Clifford Chance

In this post, we discuss certain agreement and schedule modifications that are often proposed by RWI Underwriters and the related rationale.

What representations and warranties are expected by the RWI underwriter? What representations and warranties are expected by the other deal participants?

Representation and warranty insurance is designed to cover exposures resulting from unknown matters following a reasonable, market standard due diligence review process conducted by the insured and its advisors. For the product to work as designed, the representations and warranties to be covered are expected by RWI Underwriters to have been fairly negotiated and reasonably capable of being confirmed as accurate based on reasonable, market standard diligence. Similar to the determination of the scope of due diligence to be conducted, determining the scope of representations and warranties to be provided regarding the target business and the other risk allocation related provisions contained in the deal documentation has always been a negotiation between buyers, sellers and their respective advisors. When representation and warranty insurance and other transactional risk insurance products are utilized, that negotiation is expanded to include insurance brokers and underwriters involved in procuring and issuing deal insurance in order to identify any potential coverage gaps and maximize coverage.

While certain agreement provisions may be entirely appropriate as between buyer and seller as a means of allocating risk between the parties, such provisions may not be appropriate for RWI coverage as the risk of loss is beyond what an RWI Underwriter can reasonably accept based on the level of premium being paid for coverage. Using a synthetic modification allows the agreement provision to remain in the agreement for all purposes as between buyer and seller but modifies the provision for purposes of the policy so that a loss associated with a possible breach of the agreement provision is not allocated to the RWI insurer. In some cases, a proposed modification may lead the parties to change the agreement which, in many instances, bridges a negotiation gap between buyer and seller or leads to additional diligence being done so that a representation can be covered by the policy. As such, the process of involving the RWI Underwriter in the agreement negotiation process may facilitate the negotiation process and/or draw attention to certain matters which otherwise might not have been the subject of detailed diligence or specific discussion between the parties.

Based on these principles, RWI Underwriters typically modify agreement provisions for the following four reasons:

• a representation is not of a type that is susceptible to market standard diligence;
• a representation is forward looking or in the nature of a covenant rather than a representation although "styled" as a representation;
• a representation is not a market standard representation; or¹
• an agreement provision acts as a risk shifting device which could expand RWI coverage beyond its intended scope.

CERTAIN AGREEMENT MODIFICATIONS²

Agreement Provisions

Set forth below are several agreement provisions that we typically see modified.³

Definitions

Loss

The "Loss" (or "Damages") definition is a definition that RWI Underwriters focus on as typically the policy's Loss definition will follow the agreement's Loss definition. As whether the quantum of Loss under a policy should be based on a multiple or diminution in value ("DIV") is often one of the most heavily negotiated/litigated portions of a claim under a policy, the RWI Underwriter does not want to agree, up front, to an affirmative grant of such damages but rather wants to be able to review the matter based on the specifics of a claim and the then-prevailing applicable law.

Historically, polices contained a multiple of damage/DIV exclusion; however, such an exclusion is no longer market standard. Market standard now is that the agreement must, at least, be silent with respect to multiple of damage, DIV, indirect and other similar types of damages and the policy will follow the agreement (i.e., silence in the agreement results in silence in the policy). If the agreement Loss definition contains an affirmative grant of multiple damages, DIV damages, indirect and other similar types of damages, the RWI Underwriter will most likely deem such language not applicable to the Loss definition in the policy. It is worth noting that if the agreement contains an affirmative prohibition against multiples of damages/DIV in cases where the seller is providing some level of indemnification for matters otherwise covered by the policy, the policy is likely to also contain an affirmative prohibition against such types of damages as the RWI Underwriter will likely not accept types of damages deemed unacceptable to the seller.

Liabilities

The "Liabilities" definition has expanded over time and is now typically very broad in agreements. While the Liabilities definition often goes beyond what is likely able to be reviewed in a due diligence process (e.g., including inchoate losses), RWI Underwriters, for the most part, will not modify the Liabilities definition but may review the places where the definition is used in the agreement and propose modifications to limit its effect. For example, RWI Underwriters might seek to minimize the impact of a broad Liabilities definition by proposing modifications where the definition of Loss includes "Liabilities" and for representations and warranties stating there are "no facts or circumstances" which could lead to a Liability.

Representations and Warranties

Financial Statements

The Financial Statement representation is the basis for many large claims in the RWI market. RWI Underwriters often propose modifications to the Financial Statement representation if:

• the Financial Statement representation related to the interim financials does not contain a carve out for lack of notes and being subject to year-end adjustment, the RWI Underwriter may propose that such carve out be synthetically added.
  • Normal market practice in the preparation and presentation of interim financial statements is for such financial statements to not contain notes and to be subject to adjustments in connection with the preparation of year-end financials. As such, the purpose of the modification is to bring the representation in line with such standard market practice.

No Undisclosed Liabilities

The No Undisclosed Liability (NUL) representation has been broadened in acquisition agreements over time and is now viewed by many as a "catch all" representation. RWI Underwriters focus on the standard (i.e., whether the representation addresses any liability or only any liability required to be disclosed on a balance sheet prepared in accordance with GAAP), the carve outs and the carve backs to the carve outs. Given current market conditions, RWI Underwriters are unlikely to propose changes to the standard (even if a broad liability definition is used) but may synthetically add a carve out for ordinary course liabilities if such carve out is not present.

RWI Underwriters propose a modification carving out ordinary course liabilities simply to reflect that the target business is a going concern and therefore incurs/has ordinary course liabilities that accrue after the date referenced in the NUL representation which ordinary course liabilities should not be the basis for a claim under the policy.

Compliance with Laws

Given that recent market studies on RWI claims have stated that there are an increasing number of claims arising from a breach of the Compliance with Laws representation, RWI Underwriters want to make sure the scope of the Compliance with Laws representation is not too broad and is susceptible to market standard diligence. RWI Underwriters often propose adding a knowledge qualifier to language stating there are no "facts or circumstances" which could lead to the target being determined to have failed to comply with law as without such a qualifier the language might be considered overbroad and not subject to being able to be properly diligenced.

Accounts Receivable

While policies will cover many aspects of the Accounts Receivable representation, RWI Underwriters will often propose an agreement modification which deems deleted a representation that accounts receivable are collectible. RWI Underwriters often modify collectability of accounts receivable as the policy is not intended to be a surety for or guarantor of collection or to cover statements of unknowable future events (i.e., that receivables will ultimately be collected).

Intellectual Property

The Intellectual Property representation often states that the target business owns or has rights to all IP necessary to conduct its business as proposed to be conducted following the closing and that the business will have the same rights after closing as it had before closing. As such a representation is forward looking in that it goes to the conduct of the target after the closing and interposes uncertainty regarding what is proposed for the business going forward, many RWI Underwriters will deem the "proposed to be conducted" language deleted and will insert "immediately after" before "closing".

Customers/Suppliers

The Customers and Suppliers representations are another example of representations that have broadened over time in agreements. While a buyer might want an enhanced representation that provides assurances as to the quality and expected continuation of the target's business relationships, the RWI Underwriter generally wants to make sure the representation is able to be reviewed through the diligence process. This often means that to the extent a Customers or Suppliers representation speaks to any notices of impending termination of business relationships, the RWI Underwriter will require the representation to address only notices in writing or to be knowledge qualified and will propose modifications to the extent that is not the way the representation is formulated by the parties to the agreement. In addition, often the Customers and Suppliers representation speaks to notices of reduction in levels of business with the target. As the RWI Underwriter does not want to provide coverage for normal business fluctuations, this part of the representation may be proposed by the RWI Underwriter to be qualified by "other than in the ordinary course of business." An RWI Underwriter often focuses on this representation as a breach of the Customer/Supplier representation may lead to the buyer being able to make an argument that the results of the breach negatively impacted EBITDA and therefore a multiple should be used in calculating damages.

While the RWI Underwriter does not want to cover an unknown/unwritten matter or a decrease in a business relationship in the ordinary course, the buyer wants to know about such items (and may have recourse under the agreement indemnity if the transaction has a limited seller indemnity). Thus, by making the synthetic modifications discussed above, the buyer gets what it wants from a disclosure perspective (and may perhaps have an indemnity claim against the seller if the representation proves to be inaccurate when made) while the coverage under the policy is limited to matters that can be properly vetted though market standard diligence.

Notice required to be written

RWI Underwriters often propose representations regarding "notice" be synthetically modified to add "written" before it. In determining the effect of such modification, the quantum of potential loss with and without such a modification for each representation for which such modification is proposed should be considered. This is because the synthetic addition of "written" before "notice" may only protect against defense cost Losses and not Losses related to the underlying matter.

Using the Material Contract representation as an example, if there is an actual breach of a material contract by the target, the representation is likely breached regardless of whether the notice provision portion of the representation is qualified by "in writing." Thus, it may be that if there is notice of a breach (but no actual breach) whether notice is provided in writing or not may only relate to the ability of the insured to obtain defense costs. To further clarify, in the scenario with no breach but notice is synthetically modified by "in writing" and no written notice was provided, the representation is not breached and the policy will likely not respond; however if the representation was not so modified and it is determined that there was oral notice of a breach of a material contract, the policy would respond, at least for defense costs.

Pre-Closing Tax Indemnity

To the extent the agreement contains a pre-closing tax indemnity and such pre-closing tax indemnity is the basis for the pre-closing tax coverage under the policy, modifications are often made to ensure the pre-closing tax coverage under the policy only covers:

• the historical operations of the target; and
• those taxes not otherwise already accrued or reserved for on the books and records of the target.

And does not cover:

• taxes arising from the transaction itself, such as transfer taxes, taxes arising from a pre-closing reorganization or taxes arising from a transaction-based tax election such as a 338(h)(10) election;
• taxes of the sellers;
• taxes accrued or reserved for on the target's books and records;
• any matter disclosed on the disclosure schedules which would be reasonably likely to lead to a liability for taxes;
• tax arising in a post-closing period; or
• any taxes arising from a matter specifically excluded under the policy.

As with many of the other modifications, the RWI Underwriter proposes the modifications to the pre-closing tax indemnity for purposes of the policy in order to cover the historical operations of the target but not the tax effect of the transaction (over which the buyer and seller have control and the ability to understand the relevant tax items) or the tax obligations of the seller.⁴

CERTAIN DISCLOSURE SCHEDULE MODIFICATIONS

While typically fewer modifications are made to disclosure schedules than to agreements, RWI Underwriters will usually propose modifications to disclosure schedules if the text of the disclosure schedules appears to limit the disclosure or if the disclosure schedules make additional representations or future promises about how a disclosed matter will be addressed.

Limiting Disclosure

As disclosed/known matters are generally not covered by RWI policies, RWI Underwriters do not want limiting language in the disclosure schedules to either call into question whether a matter was sufficiently disclosed such that a representation is not breached or create claims disputes as to whether there was knowledge of a matter which rises to the typical "actual knowledge" standard required in the policy in order for coverage of such known matter to be excluded.⁵ Therefore, to the extent disclosure schedules do not have typical cross reference language or have language that a matter is disclosed for "informational purposes only," the RWI Underwriter is likely to propose a modification to either add standard cross reference language or delete the "informational purposes only" language.

Additional Representations/Statements about Future Events

When disclosure schedules make statements which state a maximum potential liability for a matter or state that a matter is fully insured, the RWI Underwriter may propose a modification. It is likely that the proposed modifications will delete the statement of maximum liability or the statement indicating that the matter is fully insured in order to avoid a potential claim for the amount the actual liability exceeds the disclosed potential maximum liability with respect to the disclosed matter or if the matter is not actually insured, in whole or in part, despite the disclosure to the contrary, to avoid a claim for the uninsured amount.

Materiality Scrape

RWI Underwriters will typically, in a limited seller indemnity deal, follow the materiality scrape, if any, contained in the agreement (i.e., if the agreement contains a single scrape, so will the policy).⁶ It is also typical that RWI Underwriters do not scrape the term "material" from defined terms or from the Absence of Changes or similar representation because to do so would lead either to significant amounts of items that were not reviewed in connection with the diligence process being covered by the relevant representation (i.e., the difference between "Material Contracts" and "Contracts" or "Material Customers" and "Customers") or, in the case of the Absence of Changes representation, to scrape materiality would synthetically create a representation that does not otherwise make sense.

CONCLUSION

Allocating risk of a breach or inaccuracy of a representation or warranty or other agreement provision to an insurer changes the dynamic and analysis as to the scope of the representations and warranties or other agreement provisions a seller may accept (particularly in a no-seller indemnity deal). Modifications proposed by RWI Underwriters can help reallocate risk to a more balanced approach whereby buyer achieves its goals of requiring more fulsome disclosure, having some comfort on the bring down of the representation and warranties at closing and having broader agreement provisions, but the risk is not otherwise passed on to the RWI Underwriter which otherwise might not only have an adverse impact on the particular Underwriter's "book" but also the overall sustainability of the RWI marketplace. Drafting and negotiating an agreement with the concepts discussed in this post in mind and engaging with the RWI Underwriter and broker early in the process can lead to a more efficient process and one in which the agreement provisions are supported by agreed upon diligence procedures.

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¹Often in the case of a non-market standard representation, RWI Underwriters can determine from the proposed insured and its advisors the genesis of the representation and the diligence done to confirm its accuracy which may obviate the need for a proposed modification.

²We note that different RWI Underwriters have different risk tolerances and take different positions with respect to modifications (either generally or with respect to a specific risk). As such, the discussion in this Article of modifications is general in nature and different RWI Underwriters may take different positions on the matters discussed either due to overall risk tolerance or the risk profile of the specific risk under consideration.

³The discussion of modifications in this section is intended to be representational rather than exhaustive.

⁴It is important to note that unless proposed as an exclusion, changes in the policy to the Pre-Closing Tax Indemnity language contained in the agreement do not limit a loss arising from a breach of any tax representation contained in the agreement.

⁵Typically, certain members of the insured's deal team must have "Actual Knowledge" of a matter in order for the matter to be excluded from coverage as a known matter. This generally requires actual conscious awareness of a matter and that such matter actually constitutes a breach.

⁶For purposes of the discussion of materiality scrapes, we consider "fundamental only" indemnity deals equivalent to no seller indemnity deals and therefore would anticipate a synthetic double materiality scrape (i.e., for breach and loss) in the policy regardless of the materiality scrape, if any, contained in the agreement to the extent the RWI Underwriter is satisfied that the disclosure process has been relatively comprehensive.