Blog

Distressed Sales: Reps and Warranties Insurance Can Help

Mergers & Acquisitions

Emily Maier

Yelena Dunaevsky, Esq.

May 21, 2020

7 minutes

The bankruptcy process can be difficult to understand, so we've created simple guidance for how to make the most of Reps & Warranties insurance.

This blog post can also be found on our Coronavirus Resource Center.

It is too early to say what the long-term effects of the novel coronavirus will be on the world economy at large. It does seem reasonable to suppose, unfortunately, that many businesses will take hits that prove fatal. As such, we expect to see a greater increase in the number of distressed sales. The good news is that reps and warranties insurance (RWI), as well as other transactional insurance products, can be used in a distressed sale to make a seller or its assets more attractive to potential bidders and to streamline the sale process.

business papers in folders with binder clips

While we will focus mostly on RWI for this article, it is worth noting that if parties are looking to mitigate specific risks in a distressed situation that do not necessarily stem from the representations and warranties written into the purchase agreement, those individual risks may be covered by a contingent liability policy or a tax policy, or a creative combination of both.

A contingent liability policy covers things like litigation or environmental exposures, intellectual property infringement claims, employment matters and disputes and exposures relating to historical accounting methods.

A tax insurance policy can reduce or eliminate potential tax exposure that may result from issues in tax treatment of a past transaction, investment or other legitimate business activity.

If reps in the agreement are minimal or even nonexistent, some of the risks may be covered by a creative combination of tax and contingent liability products that are not tied to the reps. A combination of a knowledgeable, versatile broker and a creative insurer can be extremely effective in finding the right solution.

The bankruptcy process can be incredibly complex, but to keep things simple, the table below is broken down into three columns by type of sale:

The left column focuses on a non-distressed sale by a solvent, established, medium-sized or larger company. It provides a baseline for typical risk coverage and the effect of RWI on the sale. Use this as a point of comparison for the other two columns
The middle column is the 363 bankruptcy sale, which we are defining as a sale of assets under Section 363 of the United States Bankruptcy Code. This type of sale enables debtors to fulfill their obligations to creditors by selling their assets and using the funds collected to settle their debts. These assets are sold "free and clear" (for the most part) of any residual liabilities.
- Note that many of the standard reps will be absent from the purchase agreement in a bankruptcy-driven sale, due to the ability of the 363 sale process to limit post-sale risks. However, some of the liabilities the buyer will need to take on after the sale will be excluded from the cleansing process of the 363 proceeding. These may include regulatory compliance, environmental issues, products liability claims and intellectual property infringement, some of which may be covered by either a RWI or a contingent liability policy.
The right column focuses on the sale of a company that is either distressed or close to bankruptcy, but not in a court process.

Each of the rows in the chart represents how reps and warranties insurance could respond to each area of concern listed for each type of sale.

Area of Concern	Non-Distressed Sale	363 Bankruptcy Sale	Out-of-Court Distressed Sale
Liability	Third-party liability covered by RWI policy subject to terms and conditions RWI would cover buyer's negotiated first-party claims for breach of seller's reps in purchase agreement	Most of the historic third-party liability is eliminated. RWI would cover buyer's negotiated first-party claims for breach of seller's reps in purchase agreement.	Third-party liability covered by RWI policy subject to terms and conditions RWI would cover buyer's negotiated first-party claims for breach of seller's reps in purchase agreement.
Recourse Against Seller for Breach of Reps	Yes, limited to amount of liability/cap accepted by seller and escrow or for fraud RWI lightens seller's burden with reduced escrow and allows buyer to insure for the amount of potential loss it wants, rather than the amount a seller wishes to cover.	No, per Section 363, depending on nature of liability RWI affords only available protection against breach.	Unlikely, considering seller's status and its ability to stand behind its reps and warranties RWI affords only available protection against breach.
Deal Price/Value	Seller may be able to put a minimal amount in escrow and keep more of the sale price. Buyer may be able to offer a lower price as a result of taking some of the seller's burden away.	May increase the perceived value of seller's assets, maximizing value for creditors Buyer may be willing to pay higher price with added RWI protections.	May increase the perceived value of seller's assets, maximizing value for creditors Buyer may be willing to pay higher price with added RWI protections.
Wider Choice of Buyers	Some buyers who would not have been able to accept the seller's terms would be able to bid using RWI to close the gap on their requirements.	May attract buyers who might not have otherwise been open to an "as is" deal with no indemnity	May attract buyers who might not have otherwise been open to an "as is" deal with no indemnity
Diligence Required for RWI Placement	Standard diligence	May need less diligence on potential areas for third-party claims Only stalking horse bidder may have sufficient access to diligence materials, so availability for non-stalking horse bidders of RWI coverage may be more limited	May need more overall diligence due to likelihood of aggrieved stakeholders and depending on cause of distress May need less financial diligence because buyer is not acquiring a valuable balance sheet
RWI Premium Costs	Current market standard––2.5% to 3%	Lower due to cleansing through bankruptcy proceedings	Higher due to increased likelihood of unhappy stakeholders
Types of Reps in Purchase Agreement	Standard	Lighter seller reps	Depends on extent and cause of distress
Synthetic Tax Reps (Reps in policy but not in purchase agreement)	May be provided by insurer	May be provided by insurer	May be provided by insurer
Buy-Side vs. Sell-Side and Process	Typically, a buy-side policy would work best.	RWI reduces risk of disruption to the bankruptcy proceeding arising from future R&W claims. A seller-flip, in which the seller/debtor negotiates the insurance policy with a broker and once the winning bidder is chosen, flips that policy onto the bidder may be a possible approach. If the insurance is approached from the buyer side and the bidder is not the stalking horse bidder, the insurer may charge pre-exclusivity fees.	A buy-side policy would most likely work best here as well unless the seller has the leverage to take charge of the insurance process.

We believe that RWI, potentially in combination with other transactional insurance products, will be able to provide an extra layer of protection for both the 363 asset sale and for distressed companies. That, in turn, will mean a better outcome for both buyer and seller.

The use of RWI is the most cost-effective and provides the highest benefit to the deal when discussed early in the sale process.

If you are interested in acquiring a distressed business or are looking to acquire 363 assets we recommend that you reach out to a knowledgeable RWI broker as soon as you start looking into these types of transactions in order to improve your potential offer and its outcome.