Striking the Right Balance: Rep & Warranty Due Diligence Coverage

Rep and Warranty Insurance (RWI) generally provides coverage for financial losses resulting from breaches of representations and warranties made by target companies or sellers in company purchase agreements. Like all insurance policies, RWI policies have exclusions. However, those exclusions, like RWI insurance, are highly specialized.

They generally fall into two categories:

• Standard RWI Exclusions: These types of exclusions are found in virtually every RWI policy and include, among other things, purchase price adjustments, forward-looking warranties, breaches of which the buyer (or seller) had actual knowledge, items on the disclosure schedule, etc.
• Transaction-Specific Exclusions: These exclusions usually result from a gap or void in information or an issue discovered during diligence, or conversely, if a rep and warranty is too broad. As a result, these may be impacted by the transaction negotiation process.

Often, transaction-specific exclusions arise when an insurer designates an “enhanced” or “heightened” diligence area. While not necessarily a trigger for automatic or blanket exclusions, these “enhanced” areas raise underwriting concerns and are a focal point for RWI insurers. Most insurers will want to review a buyer’s diligence in these areas before providing coverage. Common enhanced diligence areas include cyber security/privacy, employment matters (wage and hour), products liability, unique regulatory matters, and/or specialized industries.

Accordingly, a buyer engaged in a transaction involving an area that has the potential to become an enhanced diligence target may want to retain specialized counsel to review those aspects of the deal during the initial diligence, before RWI is procured, to better understand potential pitfalls and to be able to address insurer questions about enhanced diligence areas. For example, in a merger and acquisition regarding a brewery, an RWI insurer might be interested in confirming that the brewery holds the appropriate state and federal alcohol licenses and label approvals to operate in all identified states. As such, retaining specialized counsel to review the existing licenses and labels pre-close, may help identify potential issues that can be addressed before seeking RWI.

In some cases, insurers may be willing to narrow or remove deal-specific exclusions based on the diligence performed, especially if the information is presented in a way that addresses potential risks to the insurer. Any such diligence, particularly as it relates to unique or specialized industries, must strike a delicate balance between the goals of identifying material issues that could harm the transaction and result in financial loss, and unnecessarily raising red flags that may trigger exclusions. This is especially true when using specialized counsel who do not frequently work on M&A deals or have experience with the RWI underwriting process. Therefore, it is important that any diligence performed and analysis provided be evaluated in the context of the larger transaction. To ensure the diligence does not result in unintended exclusions, here are some best practices to consider when working with specialized counsel:

• Identify and outline the goals for the due diligence review, including the specific goals for the enhanced diligence.
• Clearly delineate the parameters for the enhanced diligence to ensure that no pertinent information or contractual provisions are overlooked or mistakenly presumed to be within another party’s scope of work. For example, identify exactly what issues or specific contractual provisions specialized counsel will review, as well as what will be covered in the overall diligence review. If there are areas of overlap, be sure to review the overlapping analysis for any conflicts.
• Communicate early and often regarding outstanding documents or information necessary to complete the diligence.
• Discuss the results of the enhanced diligence to ensure all pertinent information material to the transaction is identified.
• Carefully evaluate what information to include in the overall diligence analysis and summary.

Appropriately structured RWI policies can provide reassurance and protection to sellers and buyers alike against risk of loss. Careful and detailed diligence is an important element in all successful deals. For purposes of securing an RWI policy, however, arguably an even more critical element is to ensure the diligence includes only necessary and well-presented information that does not sound unnecessary alarms. Consulting with insurance counsel to review all proposed RWI submissions before they go to the insurers, particularly regarding any areas of enhanced diligence, may help the buyer secure more complete and comprehensive coverage.