This article first appeared in Bloomberg Law on October 4, 2018.
The #MeToo movement has affected many areas of everyday life from twitter rants to water cooler conversations and even Supreme Court justice confirmations. Lawyers and M&A practitioners are trying to incorporate this “new normal” into merger agreements. In this article, Emily Maier of Woodruff Sawyer discusses how these new representations interact with another “new normal” in the M&A world, representation and warranty insurance.
On October 5, 2017, The New York Times published their infamous article detailing decades of sexual harassment by Harvey Weinstein which led to the collapse of his company. Weinstein and the ensuing #MeToo movement have led to a landslide of women and men coming forward to name and accuse perpetrators and to discuss an epidemic of harassment. Besides being a major movement to validate victims, bring perpetrators to light, and hopefully curb the levels of harassment and assault, it has led to devalued brands, senior level public firings, and litigation.
As risk goes, so too do the efforts of lawyers to mitigate risk in M&A deals. In some industries, culture and employee behavior are a very big part of the value of a company. This is especially true in media, technology, and hospitality industries in which “social due diligence” is now a norm, and brand value can easily be tarnished. Representation and warranty insurance (“RWI”) is, in essence, breach of contract cover for the representations given by a seller to a buyer in a merger or acquisition. As an RWI broker, I have seen “Weinstein Clauses” proliferate rapidly.
As early as February of 2018 our firm began seeing buyer requests for representations concerning sexual harassment issues in M&A agreements. By August 2018, it was commonplace to see “Weinstein Clauses” being added to M&A deals of all sizes. First, “Weinstein Clauses” appeared in larger media and tech deals. Now the request for such clauses is not uncommon even in mid-size and small transactions. The use of the clause has also expanded beyond the media and tech sectors to industries such as hospitality, healthcare and manufacturing.
The “#metoo” Representation
The standard “Weinstein” or “#metoo” representation includes a statement or attestation that no accusations of sexual harassment have been made against managers or directors, nor specifically named or widely defined executives who manage large groups. For example:
“To the Company’s Knowledge, in the last ten (10) years, (i) no allegations of sexual harassment have been made against any officer of the Company, and (ii) the Company has not entered into any settlement agreements related to allegations of sexual harassment or misconduct by an officer of the Company.”
Source: Bloomberg Law Precedent Database
It has been suggested, and is likely true, that the purpose of these representations is as much to force disclosure as to allow for a potential claim for breach of the representation at a later date. The #MeToo movement has exposed the possibility that multiple companies may be operating in a culture of silence, with people within an organization protecting or turning a blind eye to high-level perpetrators. It may be hard to break that culture when it comes to disclosures, so asking for a “#metoo” representation during a deal could prove helpful.
Depending on the terms of the sale and purchase agreement, disclosure against the representations is a good method of protection. However, what if a company genuinely believes that it has nothing to disclose? What steps can a company take to ensure that the insurance policy responds to any breach of a “Weinstein Clause?” In other words, how do you ensure that the representation is not excluded under the policy?
How Insurance Underwriters Assess Risk
One of the reasons representation and warranty insurance became popular in the last few years was because private equity buyers started using it to differentiate their bids. By using the insurance, they were able to offer a potential seller an exit with little or no escrow. By freeing the funds from escrow the seller now could distribute those funds to investors or use the capital gained from the sale more quickly. Private equity buyers subsequently discovered that the use of RWI in M&A transactions: (1) made the conversation around indemnification much easier and (2) allowed for a better set of representations and a quicker turnaround on a deal.
Therefore, when looking at how insurance underwriters assess the risk, it is worth remembering that they are stepping into the shoes of the seller and that their concerns are similar to a seller’s concerns.
As with all aspects of RWI, the underwriter assesses the risk in two ways: (1) the actual language of the agreement and (2) the due diligence done by the buyer in the M&A transaction.
Turning first to the language of the agreement, the insurance underwriter typically asks the following questions:
Loss. How is loss defined? Can the buyer potentially claim a loss in the form of multiples of the purchase price, does the buyer have the ability to claim for consequential damages, or is diminution in value part of the determination?
Materiality Scrape. Is there a materiality scrape? A materiality scrape is a clause that modifies and/or diminishes the value of having representations limited to “that which is material.” A single scrape clause applies only to whether a breach has occurred. A double scrape clause applies to whether a breach has occurred and to the amount of the breach. Having the scrape makes it easier for the buyer to bring a claim.
Sand-Bagging Language. Is there any sand-bagging language? Sand-bagging language allows a buyer to bring a claim for a breach the buyer may have discovered during due diligence but which the buyer may not have disclosed to the seller.
Knowledge Scrape. Is there a knowledge scrape in the agreement? Like the materiality scrape, the knowledge scrape modifies or diminishes the value of having representations limited to “as far as the seller is aware.”
Flat/Nuanced Reps. Are the representations flat or nuanced? A flat representation is a direct representation of something that is or something that is not. A nuanced representation can include materiality or knowledge qualifiers or be limited to certain dates.
Industry. Are the representations logical in light of the seller’s or the target’s industry? For example, a smelting operation that has multiple pages of environmental representations makes sense, but a chain of hairdressers with the same set of representations would make underwriters question the reason behind those representations. Similarly, insurance underwriters would expect to see more drilled-down representations on Employment Practice Liability (“EPL”) issues (e.g. wage and hour violations or discrimination claims) in: (1) large retail organizations; (2) technology companies (because of recent scandals involving venture capital investors and female founders); and (3) media companies, in particular. If a company has extensive and detailed representations around “#metoo” issues but no related disclosures in the disclosure schedules of its merger agreement, the insurance underwriters are likely to question whether all is being revealed.
From these points in the sale and purchase agreement, the underwriter will gauge how a loss will be calculated.
Striking a Balance
It is worth remembering that most buyers of companies get representation and warranty coverage so they can minimize the amount of escrow the seller has to provide and avoid having to sue the management team they’ve just spent millions of dollars acquiring.
If you are a potential buyer of a company, you will want to have as broad a set of warranties as possible. In addition, you’ll want to define loss as widely as possible. Depending on the power balance—when a buyer of a company is willing to pay above market price or a seller is very keen to sell—the agreement may end up being heavily in favor of the potential buyer and the buyer could get extremely wide protections, including in the area of culture and employee behavior.
The challenge for the buyer of a company whose seller is willing to provide extremely broad representations, however, is to convince an insurance underwriter to step into the seller’s shoes. The buyer is unlikely to accomplish this task unless those broad representations can be verified through due diligence.
In an M&A transaction, the buyer’s goal is to be able to recover from loss associated with the seller’s sexual harassment problems without having to sue the seller’s management team or force it to take on a large escrow. The buyer must decide which is more useful to it: a broad representation from the target or the seller, which has no recourse other than from the new management team, or a narrower representation that allows the buyer to seek recourse against the insurance company should a problem arise.
A good due diligence process conducted by the buyer in an M&A transaction goes a long way to convince insurance underwriters to cover a “Weinstein” or “#metoo” clause. Key questions or deliverables the insurance underwriter would pose include:
1. How much access did the buyer’s diligence teams get to the target?
Knowing that the buyer’s team sat down face-to-face or had multiple calls with the target’s management team and human resource department is more comforting to an underwriter than seeing a set of questions and answers on a Q&A tracker. This information can be discussed on the insurance diligence call when the underwriter will ask a prospective insurance buyer to give a general overview of the buyer’s diligence process.
2. How fulsome were the target’s Q&A replies?
The insurance underwriter may ask the buyer about the formal Q&A tracker or more generally on the insurance diligence call whether the buyer’s team received comprehensive, detailed responses to its diligence questions or whether the responses were insufficient and difficult to obtain.
3. Were third parties engaged or was it handled internally?
To combat any potential “code of silence” issues, it is helpful for the buyer to have third parties conduct due diligence on the above points. This also serves to reassure the buyer and the insurance underwriter that the right questions are being and were asked. Companies like Denison Consulting and Meliorate, as well as human resources and integration specialists, can help with this process.
4. What is the nature of the target’s existing insurance coverage and is there any claims history?
A robust, in-place Employment Practices Liability policy that responds to sexual misconduct accusations and a clean claims history will go a long way to avoiding any exclusions on the buyer’s RWI policy. They may be the buyer’s greatest defense against sexual misconduct liability.
Any RWI policy is likely to only respond to a claim after the target’s existing insurance policy responds to it and becomes exhausted by paying out its full limit. It is therefore critical for the buyer to understand the nature of the target’s insurance policy already in place that might cover a breach of a “#metoo”-style representation.
As with all insurance policies, the devil is in the details. An example from personal experience involved a target company that had very robust EPL insurance. However, it had a named exclusion for a specified senior individual who was the most likely candidate to cause an EPL issue. This exclusion, effectively, rendered the coverage moot in practice.
In addition to determining the nature of the target’s existing insurance coverage and any potentially crippling exclusions, a buyer in an M&A transaction would be well served to obtain a claims “run.” A claims run is a document from the insurance carrier that outlines any previous notifications or claims in the last three to five years. This is a great way for the buyer to inform the insurance underwriter of any existing problems or demonstrate a lack thereof.
Any ability to show that the target has strong human resource and sexual harassment policies and/or good training records is also in the buyer’s favor.
Some private equity firms and corporate buyers also do market research via search engine and social media assessments to evaluate the value of the target’s brand, which can also help uncover risk and give a clearer picture of how a breach affecting the value of that brand might be assessed.
Have you asked the seller these questions?
As a buyer in an M&A transaction you may want to look for strong answers from the seller in the following areas and pass this information on to the insurance underwriter:
1. What is the company’s culture, including awareness among employees that any criminal conduct will not be tolerated?
2. What resources have been dedicated to training and awareness of sexual harassment issues?
3. What is the quality and experience of the personnel involved in such training or awareness initiatives?
4. Are those individuals able or empowered to impose sanctions against poor behavior?
5. What specific actions by senior leaders and other stakeholders have been taken to demonstrate their commitment to addressing sexual harassment?
6. What has the company done to identify, analyze, and address any poor behavior?
7. How does the company implement and utilize information from confidential reporting and investigations?
8. What disciplinary actions has the company taken in response to misconduct?
9. In the event of misconduct, were there missed opportunities to detect the issue?
10. In the event of misconduct, how did senior leaders, through their words and actions, discourage the type of misconduct in question?
Representation and warranty insurance policies exist to cover legitimate mistakes in the diligence process and issues that were either genuinely unknown or not revealed by a good diligence process. Insurance is not a substitute for good diligence.
With these caveats, it should not be particularly difficult to get coverage for “#metoo”-style representations in the current market. The diligence process has the value of forcing full disclosure from a potential seller who might otherwise be disinclined to reveal exceptions to a “Weinstein Clause.”
Emily Maier leads Woodruff Sawyer’s M&A practice. She provides consultation and support to clients seeking to minimize their risks associated with merger & acquisition activity. This includes Representations and Warranties, Tax Opinion Liability and Litigation Buy-Out coverages. Emily’s deal experience covers both American and European deals. Her clients are as diverse as their locations. She has worked with both strategic and private equity buyers and sellers over a wide range of transaction sizes and industries