R&W Claims 101: Key Policy Sections That Impact Claims

Though reps and warranties insurance policies are becoming increasingly common in the mergers and acquisitions (M&A) world, there is much less familiarity with the handling of any resulting claims. Even seasoned clients and attorneys are sometimes unsure about how to determine whether a potential claim is valid. That’s where an experienced broker can be especially helpful.

Even if a particular action results in a breach of a representation or warranty in the purchase agreement, the policy won't always cover the breach. The insured needs to review the purchase agreement and related disclosure schedules in tandem with the policy to determine whether the alleged breach resulted in loss and entitles the insured to recover from the carrier.

As discussed in a previous post in this series, there are three prongs one must meet to be entitled to recovery under an R&W policy: Determine whether a breach has occurred, explain how the breach has affected the insured, and quantify damages. To determine whether something is covered under the policy, one must review the policy’s insuring agreement and its exclusions. It is also important to review the definitions within the policy to get a clear picture of what the policy covers.

In this article, part three of a five-part series on the fundamentals of R&W claims, we discuss two areas within the reps and warranties insurance policy that often impact coverage.

What Is Included in the Definitions of "Breach" and "Loss"?

A breach is generally defined as a misrepresentation or inaccuracy of any of the covered representations or warranties, which results in the insured suffering damages. The total of all losses, damages, fines, taxes, costs, penalties, etc., that are incurred are collectively known as “loss” under the policy. Remember that whether you’re dealing with a buy-side or sell-side policy, the insured must first determine if a breach has occurred.

Buy-side policies, which insure the buyer in a transaction, make up the vast majority of RWI policies. A buy-side loss is what is incurred or suffered by the insured arising out of a breach of the purchase agreement, along with any covered costs.

Sell-side policies provide coverage to the seller and make up a very small portion of RWI policies. A sell-side loss is one in which the seller must pay to or on behalf of the buyer indemnified parties as the result of any breach. This means that if there is a proven breach, resulting in the buyer incurring damages, the seller would reimburse the amount above the self-insured retention. This includes any defense costs.

It is extremely common for insureds to retain outside experts such as attorneys, forensic accountants, data mining consultants, and engineers to independently verify claims, and such costs are covered by the R&W policies. This also would include costs to verify that a breach occurred as well as what damages were incurred.

Review the Standard Exclusions

Every R&W policy contains standard exclusions, which apply to all potential matters. While each carrier may have slight deviations in coverage or wording, the following are generally seen in a typical R&W policy:

• Actual knowledge of the deal team. In each transaction, a few principal members of the buyer entity who were involved in all aspects of the deal (the deal team) will be asked to affirm at signing and closing that they have no knowledge of anything that could give rise to a breach. Should it be proven that these individuals did, in fact, know of any issues, those matters would be excluded from coverage.
• Post-completion adjustments. These include working capital or purchase price adjustments.
• Fines/penalties if uninsurable by law. It would be against public policy to provide coverage in these instances.
• Fraud. For sell-side policies, no coverage is provided to the seller in a transaction. For buy-side policies, coverage is provided to the insured, although the carrier retains subrogation rights.
• Covenants, estimates, projections, and forward-looking statements. These can’t be underwritten, as they are future actions.
• Pension underfunding. R&W policies do not provide coverage for failure to correctly fund workers’ pensions.
• Secondary tax liabilities. As these are principally liabilities that are the responsibility of entities other than the target, coverage is not provided.
• Net operating losses or other deferred tax attributes. These are economic benefits reduced by canceled debt excluded from income and are not covered by R&W policies.
• Injunctive relief. These are awarded by a court to legally impel the defendant to stop a specific action and are excluded.
• Specific indemnities. These are indemnities that the seller agrees to retain liability for, and thus would not be covered under the policy.
• Items specific to the deal. For example, the carrier may determine that the environmental exposure is too great a risk to comfortably take on for a manufacturing target, or it determines that a healthcare-related business may have a corporate practice of medicine exposure. These deal-specific exclusions are weighed and determined on a per-deal basis.

Understanding your R&W insurance policy and the key sections that impact claims gives you an idea ahead of time whether you have a valid claim. Better yet, experienced claims professionals at Woodruff Sawyer can walk you through the claims process and advocate for you, ensuring you get paid for your loss.