diligence process
In transactions involving RWI, insurers will identify certain heightened diligence areas that are driven by specific concerns regarding the target or its industry. These areas may be excluded from coverage to the extent insurers are not satisfied with the outcome of the due diligence. In the current context, insurers are routinely flagging the impact of COVID-19 on the target's business as a heightened area of diligence. We have noted increased scrutiny in the following areas due to the pandemic: sufficiency of IT systems, employee health and safety measures, employment layoffs and work-from-home operations, diversity of supply chain, sufficiency of business continuity plans, material contracts (including termination clauses and force majeure clauses), financial health of customers, industry performance, accounts receivables and compliance with laws. In the case of asset-based transactions, insurers are tailoring their approach and taking a closer look at the target's purchased assets and financial statements.
In addition, as certain health authorities are imposing strict social distancing rules, site visits and environmental testing as part of due diligence (which are common in private equity transactions) may be difficult, creating additional exclusions in the RWI policy. Buyers and insurers will want to evaluate the target's ability to continue or reopen its operations during the outbreak in compliance with guidelines issued by national and local health authorities. As each city, state, province and country has enacted different corporate, tax and labour measures and subsidies to assist businesses, the advice of local counsel should be sought to help review the strategies put in place by the target.
As noted previously, insurer's due diligence is crucial in determining applicable exclusions to the RWI policy. As COVID-19 will be an area of heightened concern in the quoting stages, parties should not downplay the impact of the pandemic on the target's operations. By addressing insurers' specific concerns early on, parties will create a good relationship and ensure the RWI policy adequately fits their needs.
Increased involvement of insurers in purchase agreements
Insurers are actively involved in transaction documents as they look to evaluate and assess a potential transaction. Due to the current context, they will want to review representations and warranties, disclosure schedules, material adverse change clauses and knowledge qualifiers with a more oriented focus. Given leaner deal flow during the pandemic, insurers have more time and resources to conduct an extensive analysis and tailor their exclusions and policies accordingly.
So far, buyers have been trying to include pandemic-specific representations and warranties in their purchase agreements, which have mainly been excluded from coverage by insurers. Instead, we recommend that both buyers and sellers look at the representations and warranties in their purchase agreement on a case-by-case basis to assess the impact of the pandemic on each representation and warranty. Buyers will be well served to consider which representations will be immune to the effects of COVID-19 and be ready to negotiate with insurers in order to carve those out of any exclusion in the RWI.
Parties and their advisors should think about how their representations will need to be adjusted to take into account issues identified in diligence which arise from COVID-19. For example, the concepts of "material adverse change", "ordinary course of business" and "absence of certain changes" may have different meanings post-pandemic and should be reviewed closely. As such, parties may want to have two separate sets of RWI which would include a first bring-down from the date of the balance sheet to the first date of the lockdown and a second bring-down for the changes between the date of the lockdown and the signing of the transaction.
Furthermore, two-step transactions with longer interim periods may present a bigger challenge in the current context. Whereas insurers would routinely cover representations and warranties at signing and closing, the uncertainty surrounding COVID-19 has resulted in a more conservative approach. Parties should expect insurers to tailor COVID-19 exclusions with respect to representations and warranties at signing but insist on broader exclusions with regards to representations and warranties at closing. Insurers are using this approach to limit their interim period risk, especially in transactions where interim periods are of more than four months (such as in regulated industries).
As a result, parties will need to negotiate and allocate the potential adverse impact of the pandemic amongst themselves if excluded in whole or in part by the insurer from the RWI policy. Parties will need to consider risk allocation mechanisms such as special indemnities, purchase price reductions, deferred payments, earn-out arrangements, scope of material adverse effect clauses, interim operating covenants, indemnity and escrow structures.
Substantive bring down calls
When all you have is a hammer, everything is a nail. Parties should expect longer and more substantive bring-down due diligence calls, especially in transactions where interim periods are longer or in cases where transactions were signed prior to the outbreak. Insurers will inquire on the financial and operational impacts of COVID-19 to date, on how the target has addressed operational and compliance issues that have arisen due to the pandemic and on unforeseen developments related to COVID-19. They will be assessing the pandemic's effect on the representations and warranties in the transaction agreement, including with respect to revenue, sales, material agreements, supply chain, closure of facilities, employees and regulatory matters. Insurers will also seek information regarding the strategies implemented by the target to mitigate the impact of the pandemic, as well as the target's continuity plans.
To better assess their risk, insurers will want to determine if and why, in the parties' opinions, there has been a "material adverse change" or "material adverse effect" on the target as a result of COVID-19. Insurers may also want to know if any negotiations occurred regarding the purchase price since signing and whether any disclosure schedules have been revised in light of the pandemic.
On a related note, officers should be vigilant when confirming interim period covenants via officers' certificates. A thorough analysis should be conducted regarding such covenants to ensure that they are still true and correct as of the date of closing, even if known changes have been previously disclosed to the other party.
Conclusion
Following discussions with insurance brokers, we note that although market changes in the US and in Canada are generally consistent, there has been a small rise in insurance-related claims in the US which we have not yet witnessed in Canada.
As the impact of COVID-19 on global markets is quickly evolving, we expect that the impact of the COVID-19 on M&A transactions generally, and RWI in particular, will continue to change rapidly. As we have seen stability in premiums and retentions given high competition in the face of a decrease in deal flow, we expect that RWI will continue to remain a valuable tool for parties to utilize in today's environment.
Footnotes
1. 2019 ABA Private Target Mergers & Acquisitions Deal Points Study - Indemnification/RWI Cheat Sheet
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
