R&W Claims 101: Types of Claims

Representations and warranties (R&W) insurance covers a breach of the reps and warranties contained in the purchase agreement governing a merger or acquisition. Since reps and warranties insurance policies are backward-looking, coverage is only provided for issues that the insured becomes aware of post-signing but that arose from actions or inactions that occurred before signing. But if the insured believes there is a breach, how do they know if it's covered and work toward getting it resolved?

In this blog, part two of a five-part series on the fundamentals of R&W claims, we cover the types of claims, what constitutes a claim, and some challenges the insured may face in resolving the claim. Our first article provided a claims primer on RWI policies.

First- versus Third-Party Claims in Reps and Warranties Insurance

R&W policies provide coverage for both first-party and third-party claims.

An indemnification claim, also known as a first-party claim, involves the insured on the R&W policy directly bringing a claim for coverage under its own policy, alleging that reps within the purchase agreement have been breached. Some instances of first-party claims include:

• Breach of the financial statements. For example, reps might state that financial statements must be true and correct and comply with generally accepted accounting principles (GAAP).
• Not conducting business in the ordinary course. The seller must conduct its business consistently with industry customs and practices.
• Undisclosed liabilities. One example is if the seller fails to alert the buyer of a potential lawsuit.
• Not maintaining adequate internal controls. If the company doesn't have sufficient safety measures to protect its employees and the insured subsequently must upgrade its equipment for safety purposes, a claim could be filed.
• Problems with material contracts. This could apply if a vendor is unable to provide its goods or services to the insured, and it affects the business's ability to deliver its final product to customers.
• Problems with customer relationships. For example, if the seller had entered a contract with a client that falls through later even though the seller had represented that all contracts continued to be valid, and that recession affects the new owner's business and income, the insured can file a claim.
• Non-compliance with laws. One example is if the seller failed to obtain a needed permit before taking any actions that require one, such as new construction.

Third-party claims arise when someone outside of the M&A transaction submits a claim against the business. Some examples of third-party claims include:

• A tax audit by the IRS
• A governmental investigation into business practices
• A vendor's claim to enforce a contract
• Employment claims, such as harassment, discrimination, or payment issues

What Constitutes a Claim?

Reps and warranties insurance policies can be purchased by either the buyer or seller. The vast majority (over 90%) are purchased by the buyer; this is called a buy-side policy. This can offer the seller a clean exit, covers seller fraud, and promotes a peaceful buyer-seller relationship as the buyer can submit a claim via the policy and bypass the seller entirely.

A smaller number of RWI policies are purchased by the seller; this is called a sell-side policy. This is typically purchased when the buyer has a lot more leverage than a seller, such as a mom-and-pop shop being purchased by a major international retailer. In the case of a lawsuit, the policy would backstop the seller’s liability for claims of a breach of a rep or warranty. Its coverage is more limited than a buy-side policy, and unlike with buy-side policies, seller’s fraud would not be covered since the seller is the insured.

Under a buy-side policy, a claim can be filed against the policy because of the actions of the seller or a third party.

Sell-side policies only insure against third-party claims, such as:

• The buyer files a claim against the seller under the acquisition agreement
• A lawsuit is filed against the buyer (now the owner of the target company) for the seller's conduct before closing.

What Do You Need to File a Claim?

The insured must provide the carrier with notice of a claim. This must contain:

• Facts, circumstances, or issues leading to the claim notice and identification of the representations and/or warranties within the purchase agreement the insured believes were breached. Many claim notices will contain multiple claims of breaches and/or assert that the same facts constitute breaches of more than one rep and/or warranty. It is quite common for an alleged breach to cross into many areas and reps.
• Damages claimed by the insured as a result of the breach. It is not uncommon for the amount to be unknown at the time of filing; this can be supplemented at a later date.

R&W policies no longer require a buyer (the insured) to pursue a claim against the seller before the buyer seeks redress under the policy. That means even if, for instance, the buyer discovers a year after signing that the seller negligently provided incorrect financial information, the buyer doesn’t have to sue the seller but can file a claim under the policy. The buyer can also choose to do both, and often does so.

Cooperation Leads to a Quicker Resolution

Cooperation with the carrier is the easiest way to resolve the claim. Providing the carrier with comprehensive information as soon as possible will move the process along, as the carrier will begin to analyze that information and see if anything else is needed. Unwillingness to provide information, or taking an adversarial stance, will only slow the process and ultimately lengthen the time it will take for the carrier to be able to make a payment under the policy.

The carrier cannot pay for the loss under the policy unless these three prongs are met:

• Determination of which reps in the purchase agreement were allegedly breached
• Proof of how they were breached
• Quantification of damages

The time between putting the carrier on notice to resolving the claim will depend on the amount and speed of the information supplied. The process can take months or years.

Getting the information for all three prongs can be challenging. Identifying the breach is the easy part; proving it is usually harder. You may need to involve outside advisors like forensic accountants or gather information and documents from a vendor or even the seller (which might not be so cooperative). It may involve dealing with strong personalities at your company, with counsel, or with the carrier, and having to ensure everyone stays focused on the result.

Remember that the carrier is not the adversary; its team simply needs the necessary information to resolve the claim. Thus, the easier you make it for them and the more information you provide in answer to their requests, the better it will be for you and the faster you can get your claim resolved.

There are endless types of claims that can arise. It's best to work with professionals who know how to navigate the claims process and assist you in your fact-finding mission. Our team of brokers and claims professionals at Woodruff Sawyer have this experience and can help you get a resolution for your claims.

Woodruff Whiteboard Breakdowns: Parts and Dynamics of a Reps & Warranties Policy