Representation and Warranty Insurance

Understanding the Claims Process and Anticipating Issues

The merger and acquisition (M&A) market has evolved over the last several years and faced turbulence in 2020. One increasingly popular aspect of an M&A transaction is the use of representation and warranty insurance policies. After acquiring a business, a buyer may become aware that representations and warranties in the purchase agreement that it relied upon regarding the acquired company were inaccurate. For example, the buyer may learn the company’s historical income was overstated and, as a result, the buyer had overvalued the company. If the buyer purchased a representation and warranty insurance policy at closing, it may be able to recover such losses through an insurance claim. This article focuses on some of the issues that can arise when such claims are instead subject to an insurance policy.

The merger and acquisition (M&A) market has evolved over the last several years and faced turbulence in 2020. One increasingly popular aspect of an M&A transaction is the use of representation and warranty insurance policies. After acquiring a business, a buyer may become aware that representations and warranties in the purchase agreement that it relied upon regarding the acquired company were inaccurate. For example, the buyer may learn the company’s historical income was overstated and, as a result, the buyer had overvalued the company. If the buyer purchased a representation and warranty insurance policy at closing, it may be able to recover such losses through an insurance claim.

In our July 2019 edition of Raising the Bar, Representation and Warranty Claims, we described traditional representation and warranty claims, in which a buyer brings a claim against a seller for indemnification of breaches. In this article, we focus on some of the issues that can arise when such claims are instead subject to an insurance policy.

Comparison of Insurance to Traditional Seller-Indemnification

Representation and warranty insurance claims have many elements in common with traditional indemnification claims against sellers. For a buyer to recover under either claim, it must (1) demonstrate that a breach occurred and (2) calculate the losses it is entitled to receive because of such breach.

To demonstrate a breach, the buyer will need to identify the specific representation or warranty within the purchase agreement that was incorrect. For example, the buyer may claim a breach because the financial statements were misstated despite a representation in the purchase agreement that they had been prepared in accordance with GAAP. In evaluating whether a breach occurred, a buyer should consider the terms in the purchase agreement or insurance. For instance, the insurance policy may require a misstatement to be material for a breach to be claimed. Alternatively, the policy may expressly contain a “materiality scrape” that removes the concept of materiality in determining whether a breach occurred.

In quantifying losses, the buyer will need to determine the appropriate measure. For example, a buyer may determine losses associated with an earnings overstatement should be calculated at the same multiple of earnings originally used to value the business (particularly if the issue results in a permanent reduction of earnings that will continue to impact the business into the future). Conversely, a one-time item may be valued on a dollar-for-dollar basis.

While the fundamental issues are like traditional seller-indemnification claims, a claim brought under a representation and warranty insurance policy has to be evaluated pursuant to the specific terms of that insurance policy. The policy may specifically prohibit recovery of certain amounts, or, conversely, may provide for recovery of amounts that typically are not recovered in traditional seller-indemnification claims. For example, a representation and warranty insurance policy may allow the buyer to recover costs for investigating and adjudicating a claim.

Another element that distinguishes insurance claims is the information asymmetry that often occurs between the buyer and the insurer. Because an insurer is not typically involved in the buyer’s and seller’s negotiations, the insurer may not know how the parties reached the purchase price or other specific elements negotiated regarding the deal. This information may be pertinent in evaluating whether a breach occurred and quantifying losses. In such cases, the buyer will need to determine what information is available regarding the historical deal negotiations.

Finally, similar to other insurance policies, representation and warranty insurance policies have a maximum amount of coverage the policy provides as well as a deductible the buyer must incur prior to being able to make a claim. These limits vary significantly based on premium and individual circumstances of acquisitions.

Typical Claim Procedures

Claims arising under representation and warranty insurance policies often follow the process set forth below:

Claim Notice: The buyer files a claim notice with the insurer, identifying the breach and specifying a loss amount. This notice typically provides a description of the issues that caused the breach and supporting documentation showing the calculation of the loss.

Insurer’s Review Period: The insurer will review the buyer’s claim notice and identify what additional information it requires to evaluate the claim. The insurer will communicate those additional requests to the buyer.

Coverage Position: Within a specified period following the claim notice, the policy typically requires the insurer to respond with a letter indicating its coverage position. This position will indicate whether the insurer is rejecting the claim, accepting the claim, or partially accepting the claim. If the insurer is rejecting any portion of the claim, the coverage letter will state the insurer’s basis for such rejection.

Settlement Period: If the buyer does not agree with the positions stated in the insurer’s coverage letter, the parties typically engage in settlement negotiations. These negotiations may involve direct meetings between the insurer and the buyer or, instead, may involve the parties’ advisors exchanging information. The parties may conduct such meetings informally or in a more formal process, such as mediation.

Arbitration: If the parties are unable to settle the matter, most insurance policies require the dispute to be resolved by binding arbitration. The insurance policy typically designates the organization (e.g., AAA, JAMS, or CPR) to which any arbitration claims will be submitted.

Pitfalls to Avoid

If a buyer is not careful in pursuing its claim, several hazards can arise. Below are a few examples of common problems buyers’ encounter.

Filing a Claim Without Gathering Sufficient Support

Buyers often file insurance claims when they believe a breach has occurred even though they have not yet gathered sufficient evidence to document the breach or quantify the loss. Failing to gather such supporting documentation prior to filing the claim will often slow the process. Further, upon gathering additional documentation the buyer may need to revise its claim, which can further impede the resolution of the claim.

Improperly Evaluating the Nature of the Loss

A buyer may realize a breach has occurred but fail to identify the losses associated with the breach. For example, a buyer may improperly apply a multiple in its loss calculations, or, instead, use a dollar-for-dollar calculation when a multiple would be more appropriate. Loss calculations are specific to the facts and circumstances involving the breach as well as the specific terms of the purchase agreement and insurance policy. A buyer should evaluate each such element closely prior to quantifying any losses.

Mismanaging the Claim Process

After filing a claim, a buyer may fail to timely respond to an insurer’s request for information, lose track of the information it previously provided, or submit conflicting information or analyses. These types of issues may result in additional questions and requests from the insurer that the buyer must subsequently address. A buyer should manage the claim process diligently to avoid unnecessary delays.

Conclusion

Although representation and warranty insurance policies have become more common, many purchasers have little or no experience filing such claims. A party considering filing such an insurance claim should carefully evaluate: (1) the terms of the purchase agreement and insurance policy; (2) the specific facts that could demonstrate a breach; (3) the correct measure of losses resulting from the breach; and (4) what documentation exists to evidence the breach and losses. Prior to filing a claim, it is often helpful to consult with dispute advisors that can help guide the process.

This article was previously published in Alvarez and Marsal Insights, September 30, 2020, and is republished here with permission.

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Matthew Bialecki is managing director for Alvarez & Marsal Disputes and Investigations, LLC and has over 25 years of experience as an expert witness, arbitrator and consultant in a variety of areas including litigation and fraud and forensic investigations. He specializes in disputes with complex financial issues, financial and forensic accounting investigations, and post-merger and acquisition disputes.

Mr. Bialecki can be contacted at (312) 288-4001 or by e-mail to mbialecki@alvarezandmarsal.com.

Bradley Boudouris is senior director for Alvarez & Marsal Disputes and Investigations, LLC and specializes in post-acquisition disputes, including working capital, earn-out, and indemnification claims, accounting and financial reporting for complex transactions, forensic investigations involving technical accounting matters, and preparation of financial statement audits and restatements.

Mr. Boudouris can be contacted at (312) 288-4042 or by e-mail to bboudouris@alvarezandmarsal.com.