Over the past decade, Representation and Warranty Insurance (RWI) has become the default mechanism by which private equity buyers protect themselves from loss arising from breaches by a seller of its representations and warranties (R&Ws) in an acquisition agreement. During that same timeframe, the RWI product has also expanded to provide coverage for buyers in several other unique transaction contexts, including take-privates, mergers-of-equals, joint ventures, GP-led secondaries, and sales out of bankruptcy and pursuant to section 363 of the Bankruptcy Code.
In this article, we take a closer look at how RWI has evolved to accommodate the unique aspects of take-private transactions.
At a high level, take-private transactions involve the acquisition by a private entity of the outstanding equity interests of a public company and the de-listing of such company from public exchanges. There are several reasons for accomplishing a take-private transaction, including the ability to grow and streamline a business without (i) onerous public company reporting and regulatory requirements, or (ii) public shareholder oversight with an eye toward meeting quarterly earnings objectives.
Of course, take-private transactions are not without risk. The private entity making the acquisition typically finances the transaction with a significant amount of debt, betting that the improved company’s operating cashflow will sufficiently service the interest payments. Additionally, the buyer’s equity in the target loses the liquidity offered by public markets, increasing the difficulty of exiting the investment. Once restructured, the private owners can take the company public again at a later point to realize returns for their investors or continue operating the business in hopes of capturing the long-term value accretion of the restructured company.
While take-private transactions are similar in many ways to traditional private equity buyouts, they involve a number of unique considerations as it relates to an RWI placement. For example, (i) the R&Ws in public-style acquisition agreements typically are Material Adverse Effect (MAE) qualified, (ii) the disparate shareholder base complicates the carrier’s right to subrogate against the sellers for fraud, and (iii) carriers typically are hesitant to cover R&Ws regarding shareholder derivative suits and accuracy of securities filings. For these reasons, take-private transactions have, historically, amounted to more difficult RWI placements. That said, in recent years carriers have become more comfortable with the take-private structure and, accordingly, such complicating factors can be overcome with advance planning and careful broking. Here we will take a closer look at each obstacle enumerated above and discuss potential solutions.
A typical public-style purchase agreement will forego any seller indemnity (i.e., is structured as a “walk-away” deal) and the R&Ws in such agreements are typically subject to an MAE qualifier. As opposed to simple “materiality,” an MAE is a term of art requiring significant harm to the company as a whole before it will be determined that a breach has occurred. For example, the Delaware Court of Chancery has noted that, to amount to an MAE, a breach must cause a sustained and significant decline of a company’s performance and suggests that a 20% decline in company value or a 40% reduction in profits would meet such threshold. Accordingly, MAE-qualified R&Ws significantly reduce the diligence and scheduling obligations of the sellers.
A typical RWI policy, on the other hand, will scrape most materiality and MAE qualifiers included in the R&Ws in a purchase agreement, effectively covering the R&Ws flat. Accordingly, during a typical RWI underwriting process, carriers will confirm that, notwithstanding the materiality qualifiers in the R&Ws, buyers and sellers diligenced and scheduled against the R&Ws as though such R&Ws were being made without regard to any materiality threshold. When the R&Ws are qualified by an MAE, however, that confirmation is of even greater focus for carriers as the margin for error in scheduling and diligence becomes significantly greater. As such, it is imperative that buyers and sellers in take-private transactions understand from the outset the importance of conducting a thorough diligence and scheduling exercise to avoid losing out on the benefit of the materiality scrape present in most RWI policies.
In a typical RWI placement, carriers do not require a right to subrogate against the sellers for any loss the carrier pays out to the buyer, except in the event of fraud of the sellers. This structure mirrors the traditional indemnity construct, which also carves out fraud from the exclusive remedy clause. Carriers rely on the fraud exception to ensure that sellers act in good faith during the diligence and scheduling process.
In a take-private transaction, however, not only are shareholders less likely to be involved in the transaction process, but the disparate nature of a public target’s shareholder base precludes any reasonable avenue for recovery for seller fraud by an RWI carrier. This issue can be addressed in several ways. One such way would be to require that the management team and/or certain major shareholders involved in the transaction and scheduling process agree to remain on the hook post-closing for fraud. This solution gives carriers comfort that the parties negotiating the transaction documents will act in good faith and limits, to a reasonable number, the parties that would be responsible for a post-closing fraud claim. A second, and significantly more buyer-friendly, potential resolution is to request that the carrier forego any right to subrogate against seller parties for fraud. While, historically, carriers resisted this approach, in recent years many have become increasingly receptive given that, as the market for take-private transactions (and RWI generally) has matured, carriers are gaining comfort that all parties will act in good faith regardless of whether they are subject to recourse for fraud.
Finally, take-private transactions, as opposed to typical private equity-style buyouts, (i) can involve 10b-5 and other representations related to compliance with securities laws and accuracy of public filings, and (ii) are subject to shareholder derivative suits and appraisal proceedings under state corporate law.
As a general matter, carriers will exclude from coverage all representations and losses related to claims by public shareholders, shareholder derivative suits, appraisal actions and violations of securities laws. Such issues are difficult to diligence adequately, and with respect to derivative/appraisal actions, are all but inevitable. Accordingly, clients should be made aware of such coverage limitations at the outset to avoid any unnecessary surprises during underwriting. In addition, as any broad representation regarding accuracy of public filings will be excluded from coverage under a R&W policy, clients should endeavor to also include specific subject-matter representations in the acquisition agreement.
While take-private transactions are subject to a number of complications not present in a typical private equity-style buyout, such complications are manageable and can be addressed with proactive consideration and negotiation. As softening credit markets result in more frequent take-private transactions, it is imperative that buyers engage a knowledgeable and experienced broker to ensure they make informed decisions during the RWI placement process.
Willis Towers Watson hopes you found the general information provided in this publication informative and helpful. The information contained herein is not intended to constitute legal or other professional advice and should not be relied upon in lieu of consultation with your own legal advisors. In the event you would like more information regarding your insurance coverage, please do not hesitate to reach out to us. In North America, Willis Towers Watson offers insurance products through licensed entities, including Willis Towers Watson Northeast, Inc. (in the United States) and Willis Canada Inc. (in Canada).
