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One of the trends we have observed over the past couple years is an increase in buy-side Representation and Warranty Insurance (“RWI”) to reduce Sellers’ exposure to post-closing indemnification obligations in a seller-favorable market. However, the global situation involving COVID-19 has had a sudden and direct impact on the M&A landscape and appears to have resulted in a rapid shift to a buyer’s market, at least for the time being. For many upcoming M&A deals, that shift, coupled with the RWI market’s response to the uncertainties surrounding the COVID-19 situation, is likely to facilitate a trend away from buy-side RWI and towards traditional escrow structures to ensure indemnification security during the post-closing period.
Initial responses from the RWI market regarding the COVID-19 situation have been precautionary in nature, with many RWI underwriters proposing COVID-19 exclusions for all RWI policies or taking a “case-by-case” position. Many of the COVID-19 related changes exclude any losses “arising from”, “related to”, or “increased by” the COVID-19 virus or related government action. Most if not all underwriters are including COVID-19 as an underwriting focus area. Merger parties should pay particular attention to whether proposed exclusion wording is narrowly focused on particular reps & warranties or the acquired company’s unique COVID-19 risk. Parties should also know that financial diligence on the acquired company’s past financial performance may not be sufficient anymore. More recent monthly earnings reports may be required to ensure that the target appears able to sufficiently handle the effects of the pandemic and to help comfort underwriters regarding Buyer’s awareness of COVID-19’s effect on the acquired company. All of this has introduced substantially greater uncertainty regarding whether insurance can be obtained on any particular deal and whether it will actually cover post-closing losses. If any breaches of related representations and warranties within the purchase agreement may be excluded from insurance coverage if they are related to COVID-19, then merger parties may not feel good about their likelihood of recovery since the pandemic is impacting pretty much everything right now.
The good news is that there is a tried and tested alternative to RWI that can bring some peace of mind to Buyers. Traditional escrow arrangements are a simple, secure way to collateralize Sellers’ indemnification obligations and protect Buyers from losses resulting from breaches of representations and warranties, covenants and other indemnifiable losses under the purchase agreements. Unlike Buyer holdbacks, which can be subject to the credit risk of the Buyer during these unsure times, escrow funds can be held with an appointed third-party escrow agent. The funds maintain high liquidity, readily available to settle any claims that arise, even those related to COVID-19 should the definitive agreement allow. We have historically seen 10-11% of the purchase price held back in escrows to cover the full indemnity obligations of the sellers. Alternatively, the parties could establish a separate COVID-19 related escrow fund to cover any losses that the RWI policies exclude, but that runs the risk of adding complications and uncertainty to a deal.
While there are many unknowns in the world right now, it doesn’t mean that your transaction has to go pencils down. Depending on the facts related to a particular deal, increasing due diligence and establishing an escrow fund may properly protect against any pandemic related losses. Ensuring indemnification obligations can be met through readily available funds, without having to fight an insurer about whether a claim is carved out from coverage, should ensure a smoother post-closing period for all parties involved.