DealMakers - 2023 Annual (released February 2024)
Representation, Warranty and Indemnity (RW&I) Insurance
by Shahid Sulaiman, Sebastian Petersen and Davin Olën
International Perspectives Informing a South African Approach
Merger and acquisition (M&A) transactions involve a level of risk for buyers. To mitigate the risks, buyers conduct thorough due diligence investigations on target companies, and require sellers to provide representations, warranties and indemnities (RW&Is) in transaction agreements.
Due diligence affords buyers an opportunity to assess the viability and risks of a potential transaction. Representations and warranties flow from the due diligence exercise. They are statements of fact or promises made by the seller regarding the business of a target company. This helps buyers understand the true nature of what they are acquiring. Indemnities are contractual obligations in terms of which sellers undertake to compensate buyers for specific losses or liabilities associated with the breach of a representation, warranty, financial exposure, or the like. RW&Is are used as a mechanism to shift the risk of purchasing an asset or business from the buyer to the seller in the event that the representations and/or warranties prove to be untrue or inaccurate, usually in a material respect.
RW&I insurance, however, is an additional mechanism for buyers (and, in some cases, sellers) to further shift the risk associated with a transaction off their balance sheet and to a RW&I insurer.
Buy-side RW&I insurance protects buyers from seller breaches of representations or warranties by allowing buyers to directly approach the insurer for indemnification. Sell-side RW&I insurance protects sellers by allowing them to approach the RW&I insurer if a claim is made against them for breach of a representation or warranty.
RW&I insurance is not commonly utilised in the South African market, and is more commonly encountered in developed markets. We deal below with RW&I insurance from an international perspective, and contrast that with its use in South Africa.
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International Perspectives
RW&I insurance is commonplace in more developed markets, such as the United Kingdom, Europe, the United States of America and Canada.
Shahid Sulaiman
Sebastian Petersen
Davin Olën
Its use is often found in mid to large-cap and private equity deals, with buyer policies being the norm. Inherently, sellers have a preference for limited or no post-closing recourse, which has driven the increased use of buy-side RW&I insurance.
The term “materiality scrape” (sometimes referred to as a “materiality read-out” provision) is commonly encountered in the context of RW&I insurance. Materiality scrapes are provisions that disregard any materiality, material adverse change (MAC) or material adverse effect (MAE) qualifiers in representations and warranties for the purposes of indemnification. These pro-buyer provisions stipulate that when determining: (i) whether any given representation or warranty is inaccurate, or (ii) the amount of damages or losses from any such inaccuracy or breach, that any “materiality” or MAC or MAE qualifiers in the seller’s representations and warranties be disregarded, eliminated or “scraped” for indemnification purposes. Materiality scrapes modify the scope of the risk transfer to the insurer and are, therefore, usually subject to significant negotiation.
Materiality scrape provisions are most common in the United States of America (USA) and Canada, with the USA favouring a “double materiality scrape” (the exclusion of materiality qualifiers when determining whether a breach occurred and in calculating losses), and Canada favouring a “single materiality scrape” (the exclusion of any materiality qualifier for calculating losses only). Because the allocation of risk and liability between buyer and seller is affected by materiality scrapes, RW&I insurers pay particularly close attention to such provisions, with a view to limiting their use in transaction agreements.
A pro-seller approach followed by sellers in the United Kingdom is to “box-in” certain warranties. Boxing in warranties limits a buyer’s claims to specific matters (for example, intellectual property or tax matters). This approach is favoured by RW&I insurers as it limits the affected parties’ exposure to indemnity claims and, by extension, the risk transfer to the insurer.
RW&I Insurance in South Africa
RW&I insurance is not as prevalent in the South African M&A market as it is in more developed M&A markets. This is partly due to the cost associated with obtaining RW&I insurance and the limited offering of the product in South Africa. However, that being said, RW&I insurance is not unheard of, and foreign underwriters are often approached in this regard. Therefore, its use is largely driven by the prior exposure of transacting parties to such insurance, with no general market practice in relation to RW&I insurance in South Africa.
Our experience shows that RW&I insurance is more commonly utilised in private equity deals and deals involving sophisticated foreign counterparties. We have also seen that RW&I insurers actively require “boxing-in” provisions to limit exposure, and often scrutinise transaction documents carefully to identify materiality scrapes, with extensive materiality scrapes likely resulting in increased premiums.
RW&I insurance is an attractive tool for risk mitigation in the South African context. For foreign investors looking to enter the South African market, RW&I insurance can provide the comfort of being able to recover claims for breach of representations and warranties without having to engage in litigation in the local market. In addition, RW&I insurance can add a level of certainty to the deal, facilitating smooth execution and exits, and protecting the relationships between buyers, sellers and interested stakeholders.
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Sulaiman is the Senior Partner, Petersen a Candidate Attorney and Olën an Associate | Dentons.