Avijit Singh and Chetan Saxena
With the advent of Covid-19 nothing has been left untouched, from a daily household routine to critical market avenues, it has brought new challenges for everyone. However, with these new challenges, various new opportunities have popped up, especially for India. In terms of legal landscape, various novel legal concepts can be introduced in India (already existing in the west) on a much wider scale that can reap benefits. An important domain is the scheme of Representation and Warranties Insurance (“RWI”) in M&A transactions. While Representations and Warranties (together “R&W”) has been an important component of M&A dealings, the introduction of insurance has brought concerns along with multiple benefits. RWI is in its initial phase in India; contrary to the position in the west which has a much wider application and understanding of the concept.
Keeping in mind India’s position and future goals, this article tries to provide a conceptual understanding of the RWI models and discuss the need for adoption of RWI market in M&A deals in India. It further discusses the issues in RWI which have popped up on account of Covid-19 and how India can face the sweet chin music posed to it.
Representations and Warranties Insurance
The two terms representation and warranties are often confused to be synonymous, however, are different from each other. Representation is an assertion to the fact, which is backed by warranty stating it to be true and factually correct. To understand RWI in simple terms, it is an insurance against the losses occurred to the transacting parties due to breach of R&W. The RWI works from two sides, i.e. buyer and seller. While in most cases, the indemnification is done towards the buyers, however, there are instances where sellers also get the benefit of insurance. Under the RWI model, the buyer or the seller gets itself insured against the R&W given by the transacting parties. The insured party enters into an agreement with certain exclusionary clauses against which the claims cannot be made. The risks insured to specific in nature and differ from case to case basis.
While there are numerous advantages attached to RWI, its introduction in M&A transactions has come up with its own challenges. RWI model might seem simple but there are numerous issues inscribed in it. Thus, it becomes imperative that an understanding is developed regarding the RWI model and the issues surrounding it. The issues with respect to RWI deals arise generally at the stage of claim, similar to normal insurance deals. While claims and payment of retention amount are important aspects of RWI, multiple issues exist that demand attention in order to have more clarity on RWI.
- Scope of RWI Deals
RWI deal uses a number of clauses such as cost of coverage, seller’s and buyer’s liability, information and disclosures, etc. Further, there are inclusionary and exclusionary clauses that define the scope of RWI deals. While a major part of R&W is covered under the insurance, there are certain exclusions that restrict the scope of RWI i.e. issues occurring and discovered by the insured in the interim period of signing and closing of RWI deals, breaches discovered after the closing statements or those relating to the covenants, failure on account of parties’ due diligence and disclosures requirement are also not covered under the RWI. Furthermore, an important exclusion from the seller side insurance is the fraud on account of the seller. Lastly, R&W do not generally carry the burden of a breach by any such member involved in the deal and had a prior knowledge of any material inaccuracy which is part of the policy.
- Incentives for Insurers in RWI.
The basic purpose of any person/company entering into a contract is that it seems profitable to them. While the insurers pay duly in cases where there is a valid claim, due to the level of due diligence involved and information disclosures required, the insurers rarely have to pay for a claim. Thus, the claims more or less get set off within the retention amount. On the other hand, premium amount involved in M&A RWI are huge since M&A deals engross huge sums of money. A general market standard of 2-4% of transaction cost as a premium amount reaps huge benefits for the insurers. However, RWI in M&A deals is a very information sensitive market. There might be a case where the position of insurer is worse than what it seems like. Relevant information relating to the risks involved in R&W eventually resides with the one insured and that might be a big risk that the insurers take on.
- Transacting Parties Obligations in RWI
RWI in M&A transactions involve three parties including the buyer, the seller and the insurers. Keeping aside the role of insurers, the buyer and seller have duties and obligation under the RWI agreements. While the seller is obligated to make disclosures to both the buyer and the insurer, the buyers shall take due care that there is no lack in conducting due diligence. An important component of M&A deals with RWI is the information to the buyers. Therefore, sellers are required to provide true information that is sufficient for conducting the transaction smoothly and that which does not hamper the interest of the buyers or the seller or the insurer at a future date.
RWI- India’s Position and need for change
Over the period of time, especially in the last decade a lot has changed in terms of foreign investment coming to India. A major role in these has that been of M&A dealings with foreign investors investing in Indian companies. However, under the current legal framework major uncertainties lie among parties to move further with such deals involving RWI, especially in M&A transactions as the Indian companies have barely been a party to M&A deals involving RWI. In terms of Representation and Warranties, India has a steady market, however, India does not have a structured model under its legal framework to deal with insurance of R&W.
M&A transactions involve foreign parties as a matter of prudent practice seeks legal certainty in host state. While there are various factors that lead parties to enter into M&A deals, a very important component of the M&A deals is the tax effect arising out of it. Insurance proceeds may also be adjusted against purchase price, reducing the tax basis from the acquisition made. This needs to be backed by a legal framework that allows such adjustment of the purchase price and acquisition made. With lack of legal framework for such RWI models, investors are often hesitant due to uncertainty lying in tax aspects as related to those mentioned above. Let alone the foreign investors, the lack of knowledge among the domestic players hampers the situation a lot. The market is unaware of the benefits of such an insurance market which can help the growth of overall sector as a whole. Indian investors are often hesitant in domestic dealings too with the uncertainties that revolve around the M&A and R&W. With major protection under RWI, the sellers and buyers in the domestic market themselves would be more confident of incorporating insurance clause under their Acquisition Agreements which would eventually help them with investors across borders.
Considering India is a growing market and varied factors involved in M&A transactions, it becomes almost non-negotiable to adopt the international practices in India. The introduction of RWI framework under the legal system can really help India by not only bringing in investments in India but also having a larger market of insurance, thus having a two-way benefit.
Impact of Covid-19 on RWI deals in M&A
The swift spread of Covid-19 has hay wired the economies across globe significantly. A majority of M&A deals involving RWI have been delayed for later or have entirely been suspended. However, there are certain transacting parties who are seeking RWIs. Therefore, adapting to the needs of the transacting parties the insurers are moving forward with certain Covid-19 exclusions in the policies. Considering the pandemic is not new anymore, the same trend seems to persist until the situation in the market gets better. Various approaches are being used by insurance companies to avoid the claims occurring on account of Covid-19 related losses and claims. On the other hand, many are evaluating the exclusions on deal-by-deal basis taking into consideration the risks related to the target business. Most RW insurers have excluded any claims resulting from Covid-19 which include any claim arising out of or as a result of disturbance to the operations of the target business as a result of the spread of Covid-19, any labor shortage, government enforced lockdowns, change in consumer demand, change in supply curve etc.
During the initial phase of the pandemic, the insurers didn’t look too keen to include risks associated due to Covid-19. The exclusions, however, have been negotiable considering them being more focused on specific risks on deal-by-deal basis. Today even with inclusions of Covid-19 losses, insurers continue to raise questions of diligence taken by the parties in understanding what steps have been taking to see where the target could be vulnerable and steps taken to understand the impacts that Covid-19 had on the target’s operations, facilities, employees, suppliers and supply and distribution chains, material customers, IT systems and other matters. Overall, R&W insurers are moving to build underwriting protocols in real time to address the risks associated with Covid-19 in M&A transactions. Even with some narrowing of the exclusions, buyers may not enjoy the same protection previously given under these policies and may be in dispute as to whether or to what degree Covid-19 caused a loss.
RWI seems a proposition best fit for all as it secures everyone in the market
.. As a substitute to standard escrow obligations, the RWI provides sellers an easy exit. The buyers are also secured against non-payment for breach of R&W. The insurers are always keen to undertake insurance of such transactions on account of huge premium amount involved. Thus, the model secures everyone’s interest and benefits all.
As already discussed, India’s position in RWI does not present a rosy picture. With so much on the plate under the existing models across jurisdictions, it is time that India develops a legal framework dealing with RWI (especially for M&A purposes). Lack of knowledge and awareness among the domestic investors has been one reason why such a mechanism is still not on cards in the Indian markets. The calibrated legal framework thus not only provides a learning curve for the domestic players, but also provides certainty to foreign investors that encourage foreign investment.