Seller’s R&Ws
In nearly every purchase transaction, each party makes representations and warranties (R&Ws) to their counterparty. Common examples of R&Ws made by the seller include that it owns the assets or equity it’s selling free and clear of liens or encumbrances, and that its financial statements are accurate and prepared in accordance with generally accepted accounting principles (GAAP). Common examples of R&Ws made by the buyer include an affirmative representation that the buyer has the authority to enter into the transaction, and that it has sufficient liquidity to fund the purchase transaction. In the case of an R&W, the party makes a promise of indemnity if the representation turns out to be false.
When Seller’s R&Ws are Inaccurate
Escrow Account
Traditionally, a purchaser would recover losses resulting from a seller’s breach of an R&W from an escrow account funded with a portion (typically 10–15%) of the purchase price. This escrow account would remain in place for a set period, and any remaining funds would revert to the seller upon its expiry.
Trending Option: R&W Insurance
More recently, it has become common in middle-market transactions for the parties to obtain representations and warranties insurance (“R&W Insurance”). As such, it is important for both buyers and sellers to understand the what and why of R&W Insurance.
What Is R&W Insurance?
Just like car insurance covers damages from an accident, R&W Insurance covers losses arising from a breach of representations and warranties in a purchase agreement. For instance, if the seller failed to disclose it has some liabilities like a pending lawsuit. Instead of the purchaser recovering losses from an escrow account, the purchase agreement would dictate that the buyer would seek recovery from the insurer for covered losses.
Key Points to Consider:
Coverage Scope
While each policy differs, R&W Insurance generally covers breaches of fundamental representations and warranties that were unknown to the buyer at the time of signing. It is critical to understand the policy’s knowledge standard, actual or constructive knowledge. Note: an actual knowledge standard is generally more favorable to the seller in determining whether an event constitutes a covered loss.
Common Exclusions
R&W Insurance policies often exclude certain risks. Common exclusions include:
- Breaches of R&Ws known to either party (or their teams) before policy inception
- Items disclosed on the seller’s disclosure schedules
- Fraudulent omissions or misrepresentations
- Breaches of covenants or post-closing obligations.
Why Purchase R&W Insurance?
Seller Benefits
For sellers, R&W Insurance allows receipt of substantially more of the purchase price at closing by eliminating or reducing the need for an escrow account.
Buyer Benefits
For buyers, R&W Insurance can offer higher coverage limits than a traditional escrow (often exceeding 10–15% of the purchase price) and may provide longer survival periods for claims.
Mutual Benefit
Ultimately, R&W Insurance helps both parties minimize post-closing disputes, allowing a cleaner break after the transaction closes.
Conclusion
While R&W Insurance is not strictly required to close a purchase transaction, it has become commonplace in the market. Understanding how it works and what it covers is essential for both buyers and sellers. Always review the terms of any R&W Insurance policy with legal counsel to ensure clarity on coverage and exclusions, so that you may close your transaction with peace of mind.
This is part three of a three-part series introducing some key concepts in purchase transactions. This content is general information and should not be construed as legal advice.
More about Andrew Vining: Andrew is a Corporate Services Partner with Practus, LLP. Andrew advises businesses at every stage of the corporate lifecycle, from formation and capital raising to mergers and acquisitions, to day-to-day operations. He also represents clients in general litigation and real estate transactions.
