When acquiring another entity, many companies purchase representations and warranties (R&W) insurance to cover losses due to breaches of representations and warranties in purchase agreements. These R&W policies may apply in excess of a seller indemnity or, if the acquired entity has been resold, there may be separate lines of coverage for multiple acquisition agreements that apply to one breach. So, what happens after the deal closes and the purchaser discovers a breach?
- R&W policies cover both first-party and third-party claims
First-party claims involve issues that are discovered by the buyer after the closing that result in losses. Examples of such breaches include:
• An audit of a company’s records revealing financial or reporting issues.
• The company’s manufacturing equipment not performing to the standards warranted.
• Relations with customers not being as warranted or the buyer discovering breaches of contracts.
Third-party claims arise when a third party makes a demand or files suit against the company. For example, after closing, the company is served with a customer complaint alleging breach of contract and inference with business relations. A review of the company’s files indicates that prior to the sale, the sellers had been notified by the customer of its potential claim but did not disclose it to the buyer. This may be a breach of representations regarding contracts and litigation or claims. Another example of a third-party claim is a government civil or criminal investigation into the company.
Best practices: After a deal closes, calendar any dates for releases of escrows or limitations periods. Have periodic check-ins, three to six months prior to the calendared date, to determine whether there are any breaches that may result in a covered loss.
- What to do when a breach is discovered
Factual Investigation: The first step when a buyer discovers a breach is to gather the available information on the breach. This includes what the loss is, its cause, the amount, and whether the misrepresentation was negligent or fraudulent. It is also important to determine what, if anything, was known about the loss prior to closing and who knew it.
Analyze the transaction agreement: Review all of the representations to determine which ones were breached – one loss is often covered by multiple breaches. Is there an indemnity provision? What does it cover? Is there a limitations period or a retention? If there is an escrow, is there a release date coming up? What does the notice provision require? Are there any special notice or defense provisions for third-party claims?
Review the R&W policy: Are there any exclusions that may be applicable? What are the limits? Is there a retention or drop-down provision? Are there any applicable other insurance clauses? What does the notice requirement provide?
Notice: Provide notice to the sellers and R&W insurer. The notice should generally include (1) a description of the facts for the underlying claim or loss, (2) the specific representations and warranties breached, and (3) the potential claim amount. Make sure you comply with specific notice provisions. Always reserve the right to update the notice.
Best practices: In addition to the indemnity and R&W Policy, identify whether there are any other sources of coverage for the loss and provide notice. For example, look at any D&O or E&O policy with tail coverage for pre-closing losses or a current policy if there are post-closing allegations.
- Resolving the R&W insurance claim
R&W insurers generally have a set amount of time to respond to a claim. While they often request additional information before providing a coverage decision, they are only entitled to reasonable information. After receiving the requested information, the insurers should provide a coverage position, but may ask for more information. Policyholder attorneys should work with insurers to provide sufficient information, but attorneys should not allow the insurer to use such requests to delay providing a coverage opinion.
The R&W policies often require arbitration if a claim is disputed. This will not reduce discovery obligations, and the arbitration hearing is equivalent to a trial. Additionally, because R&W policies often contain arbitration clauses, there is very little case law. The best sources are case law on indemnification for breaches of representations and warranties or general insurance law. Mediation is another tool for resolving R&W claims, but it is often most successful after each party has had sufficient factual investigation.
Best practices: R&W claims are extremely fact-intensive. Policyholder attorneys need to work with their clients to investigate the underlying facts and losses in order to develop the claim throughout the process. Notice may need to be updated to revise the claim or assert additional breaches during the investigation.