M&A Representation and Warranty Insurance Considerations in the Wake of the Coronavirus Pandemic
Increasingly, M&A transactions are using representation and warranty insurance (RWI) to bridge the gap between a buyer’s desire for adequate recourse to recover damages arising out of breach of representations in the purchase agreement and a seller’s desire to minimize post-closing risk and holdbacks or purchase price escrows traditionally used as the means to satisfy such obligations. When it works, RWI provides a significant benefit to both parties: it mitigates the buyer’s risk in the event that the seller’s representations and warranties prove untrue, and it permits the seller to reduce the portion of the purchase price that it would otherwise have to leave in escrow to cover future claims for breach of those representations and warranties. However, as the coronavirus pandemic ravages the global economy, insurers are now expressly adding COVID-19 exclusions to their RWI policies. If RWI insurers decline coverage for these losses, the allocation of risk in the representations and warranties (and related indemnity provisions) will be more critical than the parties contemplated when they negotiated the transaction documents.
Unlike in the case of a natural disaster, insurers cannot quantify the economic fallout that may result from the coronavirus pandemic. This uncertainty breeds systemic concern about the number of insurance claims that covered parties of all varieties will bring, which in turn creates an industry-wide reluctance to cover the claims. Based on discussions with market participants, we understand that, at the present time, 70% to 80% of RWI insurers are broadly excluding losses resulting from COVID-19 and similar viruses, epidemics, and pandemics (including government actions in response thereto), 5% to 10% are narrowly excluding specific coronavirus-related losses that are more likely to be implicated in a particular transaction (e.g., losses caused by business interruption), and 10% to 15% may be willing to narrow their exclusions upon completion of the underwriting process, depending on their comfort level after conducting rigorous and heightened diligence. Insurers’ concerns are wide-ranging, but the representations and warranties causing the greatest distress appear to be those regarding customer retention, supply chain matters, undisclosed liabilities, and the absence of changes between the date of the seller’s most recent financial statements and the transaction closing date.
Insurers that are including the broad-based exclusion are casting their nets extremely wide. As noted above, these policies are excluding any losses arising out of or resulting from not only COVID-19 or other viruses, but also any government reactions thereto. This type of language could, in hindsight, encompass almost any breach of a representation. For example, what if the target company needs to furlough or terminate workers as a result of the impact of the virus on its business and, in doing so, it acts in a discriminatory manner in determining which employees to furlough or terminate? Did that discriminatory behavior arise out of or result from COVID-19? Additionally, what if the financial statements are misleading, or a representation as to collectability of accounts receivable is materially inaccurate, because the target company’s CFO did not adjust for the impact of the virus between signing and closing? Did the CFO’s actions arise out of or result from COVID-19?
Deferred closing transactions (i.e., deals that close sometime after the parties execute the transaction documents) exacerbate these concerns. In many such transactions, regardless of whether a representation or warranty breach occurred, the buyer can walk away only if the seller suffered a “material adverse effect” in the time between the signing and the closing. Thus, many buyers will still be required to close these transactions despite the existence of known risks. If the actual breach is known before the closing, then, in all likelihood, it already would have been excluded and covered by a special negotiated indemnity relating to the specific issue. However, if all that is known before the closing is the general stress on the business as a result of the pandemic, and if it is later discovered that there was a breach of a representation, insurers are more likely to get stuck holding the bag for intervening complications that arise as a result of the coronavirus pandemic.
According to our recent discussions, in both simultaneous closing transactions and deferred closing transactions that are still being negotiated, insurers are not only adding the exclusions, but also carefully reviewing, and requiring changes to, the transaction documents. For example, they may require the parties to adjust the transaction documents to ensure that, for purposes of any representation regarding the absence of changes or the absence of a material adverse effect since the date of the last financial statement, there is an exclusion for the coronavirus pandemic. This shifts more risk to the buyer to accept the impact of the virus on the target company.
Also, insurers are beginning to scrutinize whether buyers have conducted adequate diligence regarding the impact that COVID-19 will have on their target companies. While the relevant considerations will vary depending on the business of the target company, insurers are likely to focus on whether buyers have accounted for risks associated with supply chain disruptions, reduced workforces, mandated facility closures, the ability to provide remote services, and travel restrictions, among other things. Similarly, in deferred closing transactions, underwriters are expanding the scope of their bring-down calls (which take place before the closing, and which give the underwriters the opportunity to confirm that no new issues have arisen between signing and closing). Traditionally, bring-down calls were somewhat perfunctory, and underwriters would get though their questions in 10 to 15 minutes, but now, underwriters are posing far more purposeful and detailed questions about the impact of COVID-19 during the time between signing and closing. Under the current circumstances, these calls are taking one to two hours.
Meanwhile, buyers have been trying to include coronavirus-specific representations and warranties in their purchase agreements. For example, a buyer may demand a representation that the seller has not lost, and does not anticipate any loss of, customers as a result of the pandemic. Based on our conversations, insurers are routinely excluding coverage for breach of these types of representations.
This new dynamic is not limited to RWI. For example, insurers are facing mounting pressure to extend business interruption coverage to policyholders whose operations are impaired by the pandemic. In fact, in the past two weeks, several states have introduced or enacted laws or taken executive action to require business interruption insurers to cover losses attributable to viruses and pandemics. In the cases that undoubtedly will arise regarding RWI and business interruption insurance claims, adjudicators will have to consider what event really precipitated the disruption: did the losses arise out of or result from the presence or spread of the virus, the government orders and directives issued in its wake, or some other reason that may or may not be directly related to the current crisis?
If you have any questions or would like additional information, please contact Lori Smith (firstname.lastname@example.org; 212.714.3075), Patrick Devine (email@example.com; 215.864.6272) or another member of the Corporate and Securities Group.
 In most cases, it is very difficult to prove that the seller suffered a material adverse effect. For our client alert discussing whether the coronavirus pandemic constitutes a material adverse effect, please click here.