What is Representations and Warranties Insurance? by Daniel S. Hughes, CPA/CFF, CGMA, CVA; and Mike Kaczka, CPA/CFF, CFE
Posted on September 12, 2019
Representations and warranties insurance (RWI) is becoming an increasingly common and required tool to expedite M&A transactions, bridge gaps in deal negotiations and reduce buyers’ and sellers’ risks of financial losses after deals close.
At the most basic level, representations are the assertions sellers make about their companies, those entities’ financial positions and past and present operations that buyers can rely upon as statements of fact to assess and value those businesses. Sellers also provide buyers with supporting documentation and business records to warrant their representations, including, but not limited to, financial statements, tax returns, customer and vendor lists, sales contracts, product inventory, copyrights and intellectual property. In this sense, reps and warranties form the basis of a buyer’s due diligence process and are critical for minimizing risks of post-transaction disputes between buyers and sellers.
Historically, sellers have assumed the responsibility of this risk by withholding a portion of their sales proceeds in an escrow account to indemnify buyers from any claims of losses they sustain as a result of sellers’ misrepresentations or failure to disclose material information. However, the traditional escrow holdback can be costly for sellers who either do not wish to set aside a portion of the sale’s proceeds or who may need access to those funds in the near future. RWI helps to facilitate deals by providing a solution that replaces or partially replaces an escrow. Instead, these policies shift the indemnification risk to a third-party insurer and provide sellers with a cleaner exit without weakening buyers’ opportunities for full recovery.
The reps and warranties made by a seller and covered in an RWI policy are detailed in the purchase agreement along with coverage limitations, exclusions and requirements claimants must meet to demonstrate a breach and recover damages. It is important to note that there is no one-size-fits-all RWI policy. Rather, each policy is dependent on the language and provisions contained in the purchase agreement. This makes it critical for buyers and sellers to ensure the terms and conditions detailed in the purchase agreement are written to suit their unique goals and needs.
Current Trends in RWI
As the use of RWI has increased, so too have the number of claims. According to AIG’s most recent M&A Claims Intelligence Series for Representations and Warranties Insurance, almost 40 percent of all claim notifications for breaches are related to accounting issues, including financial statement and tax breaches. Uncovering and potentially alleviating these financial concerns before a deal closes is possible with the benefit of a well-planned and thorough due-diligence process. Unfortunately, this requires a significant investment of time and money, which are scarce resources in the ultra-competitive deal market. All-too-often buyers shortcut the diligence process in a rush to close deals, leaving many issues undetected until post-merger.
RWI can be considered a safety net should adverse, post-merger issues arise. However, as is the case with most types of insurance, RWI is only as good as the insured party’s ability to collect on claims that result from a specific and verifiable breach or misrepresentation of information by another party.
While insurers may have deep pockets, they also have policies and procedures for filing claims and demonstrating a breach of covered representations and warranties. The claim verification process requires demonstration that a misrepresentation occurred that is directly linked to a specific type and amount of loss covered in the insurance policy. In general, this analysis is dependent on case-specific facts and documentation, including adherence with policy language and exclusions for filing claims related to an alleged breach. Under most circumstances, quantification of specific losses must be supported by accepted methodologies and accompanied by underlying documentation, which necessitates the expertise of experienced forensic professionals.
As it relates to RWI claims due to alleged financial statement and tax misrepresentations, forensic accountants can help analyze and evaluate the correct applications of accounting principles and tax codes over periods of time and determine whether restatement of financial reporting is required based on errors or non-application of generally accepted accounting principles (GAAP). They possess the skills require to analyze multiple-based valuations and investigate the causality between value and purchase price, including the extent a change in earnings could have impacted the negotiated purchase price.
For this reason, insurance companies, transactional attorneys and their clients involved in M&A transactions are well-served to engage forensic accountants who can play a vital role to not only demonstrate proof of a breach of representations and warranties in accordance with RWI policy language, but also that an alleged breach resulted in recoverable damages.
Berkowitz Pollack Brant’s Forensic and Advisory Services practice has deep experience handling the financial aspects for claims arising from breaches of representations and warranties. This includes claims for inaccurate financial reporting due to alleged violations of generally accepted accounting principles as well as alleged overstated earnings used to determine the purchase price value.
About the Authors: Daniel S. Hughes, CPA/CFF, CGMA, CVA, is a director with Berkowitz Pollack Brant’s Forensic and Advisory Services practice, where he works with legal counsel and companies of all sizes to assess economic damages, lost profits and the quantification of business interruption and representations and warranties insurance claims. Mike Kaczka, CPA/CFF, CFE, is a manager in the firm’s Forensic and Advisory Services Practice. They can be reached at the CPA firm’s Miami office at (305) 379-7000 or firstname.lastname@example.org.