How to Approach Reps and Warranties Insurance

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M and A practitioners. Again, that's mascience.com I'm your host, Kisan Patel, CEO and founder of M&A Science. Joining me today is Josh Holloman, Partner at Cooley. Cooley is an international law firm that is known for its technology and life sciences practices as well as its experience with marquee IPOs, M&A and deep rooted venture capital connections and financing. Today we're going to talk about how to approach rent reps and warranties insurance Josh, how are you doing today?

Doing well, Kisan. How are you?

I'm great.

Thanks for taking time to come hang out. Can we kick things off a little.

Bit about your background?

Yeah, of course. So first, thanks a lot for having me and it's a pleasure to join your podcast today. As you noted, I'm an attorney at Cooley where I'm a partner in the M and A group. I've been in big law for my entire career and I've been practicing corporate law with a focus on M and A since I began working back in 2003. So so as a junior associate, my practice spanned the spectrum from company formations to venture financings, to M and A both buy side and sell side to public offerings to public company reporting work. Over time I found though, that I had a real passion for M and A, and as I did more and more M and A deals, I naturally became an M and A lawyer. And here I am today at Cooley. I'm lucky enough to have a practice that allows me to spend most of my time working with a variety of companies on their M and A activity. From public companies for whom I handle their regular buy side activity, to legacy Cooley clients who are experiencing their first liquidity events while still working with a host of high growth companies on their venture financings, general corporate work and other strategic transactions.

So call you before I'm doing a deal to make sure things don't get screwed up.

That's right, exactly. Always happy to help.

No, this is great.

I love getting your perspective on this whole thing of reps and warranties insurance. It's just growing. Sort of started as a small little thing. People are looking at it funny. Is it a made up product from the insurance industry? And then we just seen that adoption progress and now we're starting to see it with larger public companies. Can we walk through from the beginning? What are reps and warranties? Why should a company consider using one?

As I'm sure most of your audience knows, in the definitive agreement for a typical M and A transaction, whether it's merger agreement, stock purchase agreement, asset purchase agreement, the seller makes a variety of reps and warranties to the buyer about the current state of the seller's business. These range from capitalization to IP to litigation to employee benefits to a host of other kinds of potential liabilities, the parties then negotiate the extent to which the seller would have liability after the closing of the transaction for breaches of those reps. So traditionally the parties would agree to escrow or hold back a portion of the purchase price to cover the buyer's damages in the event of a breach of one of those representations. And that escrow or holdback was typically around 10 to 20% of the purchase price and would last for somewhere between, call it 12 to 24 months, sometimes 18, 15, anywhere in that range. The buyer's recovery for breaches of what we called standard or general reps, which essentially means anything other than specified fundamental representations, would be capped at that escrow amount. And then for the fundamental representations, which encompass a subset of representations negotiated by the parties and often include things like the seller's authority to do the deal, capital compensation, sometimes IP and taxes. For those kinds of fundamental reps, the buyer would frequently be able to recover directly from the sellers for amounts above and beyond the escrow, sometimes capped at the purchase price, and sometimes especially for ip, capped at some amount between the escrow and the purchase price, 30 to 40% of the purchase price, for instance. Recovery for those fundamental reps would also typically be available for some period of time beyond the expiration of the that escrow that was set up in the deal. But with the introduction of rep and warranty insurance, buyers and sellers can fundamentally change this post closing risk profile. The traditional escrow can be reduced to a fraction of the traditional 10% or so escrow size, or in many cases the escrow can be eliminated altogether. This is because the rep and warranty insurance policy essentially replaces the sellers as the party responsible for breaches of the seller's reps, subject to certain limitations and exclusions that I'll talk about a bit later on. But if the buyer uncovers a breach of one of the seller's reps, the buyer makes the claim here with a deal that includes rep and warranty insurance against the rep and warranty insurer, much like they would with any other insurance policy. So as you can imagine, this of course can benefit both of the parties. First, it's obviously better for the seller because the escrow is much smaller or eliminated altogether, and therefore the sellers get their money sooner and without the risk of forfeiture associated with money that's put into escrow. Second, it can also be better for the buyer because in some instances, particularly where founders or members of the seller's management team hold equity, the buyer is otherwise forced to seek recovery against people who are still working for the target business and in many cases may be crucial to its future success. This often puts buyers in a bind as they have to choose between recovering against their own employees and potentially upsetting them, or alternatively foregoing recovery for the damages altogether. And it can also be easier to recover against an insurance policy, particularly with respect to any amounts that may exceed the amount of that escrow, where otherwise sellers would be forced to write checks back to the buyer. And in some of those cases, the bank accounts just may not have sufficient funds to do so.

This is where you got to help me interpret the layman version of this. Traditionally, on a typical given MA deal there would be 10 to 20% hold back from a range of 12 to 24 months. For CYA, something surprise comes up and there's Some repercussions for a buyer to want to go back and pursue the seller over something that was part of their warranties or representations. And it could be a number of things. And with this insurance product, we are substituting that and saying, hey, we've gotten this insurance product to cover this stuff and there's a cost that comes with it. And the one thing I wanted to make sure I got was it doesn't cover the full purchase price.

It depends on the amount of coverage you purchase. What most buyers do is purchase a policy that covers somewhere between 10 to 20% of the purchase price. So you can think of it as replicating what would have been an escrow in a traditional indemnity deal. With an escrow or a holdback, the amount of those escrows was customarily around 10 to 20% of the purchase price. And so that is what we most frequently see buyers purchase when they get a rep and warranty insurance policy is coverage in the amount of 10 to 20% of the purchase price. That said, there are what we call excess policies that can be purchased that allow for coverage for certain representations and warranties above and beyond that primary coverage. And of course, you can also buy more coverage than the 20% if you want it, or the 10%. It just becomes more expensive.

Fair enough.

Did I get the right idea on how this works?

Yeah, absolutely. And for what it's worth, the cost of these policies, I would say all in is typically somewhere between three and a half to four and a half percent of the coverage amount that you're purchasing. A portion of that is an underwriting fee, but I would say all in around 3 and a half to 4%. The premium portion of that is typically somewhere in the maybe 3 to 4% range these days of the amount of coverage you're buying.

What are reasons not to use this insurance product or why would you not use it in a transaction for this purpose?

It's probably worth giving a little bit of background on the origins of rep and warranty insurance and how it's evolved over time. I believe it was first developed and utilized in European markets way back in the early 2000s. In the years that followed that, my understanding is that it was used modestly and primarily in instances where deal negotiations broke down. The parties needed to find a way to bridge the gap. And there wasn't necessarily a known issue of any kind, but rather a major disconnect between the parties as to the amount of post closing risk the buyer and the seller were willing to bear. The product then essentially just sat on the shelf, at least here in the United States until we rolled out of the Great Recession and some enterprising private equity funds realized they would get a leg up by using it in competitive auctions as a way to win bids. And this was probably back around 2010 when you started seeing these private equity funds use it in this context. So when you back up and think about what matters most to sellers, it's really all about three factors which can be summarized as price or valuation, deal certainty and post closing risk allocation. So where a PE firm's bid may not have won based solely on the first two factors, having a rep and warranty insurance as a tool to use on the third, particularly against strategic buyers essentially saying, hey, look, our price may be the same or marginally lower than this other bidder, you're getting all or almost all of your cash at closing with us, and you don't have to worry about losing it from an escrow. And an indemnification claim was a very powerful thing. Of course, as more private equity funds started to use this as a tool in competitive situations and as strategic acquirers started to lose auctions as a result, the strategics started catching on and using it themselves. So in fact, the very sharp Deputy GC of one of my public company clients now promotes it with his corp dev team on just about every deal they do, for some of the reasons I've already noted. But he does this regardless of whether a seller has actually requested it. It may be that as part of the negotiation for who bears the cost of it, we'll let the seller request it first, but we always have it in our minds in the background, even if we don't propose it up front when submitting an LOI that it might be a tool that we want to use in our arsenal to try to win the bid. And also just to avoid some of the issues mentioned earlier, like going after the founders of the company you buy who may still be your employees for claims, we now see it used in the majority of private company deals we do. And that's consistent with what the deal studies are showing too. The 2022 SRS deal study shows that around 44% of their deals reference drop in warranty insurance, although they suspect that number is actually higher as the definitive agreement doesn't always refer to the policy where one is utilized. And similarly, the most recent American Bar association private target deal studies showed that around 65% of deals in 2021 referenced rep and warranty insurance, with the same caveat as the SRS study, which by the way was up from 52% of deals in 2019. So you can see that the frequency of utilization continues to increase. But getting back to your question, Kisan, there are some instances in which a policy may not make sense. First, you simply can't get it and every insurers may not be willing to underwrite it. For some companies in certain industries, cannabis crypto, those are industries in which it can be very difficult to get a policy placed these days. Second, it may just be too costly for some deals, depending on the deal size. Third, for some strategics, the cost of capital is just lower than it is for private equity funds who have to look to their LPs or to debt for funding. And as a result, some strategics may just prefer to underwrite the risk of damages associated with potential breaches of seller representations themselves rather than pay for a policy.

If they're underwriting their own risk, they just skip all of it and do the deal without any holdbacks.

Yeah, that's exactly right. So for some of the strategics, especially if they would otherwise be forced to pay for the policy themselves, they didn't think that they could, as a competitive matter, ask the target company to split the cost of the policy or to bear some or all of the retention. In some instances, those strategics would rather save the money on the premium and underwrite the risk themselves with essentially with balance sheet cash. And that of course could depend on the level of diligence they've done too, and how likely they think it is that there would be any potential material risks associated with the business they're buying.

The self insure option.

The self insure option, exactly.

So we have that. We have the restricted companies, public company deals.

Public company deals actually do not utilize this product as much as the private company deals. That's something that I think we might see changing over time. We could probably do a whole separate podcast on why it hasn't historically been used in public deals and whether some of the assumptions underlying that decision not to pursue it in public company deals are legitimate. But in short, rep and warranty insurance is still used in not many of those deals. One of my broker contacts said that 95% of the policies that key places are for private targets. Just to give a data point. In some ways that's not surprising since rep and warranty insurance was initially utilized as an alternative to seller escrows and private M and A. And in public or public style deals there's no seller indemnity. So in part I think it's not utilized more frequently in public deals because people simply don't expect it and assume that the buyer is taking on the risk of breaches of the seller representations. There are some other reasons people believe it's not suitable for public deals. For instance. First, because public companies are subject to reporting requirements and thus less diligence is performed and the thought is that insurance won't accept the risk. Another reason is because similarly and related to that, the reps look different in public deals as they're subject to exchange act reports and are largely MAE qualified, which means a materiality scrape is more difficult to get in the public company context and also on larger deals. The retention, which is typically half a percent to 1% of the overall enterprise value or purchase price, may also be very large in those deals and therefore make a policy unpalatable. There are responses that some practitioners would give to each of those points, noting that actually in many public deals there's a lot of diligence done, particularly given the high bar for walking away from those deals and the lack of post closing recourse in the absence of a policy. So therefore maybe you can convince and ensure that you've done sufficient diligence in terms of the materiality scrape. Are deals in which buyers negotiate hard to limit the number of MAE qualifiers in those deals, for instance, and maybe you can get an insurer to scrape materiality at a lower threshold than mae. And then also there are large, very large private company deals that still get done with rep and warranty insurance too. So some would say that the retention being too large is not necessarily an argument to forego rep and warranty insurance and a public company deal. All of that is to say I suspect that over time we'll start to see these policies used more in public deals and in particular and take privates.

Fascinating. What about the public to private? Do you see a lot of utilization.

Now or I do. I see it used a lot in the context of public companies that are acquiring private company targets. In fact private equity, those buyers were the ones to really begin using this. A lot of the strategics are now catching on and starting to use it themselves as well.

What's more likely to use insurance? Smaller or bigger deals?

It's interesting, I actually discussed with a broker earlier this week and he said that in terms of the prior question about strategics versus private equity, whereas it used to be something like 20% strategics, 80% private equity, we're now seeing it used about 5050 by strategics and private equity. But in terms of the size of the deal, how small is too small really changes over time and deal by deal, because pricing is always evolving on these products and sometimes the deal dynamics may make it worthwhile. But generally, I'd say a rep and warranty insurance policy doesn't make a lot of sense for deals smaller than around 25 to $30 million. And that's given that the minimum spend is around 200 to $250,000, regardless of deal size, on just the costs, including the underwriting fee and premiums on the coverage. And the minimum retention may be around 150 to $200,000, no matter how small the deal. So although it has been used on deals that are smaller than $25 million, you can understand why that wouldn't make a ton of sense in most cases. So, for instance, on a $15 million deal, to replace what otherwise would have been a 10% or $1.5 million escrow, you might have to spend spend $250,000 on the policy. And on top of that, you'd likely have a retention of $150,000 or more. So the math just doesn't quite work out.

That makes a lot of sense. If I want to use reps and warranty insurance, where do I start?

Well, the process starts by reaching out to a broker who specializes in the placement of rep and warranty insurance policies. And often that's just a matter of reaching out to your general insurance broker, who will have somebody within the organization who has the specialty. But the broker will then gather basic information on the deal and the target, including financials and any information memorandum prepared by the seller, and if available, the draft purchase agreement. Since, of course, the policy is tied to the reps and warranties that the seller is making in that draft purchase agreement, the broker then goes to market, which essentially means that the broker determines which of the approximately two dozen insurers out there for this type of insurance would make sense for the particular policy and solicits bids from them. In response, the broker gets back from those insurers hopefully more than one bid, which is called an nbil, which stands for a non binding interest letter. Those NB summarize the terms on which the insurer is willing to underwrite the policy and to the extent then known, at least, proposed exclusions from the policy. So although it can happen more quickly, that process typically takes around, I'd call it a week from the date the information I mentioned is provided to the broker. And so far at that point, the buyer hasn't spent any money. There's no cost to the buyer of just doing the work so far. Then once those nbls come in or the non binding interest letters, the broker and the buyer's in house or outside counsel like us will then review them with the buyer and determine which insurer to select. After one is selected, an underwriting fee of typically around $30,000 to $50,000 is paid to the insurer. That $30,000 $50,000 fee is also called a diligence fee and just as the name suggests is used to cover the costs of the legal due diligence that the underwriters counsel will be doing alongside the buyer's counsel. That 25 or you call it 30 to $50,000 fee is non refundable. So once you pay that one you're not going to get it back and it's not applied toward the premium. So this is the first point in time at which the buyer has really expended any money in the process of trying to seek a rep and warranty insurance policy. The next step in the process is for the Underwriters council to get access to the data room and perform its own diligence. It's important to understand that this diligence doesn't replace the buyer's diligence, but rather supplements it. In fact, the Underwriters Council relies really heavily on the diligence performed by buyer. Ultimately, there's a two to three hour call between the Underwriters council and the buyer's deal team members and also the buyer's third party advisors, including their accountants and legal counsel, in which the underwriters counsel asks a bunch of questions about the diligence that was performed on the target. And around 24 hours or so after that call, the underwriter will deliver a draft of the policy to the buyer along with any follow up questions and importantly any proposed exclusions to the policy. Once that happens, the buyer and its council respond to those questions and negotiate the policy and proposed exclusions.

What's the turnaround time on all this?

Although a policy can in theory get placed in just a matter of days, even maybe 48 hours, that is admittedly exceedingly difficult to do. What I do recommend to clients is reaching out at least two weeks before you anticipate signing a transaction, getting in touch with a broker at that point, and in some cases reaching out to a broker before even making your bid or delivering an LOI can make sense as it gives you as a buyer more certainty about first the availability of rep and warranty insurance. You don't always know you'll be able to get it and also the terms on which you may be able to get it. So that in turn, of course, can factor into the terms of your bid or the terms of your letter of intent. If it's not a competitive auction and you're just providing an LOI to a prospective target. Also, to the extent you can tell the seller you've already discussed the availability of rep and warranty insurance with your broker and you know you can get it, you know what the terms may look like, at least generally, it can also provide more certainty to the prospective seller and also signal to them that you're serious about proceeding with the deal.

It would still be contingent on the diligence from the underwriter.

That's exactly right. And what we normally see, it would be very uncommon for a insurer to provide an indication, right, an NBIL to indicate that they're willing to underwrite insurance for a deal and then to back out entirely based on diligence. They could. But what you would more frequently see is based on the diligence that that's performed, that there would be changes to the policy or exclusions, deal specific exclusions to the policy that could be material and potentially make the use of a policy not make sense in that particular transaction if those exclusions were wide ranging enough.

How would the insurer's diligence compare to buyer's diligence?

Insurer's diligence is not meant to replace the buyer's diligence. And typically it's not any more thorough than the buyer's diligence, but rather it supplements it. If you think about it, the amount, the dollar amount that underwriters are spending on their counsel to perform their diligence is typically a lot less than the buyer is spending on its counsel. And in fact, the underwriters want to know and see that the buyer is performing real diligence in the areas that you would typically expect a buyer to diligence on any transaction. That's one of the things that's really important from the underwriter's perspective. They'll also want to make sure that they get their hands on any diligence reports that are being provided by the buyer's advisors. For that matter, if you didn't provide one or if you told them our legal counsel is just taking a cursory look and we don't have anything to provide, that could become a real problem for getting the insurance. So they want to know that you, the buyer, are doing real, true, thorough diligence on your own and then their counsel comes in and takes a look at specific things that they go through the buyer's diligence reports, do their own assessment of risk, and then they may focus on particular items identified or not identified in those reports. It's important to keep in mind here that the perspective of the buyer versus the underwriter matters, meaning that while the buyer may be focused more on things that could create problems or exposure in the future, the underwriter is of course focused on historical risk and in particular anything that could make a representation untrue because of course, that's what they're insuring against.

What can be negotiated? Can lawyers negotiate the insurance coverage? What are the most commonly negotiated part when securing insurance?

Most definitely. Lawyers can and should negotiate the insurance policy and the coverage. So some buyers have risk management functions internally that largely run these negotiations in tandem with their M and A teams. But many, or I would say most, rely on their outside counsel to help with that process. So Cooley, for instance, we have an insurance group that works hand in hand with our M and A attorneys on the team to negotiate the policy for most of our buy side clients. And there are, as I mentioned, definitely things to be negotiated in these policies which are really more like contracts than what you might expect from a typical insurance policy. The most commonly negotiated parts are the exclusions and the deemed edits to the purchase agreement. On the first point, policies contain two types of exclusions, broadly speaking, what we call standard exclusions and what we call deal specific exclusions. Standard exclusions are things that are excluded from just about every representation and warranty insurance policy. And although this continues to evolve, this typically includes things like net operating losses or NOLs, asbestos, wage and hour issues, underfunded pension liabilities, and forward looking reps. And although there is some negotiation of these types of exclusions, and some of these are moving toward a case by case evaluation and negotiation, over time we see more significant negotiation devoted to the deal specific exclusions and what these deal specific exclusions are known risks that are identified in diligence or otherwise generally applicable to the industry in which the target company operates. We as lawyers spend a lot of time trying to narrow or remove these exclusions from the policies. This may involve performing additional diligence on potential issues to get the underwriter and their counsel comfortable with them, or just narrowing the language of the exclusion to exactly the known issue uncovered in diligence. As an example, if an exclusion is proposed, and this is one that we do actually see in practice quite frequently, but if an exclusion is proposed for Any unpaid sales and use taxes as a result of a buyer diligence report identifying a nexus and call it two particular states, we might try to narrow that exclusion to include just those two states rather than all jurisdictions, which may be the initial position that the insurer takes with their proposed exclusion. On the second point, which is the deemed edits, we're seeing an increasing number of these in policies recently. So what? These are deemed edits to your purchase agreement that apply just for purposes of the scope of the policy. And this is instances in which the insurer wants to limit the scope of certain reps such that they won't cover the entire scope as written in your purchase agreement. So this could include the addition of knowledge qualifiers to a particular representation or the deletion of specific words within a particular representation. An example of that might be a rep that says there is no liability of a specified nature. But then perhaps you as the buyer have added words that say and there's no reasonable basis to believe that there ever could be a liability of that nature. In the future, the policy may edited that sentence to remove the words no reasonable basis to believe or that clause just for purposes of the policy because the insurer deems it too broad of a rep in scope to cover.

These are good points. Any must haves that I should negotiate, especially on the buy side.

On the buy side, the key really is to keep the scope as broad as possible. In that regard, some of the things that we've just talked about, trying to limit those deemed edits in particular, and also trying to narrow the exclusions is exceedingly important. That also becomes more important in a competitive deal where to the extent there are these exclusions, you might find that it's difficult to get the seller to cover them. Ideally, from a buyer's perspective, if you have some particular risk that's excluded from a policy, then you would want the seller to backstop any potential exposure for that potential risk. But you'll find that in some competitive situations, it's difficult to get the seller to cover any of those risks. And so there's a lot of importance to keeping those exclusions to a minimum and narrowing them as much as possible. On the flip side, on the seller side, there's something called subrogation which allows an insurer to subrogate a claim with respect to the seller. To the extent that there's fraud committed by the seller, that tends to be the most important piece of a policy for a seller, especially where they're not otherwise agreeing to be responsible for any exclusions from the policy or any breaches of reps at all. But that is really a piece of it that the sellers focus on the most and frankly more so than the buyers.

If the buyer has insurance, does that.

Clear the seller for any indemnification or liability regarding the transaction?

That's a great question, Kisan, and the answer is it depends. I'd say that even a few years ago in most deals, the seller would still have some indemnification obligation, even in deals with rep and warranty insurance, and maybe would cover, call it half of the retention of the policy in the form of an escrow. So that would equate to something like a quarter of a percent to half a percent of the overall purchase price. And that's because the retention under a typical policy is between half of a percent and 1% of the overall enterprise value or purchase price. So we used to find that in many deals the sellers would be responsible for a portion of that retention. And the reason for that was driven in part by the pricing of these policies. The insurers used to provide better pricing where sellers had what we call some skin in the game. And in this instance, that skin in the game could come in the form of the sellers being responsible for a portion of that retention. Over time, that pricing differential has really decreased and in many cases it just doesn't even exist anymore. And as a result of that, there's less incentive for buyers to insist on the sellers covering a portion of that retention. In a competitive scenario, obviously it's better if you can go to a seller and propose that you eliminate their indemnification obligation for breaches of reps altogether. What we're seeing now is a lot more deals where the sellers have really truly no indemnification obligations, at least with respect to breaches of reps and warranties. It still is sometimes true that sellers will be responsible for things outside of breaches of reps and warranties, such as breaches of covenants, or in some instances, matters that are excluded from coverage under the policy. But as a general matter, in many competitive auctions these days, buyers are actually proposing true no indemnity deals, much like public company deals, as a way to try to win those auctions.

Wow, that was a yes or no question, by the way. I'm just kidding.

I would have loved to have given just a yes or no answer. You don't like it Depends. As the lawyer.

That's the lawyer. Yeah, absolutely. I've heard that enough times.

Exactly.

Break this down on these policies. I'm curious one what's the largest reps and warranty claim you've seen?

Luckily, I haven't seen a lot of really huge claims against insurers. So fortunately for me, in the deals that I've worked on, we just haven't seen any massive claims. I will say a couple of things. One is that in some instances for public company buyers in particular, to the extent they do have claims that are being made against an insurer as opposed to against a target seller, they will occasionally run those just through internal processes. So in some cases outside counsel may not have exposure to the claims that are being made. But I'll also say just anecdotally that in recent years there have been a few very large claims that have made the news where the claim exceeded the primary layer of insurance and went against what you call the whole tower. An example of that is a case with a company called Novalex, where I believe the claim was for over $150 million. So there are some of these very large claims that are starting to be made these days. And as a result, some of the carriers we're seeing now engage in limits management, which means that whereas in the past they may have taken the entire risk on a dealer, underwritten the policy, the entire amount of coverage on a policy, now they may be capping their individual exposure at something like 25 million and then getting other insurers to co insure that with them. It's going to be interesting, among other things, to see if that claims rate starts to increase with potential recession. What I hear is that didn't turn out to be the case with COVID And we had also thought that with COVID you might see an increase in the amount of claims being made. Maybe it's because it continued to be a really hot seller's market, but the current data shows that claims are made against one out of five policies. Keeping in mind that includes claims that turn out not to be legitimate and also claims that just go against the retention. So the amount of payouts would be less than that because you have to get beyond the retention before the policy actually pays out. And obviously it has to be a legitimate claim. But to give you a sense of how often claims are being made, we hear it's about 1 in 5.

How about percentage that are paid out?

I don't know what the latest data is on that. I do think there was one study that had shown that something like 87% or somewhere in the 80s, 80ish percent of claims actually did get paid out. The general thinking is that These insurers are actually very good about paying these claims and obviously a number of them get rejected for all kinds of reasons. But to the extent there are claims, they actually do tend to get paid and these policies are therefore a real thing. And the insurers backing them tend to be true insurers.

It sounds like a pretty profitable product. Except for that one out of five gets disputed. Because I think that would rack up a pretty sizable legal bill, don't you?

For sure. Do you mean a legal bill, Kisan, with respect to making the claims you'd.

Have to go through, Wouldn't you have to have a lawyer respond back if a claim is made?

Yeah. And if a claim is made against the policy, it would be like making claims against any insurance policy.

So it go through their in house process and maybe they come with some blunt statement, hey, this doesn't fit right in there.

That's right. If it's a large enough claim and meaningful enough that you care about getting the recovery from the policy, then yes, it could be costly. It could potentially lead to litigation just like an indemnification claim could. Now I will say one of the reasons that companies think that these products are advantageous to traditional indemnity structures is because it tends to be more of a clear cut process for recovery against an insurer than against sellers. Despite all the efforts that are made to spell out the instances in which a seller should be obligated to indemnify a purchaser in a purchase agreement. Of course, the terms of a rep and warranty insurance policy go into much greater detail about when the insurer should and should not be required to pay out. From that perspective, there should be a more clear cut path to recovery and to the instances in which you as the buyer should or should not be able to recover against that policy. Although just like with any breach of rep and warranty claim, a lot of that could surround whether or not there was a breach of the actual rep or warranty in the first place?

It doesn't sound too fun now to be an issuer. It sounds like you get pretty messy pretty quick. What about being a broker? That sounds pretty good.

You'd have to ask a broker that question. But I will tell you, many of the brokers in this industry are ex M and A lawyers still have their licenses too in many instances. But yeah, a very large number of the people who have gotten into this industry were M and A lawyers. And so it may be Kisan, that they are finding something better about the life of a broker than the Life of an M and a practitioner. But what is interesting about that is it means that a lot of these brokers are experienced deal lawyers too, who really do understand the nature of reps and warranties. And also the insurers have a lot of ex M and A lawyers on their staffs, which means when they're taking a look at your purchase agreement, obviously from the insurer's perspective, they don't want those reps and warranties in the purchase agreement to be too broad. And they certainly don't want them to be broader than what you would find in a customary purchase agreement because they're insuring against the risk that the seller is in breach of those. It's to their benefit to have experienced deal people on their team who can identify where those reps and warranties are broader than what you would customarily see. And I think that's one of the reasons that they have a lot of those folks on their teams.

But wouldn't the underwriter be doing all that, reviewing the purchase agreement as a broker? Would you be doing that?

So you're right, and I've talked a little bit about who is on the actual insurance teams, the underwriters teams, and who becomes the brokers or who the brokers are with respect to the underwriters. It's true that they're the ones who are looking to minimize the coverage. And for that reason it would behoove them to have people on their team who really understand reps and warranties and purchase agreements and what's common and standard and where the purchase agreement may be going away from the typical reps and warranties that you would see in a similar purchase agreement. For the brokers, their job is not to limit the coverage, as you point out, but it's still very helpful for them to have a deep understanding of M and A transactions and the reps and warranties themselves, because among other things, they should be an advocate of sorts for the buyer. They also are engaged by the buyer. They're helping you to procure the policy and to find the best policy available. But to the extent that you do have, for instance, exclusions from the policy, it's very helpful for them to understand those exclusions in the context of the overall deal and also whether those are exclusions that one would expect to see and to have that sense of the insurance market. So for brokers having that combination of experience with, obviously the insurance market in which they participate, but also M and A in general is a very useful.

Thing, that sounds like a great business you know any small broker shops that we could buy?

I'd be happy to ask around for you and get back to you on that. And let me know too.

Well, we'll work something out. I think it'd be complimentary since we have a sizable network of all these corporate M and A practitioners.

Exactly.

How about you personally? Do you recommend reps and warranties on every deal?

Not for every deal, for most deals for sure. I will say on the sell side, when I represent sellers and transactions, yes, almost without fail. Unless there's some reason that you just couldn't get a policy for that deal, then yes, I will recommend that they encourage the buyer or that we require the buyer to get a policy in virtually every single deal. On the buy side, I most commonly do recommend that buyers at least consider it. And it's for some of the reasons that we've talked about already. For instance, and this is really perhaps the biggest, in many cases our buy side clients are purchasing companies where there are either founders or members of management with significant equity in the company that we're buying. And in a traditional indemnity structure, the indemnification obligation of the sellers on a post closing basis is typically tied to the amount of equity they hold. You can be in this very awkward position of making an indemnification claim against people who are still working for you. Maybe this is now a subsidiary of your company, but perhaps that management team is really responsible for the day to day operations or success of that subsidiary. And as a result, the last thing you want to do from a morale perspective and retention perspective is to go after your own employees to pay out an indemnification claim. That's where a rep and warranty insurance policy can be particularly beneficial is because now you have a third party insurer that you can go after instead of your own employees in that scenario. Also, it can simply be easier to recover from. It could be the case that you have a claim against an escrow insurer. The escrow is sitting there to pay it out. But what if you have a claim for an amount that exceeds that escrow? And here this gets into whether you might purchase excess coverage or coverage that is greater than what an escrow otherwise would have looked like. It can be very difficult to recover from sellers and private company transactions where you have to seek money out of their pockets. An insurer should of course have the funds available to pay you should you need to make a claim against them. And finally, yet another reason that I think these policies are really a great thing for buyers in general is because of the timeframe in which you can make claims. For a traditional indemnity deal, often you would have an escrow that lasts, call it a year to on the upper end, two years for a rep and warranty insurance policy. And that would be your sole source of recovery by the way, for the general or standard reps. With a rep and warranty insurance policy, the baseline coverage for standard or general reps is around three years. And then for certain fundamental reps you get coverage for six years. So just even in terms of the length of coverage for those general reps, with an insured deal, you're typically getting at least three years of coverage. Whereas in a non insured deal that would often be right around a year, sometimes a little bit more than a year. And then for those fundamental reps, although that would be negotiated in a traditional non insured deal as well, you may not get coverage for that beyond a few years. And even if you did, query whether the money would still be there to go after those sellers in the event that there was a claim exceeding the escrow. With a rep and warranty insurance deal, fundamental reps are typically covered for a period of six years. So you just have a much longer period of time in which to discover and make a claim. One thing that we have had come up with our clients in the past and that not everyone realizes about these policies is that if you have an extended period of time between sign and close, there can be a gap in coverage. And what I mean by that is as a general matter, representation warranty insurance policies will cover breaches that occurred before signing and were discovered after signing, or that occur between sign and close and are discovered after closing. But if there's a breach that occurs between signing and closing and you discover it between signing and closing, generally speaking, a ren warranty insurance policy won't cover that. So to your question about whether we would recommend this, in every deal there are instances in which you might have a very long gap between sign and close. And perhaps there's a real risk of something going wrong that you would discover in that period of time and wouldn't have insurance coverage for. That doesn't necessarily mean that you forego a policy, but there can be instances like that in which you may have to consider whether you would also need to layer onto that some exposure of the seller in the transaction for things that wouldn't be covered by that policy because they occurred between sign and close and were discovered between sign and close or otherwise factor that into the overall deal certainty and Whether in those instances, if you weren't going to have insurance coverage, you as a buyer might be able to back out of the transaction.

So, Josh, what I really want to ask you is what's the craziest thing you've seen in M and A?

You know, I would like to say that my life is exciting enough that the craziest thing I've seen, I can't say publicly. I don't know if that's actually true.

Yeah, you just got to omit the names and dates.

That's how we do it here on M and A Science.

Nothing that could be identifying. I will say that one of the craziest, in a good way things that I saw was a client many years ago, it was a family owned company that was looking to sell to a private equity firm. And the private equity firm, and sadly some, certainly not all, but some, have a reputation for doing this, got very close to the signing date and then got on a call with the founders to propose a purchase price adjustment. In this case, the sellers said to them on the call, you are liars, you're untrustworthy, and in so many words I am never going to talk to you again. Hung up and really and truly never talked to them again. And the deal died on that phone call. And so while I have seen many deals die over proposed purchase price adjustments, I have not seen one where the founders left everybody silent on a call by telling the purchaser what terrible people they were and then literally hanging up the phone call on them. So that was an interesting one. Kisan. So although that wasn't a good story in the sense that it didn't necessarily have a happy ending where everybody came away pleased with the deal and with the deal having happened, it was mildly satisfying in the sense that we did not think there was a good justification for the purchase price adjustment in this particular transaction. So it was good to see the sellers have fortitude and say no. But otherwise, just like any deal, it certainly was not good to see it die as we always want to see a successful outcome.

Yeah, that is true. It's interesting how charged M and A can be emotionally. It's always interesting to remember that at the end of the day, it's all people doing business together for sure. Josh, this has been great. I feel like I should get like a certification, a completion on reps and warranty insurance from everything I've learned from you today. So thank you for taking the time, thank you for helping me become a better M and A scientist and thank you for the special rate I got for your time today.

Of course. Anything for you Kisan. It was great chatting with you and look forward to hopefully having a chance to do it again in the future.

If you're open to connecting with more of the corporate MA folks, we can put a link to your LinkedIn and they can come harass you on there.

Most definitely. Yeah, happy to do it. I'm always happy to connect with folks and answer any questions that people might have.

Thanks again Josh. Cheers. And here's to the deal. Foreign.

Thank you for taking the time to explore the world of M and A with our podcast. We love hearing feedback. Tag us on a LinkedIn post, add a review on Apple Podcasts.

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If you need help standing up an M and A function or optimizing one that you already have, we're here to help. And if we can't help you, we probably know someone that can. You can reach out to me by email Kisan K I S o n a science.com or you can text me directly at 312-857-3711. If you just want to keep learning at your own pace, visit mascience.com for a lot more content and resources. That's where you can also subscribe to our newsletter. Again, that's mascience.com here's to the deal. Views and opinions expressed on M and A Science reflect only those individuals and do not reflect the views of any company or entity mentioned or affiliated with any individual. This podcast is purely educational and is not intended to serve as a basis for any investment or financial decisions.