Insights

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

June 12, 2020

Mergers & Acquisitions

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.

Business planning meeting, signing papers

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.

Area of ConcernUS or UK Non-Distressed SaleUS 363 Bankruptcy SaleUS Out-of-Court Distressed SaleUK Pre-Pack Administration Sale
LiabilityThird-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.

Most of the historic third-party liability is eliminated.
Recourse Against Seller for Breach of RepsYes. 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.

No. Seller reps are typically not given and a moratorium prevents legal proceedings or enforcement from being brought against the seller.
Deal Price/ValueSeller 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.

Buyer may be willing to pay higher price with added W&I protections.

May help the company’s administrators in discharging their duty to act in the best interests of the company’s creditors by facilitating the best purchase price reasonably obtainable in the circumstances.

Wider Choice of BuyersSome 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.May attract buyers who might not have otherwise been open to an “as is” deal with no indemnity.
Diligence Required for RWI PlacementStandard 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.

Less than standard diligence, but insurer will require a minimum level of buyer diligence in order to provide warranties in a synthetic W&I (e.g., buyer diligence on virtual data room and Q&A from seller).
RWI Premium CostsCurrent market standard––2.5% to 3%.Lower due to cleansing through bankruptcy proceedings.Higher due to increased likelihood of unhappy stakeholders.Likely higher than market standard (but limited data to assess at this stage).
Types of Reps in Purchase AgreementStandard.Lighter seller reps.Depends on extent and cause of distress.Typically, none.
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.May be provided by insurer.
Buy-Side vs. Sell-Side and ProcessTypically, 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.Typically, a buy-side policy would work best. Would need to be buy-side where synthetic policies are used.

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

Alex Roy

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All views expressed in this article are the author’s own and do not necessarily represent the position of Woodruff-Sawyer & Co.

Yelena Dunaevsky, Esq.

Transactional Insurance Executive

Contributor, Mergers & Acquisitions

Yelena is a corporate finance and securities attorney and, as a member of Woodruff Sawyer’s transactional insurance brokerage team, advises clients on M&A- and IPO-related insurance solutions. Yelena specializes in SPAC transactions and is a frequent author of articles covering various aspects of corporate transactions and related insurance coverage. She serves as a managing editor of the American Bar Association’s Business Law Today.

949.435.7398

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Yelena Dunaevsky, Esq.

Transactional Insurance Executive

Contributor, Mergers & Acquisitions

Yelena is a corporate finance and securities attorney and, as a member of Woodruff Sawyer’s transactional insurance brokerage team, advises clients on M&A- and IPO-related insurance solutions. Yelena specializes in SPAC transactions and is a frequent author of articles covering various aspects of corporate transactions and related insurance coverage. She serves as a managing editor of the American Bar Association’s Business Law Today.

949.435.7398

LinkedIn