Distressed Sales: Reps and Warranties Insurance Can Help in US and UK

This post was co-authored by Alex Roy of Willkie Farr & Gallagher (UK) LLP.

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) in the United States, and the warranty and indemnity insurance (W&I) in the United Kingdom, 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.

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, so let's first take a closer look at a couple of the major types of distressed sales transactions and processes.

The US 363 Bankruptcy Sale

The 363 bankruptcy sale is the 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 UK Pre-Pack Sale

The "pre-packaged" or "pre-pack" sale in the UK is a sale of the business and/or assets of a company within a formal UK insolvency process known as administration.

Administration involves one or more qualified insolvency practitioners being appointed as administrators to take control of the company's affairs and assets for the benefit of creditors (the company's management functions are typically being displaced by the administrators).

If a rescue of the company is not possible, the administrators can sell the company's assets "free and clear" (for the most part) of the company's liabilities in order to return value to creditors. While the administrators can apply to the UK courts for directions if difficult points arise, there is no direct court involvement in the sale process.

A "pre-pack" administration is the process through which a company is placed into administration and the administrators immediately sell the business/assets of the company in a sale that was arranged before the administrators were appointed.

The goal of a pre-pack is to preserve as much value as possible for the company's business/assets by keeping the time in which the company is in a formal insolvency process before the sale happens to an absolute minimum.

Some notes on W&I and pre-pack sales:

• Until very recently, W&I for this type of transaction has not been used in the UK and they remain rare, with a very nascent market. This is because no seller reps or warranties are given in the purchase agreement for an administration sale; any liability of the administrators is expressly excluded and opportunities for seller disclosure and/or buyer due diligence are typically limited;
• There will also be limited liability of, and recourse to, the seller because the nature of administration means there is a moratorium in place on all legal proceedings or enforcement against the company;
• Administrators will seek to run a limited marketing exercise to allow bidder due diligence on a pre-pack sale under confidentiality undertakings, so that fair value can be demonstrated. The winning bidder in pre-pack sales is frequently a secured creditor of the company (using a specially incorporated vehicle), which can use the value of its secured debt to "credit bid" all or most of the purchase price;
• A nascent UK market is developing in synthetic W&I policies, where warranties are effectively given by the insurer in the policy itself rather than by the seller or the administrators in the sale and purchase agreement provided that the insurer is comfortable that the buyer has received sufficient access to due diligence on the company's assets (e.g. through review of documents in a virtual data room) and to comprehensive seller responses to buyer questions on the assets being purchased.

RWI and W&I: A Visual for Distressed Sales

The bankruptcy process can be incredibly complex, but to keep things simple, we've created a visual to illustrate how these insurance products would respond in different distressed sales.

The table below presents four columns by type of sale. The second 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 three columns.

The third column looks at the US 363 bankruptcy sale discussed above. The fourth column focuses on the sale of a company that is either distressed or close to bankruptcy, but not in a court process. And the fifth column discusses the UK pre-pack administration sales.

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.

We believe that RWI or W&I, potentially in combination with other transactional insurance products, will be able to provide an extra layer of protection for a US 363 bankruptcy sale, a US out-of-court distressed sale and, possibly, for a UK pre-pack administration sale. That, in turn, will mean a better outcome for buyers, sellers, and creditors.

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

Although it is early days in the emerging UK W&I market for pre-pack insolvency sales, in the current distressed environment we expect to see an increased appetite for such insurance being written.

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/transactional broker and an attorney specializing in this area as soon as you start looking into these types of transactions in order to improve your potential offer and its outcome.

Special thanks to our guest contributor:

Alex Roy, Associate at Willkie Farr & Gallagher LLP