The Restructuring Report

Insurance covering the representations and warranties of a seller in a purchase agreement (RWI) has become relatively commonplace in non-distressed M&A transactions. Insurance covering other specific contingent risks associated with a transaction, such as environment liability or tax liability or benefits, is also available. Less commonly, but with increasing frequency, these transaction insurance policies are being marketed and sold in transactions arising in bankruptcy and insolvency transactions.

Generally speaking, RWI is an insurance policy procured by a purchaser that insures the accuracy of the negotiated representations and warranties in the purchase agreement. In the event that any of the representations are inaccurate, the buyer is entitled to recover under the insurance policy, rather than from the seller. Responsibility for the retainage (deductible) under the policy, for matters that are not insurable, and for payment of the premiums are all negotiated issues. In some instances, the seller will have no financial responsibility, absent fraud, for claims under the purchase agreement (a so-called “no seller indemnity” deal), but at a minimum, the claims for which a seller will be responsible and the need for a significant escrow of purchase price are minimized. The attractiveness to sellers is obvious. RWI typically does not cover specific potential liabilities that are identified in the diligence process (i.e., it only covers unknown liabilities).

RWI are used in most middle market M&A deals and used in many lower middle market M&A deals, with usage expanding both upmarket and downmarket, in terms of deal size. Premiums are typically around 3 percent of the policy amount, and the coverage amount is generally 10 - 20 percent of deal value. The retainage under the policy is usually 1.0 percent of the purchase price, although all of these features are, at least to some degree, negotiable. The buyer typically engages a broker to solicit bids from underwriters for the desired policy.

In contrast to the use of RWI in a non-distressed M&A transaction, use of an RWI policy by a buyer in a bankruptcy 363 sale is not entirely obvious. By virtue of the statute, the buyer in a 363 sale will receive the benefit of a “free and clear” order, which itself provides substantial comfort that the assets acquired do not come with any liabilities that the buyer did not intentionally assume.

However, these orders do not provide complete protection. The statute, 11 U.S.C. 363 (f), authorizes sales “free and clear of any interest in such property.” But “interest” as used in this context is not defined and, worse, the word “interest” as used elsewhere in the Bankruptcy Code clearly has a different meaning not applicable here. To address this, attorneys for buyers negotiate for lengthy court orders that expand the word “interest” to very broad meanings, starting with “liens, claims, and interests” and often from there listing all kinds of risks that the sale is clear of. Currently, most judges will sign orders with very broad free and clear language, sometimes while holding their noses. At what point do these orders go beyond what the statute authorizes?

In addition, there may be claims, often held by regulatory bodies, that arise under other bodies of law. Environment law sometimes imposes liabilities on all of the parties who come into the chain of title without regard to which may have caused environmental damage. Various pension obligations or product liability claims may be enforced against successors. Will a bankruptcy “free and clear” order protect the buyer? In some situations, the answer is not completely clear.

On the other hand, the value of such a policy should be obvious. The seller in a debtor in bankruptcy, or a trustee, seeks to sell “as is” with no reps and warranties. Any success by the buyer to obtain reps and warranties is non-existent or is hard-won because the seller, the debtor and creditors are not enthusiastic about having a bird in hand that can escape after the auction and court order, especially if other birds may have been left behind in the bush. Reps and warranties that cover the business as a going concern, or otherwise address matters not directly related to the assets acquired, are therefore very uncommon. Sometimes “back-up bidders” can be induced to hang around, but most losing bidders are not willing to hang around, and those who do, offer a lower sale price. Any provisions in the winning bidder’s purchase agreement which give the buyer an out are therefore discouraged and discounted in value.

Relatedly, reps and warranties that survive after closing and which could give rise to a claim against the seller are disfavored and extremely uncommon. The seller and its creditors often anticipate a quick distribution of the sale proceeds with nothing left in the estate with which to honor obligations post-closing. It is possible to structure escrows or holdbacks, but having those mechanisms of course means there is less to distribute immediately. Bids that have those provisions, if permitted at all, will be discounted sharply, more sharply than the specific amounts held back would suggest.

Beyond the general reps and warranties may be specific contingent risks in a specific transaction. Is real property subject to specific environmental problem? Will the tax consequences be other than anticipated? There are classic insurance scenarios. The buyer simply may be unwilling to be subject to a particular risk, even if there is low probability of the worst outcome.

Other examples of specific contingent risks that may be covered are the tax consequences. There is a cancellation of debt risk. The net operating losses may be valuable. While normally those are lost in a sale transaction, if ownership transfers to holders of “old and cold” claims as part of a plan of reorganization as provided for in the Bankruptcy Code and in sections 382(l)(5) and (6) of the Internal Revenue Code, the NOLs may be preserved – with a corollary reduction of basis in some of the assets.

Returning to the reps and warranties, take a simplified example. Suppose the vendor contracts are a particular concern. The seller represents that all material vendor contracts are in place and enforceable. A bidder may be willing to bid at 100 based on that assumption. But if the contracts had been terminated (or even just one key contract), the bidder would be willing to pay only 80. With insurance available, the bidder should be willing to bid 97, taking the cost of the insurance into consideration.

A debtor in bankruptcy may decide to package the business with a pre-negotiated RWI policy for the purpose of maximizing the purchase price that would be payable by potential bidders. If the seller can arrange for such a policy – sometimes referred to as a “soft stapled” policy – that would be available to the winning bidder, whoever that turns out to be, it may be that a number of bidders can be induced to bid against each other with more confidence and at higher prices. One issue that needs to be addressed is the cost of the policy. Presumably, the cost will be borne primarily by the winning bidder. But for the portion of the premium and other upfront costs and expenses which are borne by the seller, as an expenditure outside of the ordinary course of business or as the retention of a professional, bankruptcy court approval will be needed.

As a result of current economic uncertainty, the volume of traditional M&A transactions has fallen dramatically, and sales of traditional RWI policies have correspondingly declined. Insurance advisors/brokers have turned their attention to insolvency transactions, which are certain to increase in numbers, probably dramatically. These policies have been available for some time but used only occasionally. There is increasing attention to insolvency related policies and likely some reduction in the costs to the buyers of these because of increased competition among sellers of the policies. Additionally, as competition has increased, the insurers are more willing to negotiate the exclusions. Insurers who have had broad exclusions for matters such as COVID-19 are increasingly demonstrating willingness to narrow or even eliminate these exclusions.

As a result, we expect that RWI will increasingly become part of the toolkit for insolvency professionals.

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