In response to the novel coronavirus (COVID-19) pandemic and resulting disruption in the global economy, the representation and warranty insurance (RWI) market is evolving rapidly. While the full scope of the global pandemic’s impact on the RWI market will continue to evolve as the pandemic spreads, this Sidley Update is intended as a snapshot addressing certain RWI trends that have emerged to date and forecasting trends likely to emerge.
I. Status of Deals Using RWI
The mergers and acquisitions (M&A) landscape has experienced significant disruption in the wake of COVID-19, with the frequency of new deals having slowed and some pending transactions in a seemingly constant state of reevaluation. Insurers and brokers have made clear that the RWI market remains open for business. However, until there is a semblance of economic clarity regarding the scope and nature of COVID-19’s impact on the global economy and the M&A sector, policy terms and the “normal” underwriting and due diligence processes are subject to adjustment.
II. Emerging Trends
Certain RWI trends have already begun to emerge. These include the following:
- COVID-19 exclusions have become standard. The global COVID-19 pandemic is an unprecedented event in the era of RWI. Until very recently, certain insurers were willing to bear some risk with respect to COVID-19 and were not requiring a COVID-19 exclusion. However, the market has shifted rapidly, and COVID-19 exclusions have become standard, especially with respect to transactions in such industries as public transportation, entertainment, healthcare and medical, retail, hospitality, personal care, education and others with global supply-chain dependencies.
- Approaches vary. Notwithstanding that a COVID-19 exclusion should be anticipated in any new policy, insurers’ approaches to the exclusion will likely vary. Some insurers are proposing to completely exclude any business interruption or other losses arising out of or resulting from COVID-19. Other insurers, however, are approaching COVID-19 exclusions on a case-by-case basis and are willing to narrow such exclusions based on the perceived effects of the pandemic on the target company’s business and operations. Because the exclusions proposed by the various insurers are constantly evolving as insurers gain a better understanding of the underwriting risks associated with the pandemic, buyers should solicit term sheets from multiple insurers (including descriptions of any COVID-19 exclusions). This will give them a much better understanding of each insurer’s approach to any COVID-19 exclusion prior to deciding which insurer will underwrite a specific deal.
- Most COVID-19 exclusions have proven negotiable in scope. Certain insurers have proven willing to negotiate the scope and breadth of such exclusions (e.g., insured parties have shown some success at negotiating for the exclusion to apply with respect to certain breaches but not others). To that end, buyers should carefully consider representations and warranties in their transaction agreements that are relatively immune (or at least insulated) from the effects of the pandemic (e.g., many of the customary “fundamental” representations and warranties, like authority, binding effect and others) and be prepared to negotiate to carve them out of any COVID-19 exclusion. Further, buyers should be prepared to negotiate with sellers regarding how to appropriately allocate any COVID-19 risk excluded by the applicable insurer (including, e.g., through (1) a special indemnity or the purchase price (whether through the original offer price or by way of a purchase price adjustment), (2) the scope and treatment of “Material Adverse Effect,” (3) the interim operating covenants or (4) a combination of mechanics).
- Bring-down diligence and the length of the interim period matter. Insurers commonly designate certain diligence aspects of a target business as “heightened” due diligence areas. With respect to RWI policies that are being underwritten in real time as the pandemic is unfolding, insurers have begun, as a matter of standard practice, characterizing the pandemic as a heightened diligence area.
- Buyers should be prepared for heightened focus on COVID-19 due diligence. In general, this means that, as part of the underwriting process, insurers will be assessing the pandemic’s effect on the representations and warranties proposed in the transaction agreement as well as the target business, including with respect to supply chain, financial performance, employment matters, material contracts, geography, business continuity and other insurance, particularly when deals involve prolonged interim periods between signing and closing. As a result, any buyer obtaining RWI should be prepared to discuss on any underwriting call with the insurer the effects of the COVID-19 pandemic on the underlying business and the related proposed representations and warranties and the disclosure schedule drafting and review process.
- Bring-down diligence calls will be longer and more substantive on COVID-19 issues. Further, where the underlying transaction has a separate signing and closing date (and especially when such interim period is relatively long), buyers should expect insurers’ bring-down underwriting calls, which typically take place a few days prior to the closing, to be much lengthier than those to which they are accustomed, and buyers should expect and be prepared for the insurer to discuss the effect of the COVID-19 pandemic on the target business and the ability of the seller to bring down its representations and warranties.
- Premiums and retentions have remained generally stable. As insurers gather more information and possibly anticipate greater risk related to the pandemic’s effect on target businesses, the possibility remains that insurers will increase premiums or retention amounts in their RWI policies. To date, however, policy premiums and retentions do not appear to have changed. Because the M&A market has slowed and the RWI market has followed, parties seeking RWI would be well served to negotiate the cost of policy premiums and retentions (to the extent they begin to change), as certain insurers may be willing to negotiate these items to remain competitive.
III. The Future
As the full scope of the COVID-19 pandemic’s impact on the economy and M&A sector is uncertain, so too is the manner in which the RWI market will be affected in the short and long terms. In particular, however, the RWI underwriting diligence process and the treatment of contingent exclusions are likely to continue to evolve.
- Underwriting Diligence. Among other things, the process of underwriting diligence may begin to evolve as the proliferation of shelter-in-place orders and mandatory remote work policies limit the ability for in-person diligence. In practice, it is becoming increasingly important that buyers and insurers coordinate with respect to the scope of the insurers’ due diligence expectations before underwriting commences to ensure that buyers’ due diligence efforts are sufficient to meet insurers’ expanded underwriting requirements and that any changes to or deviations from the customary due diligence process in any particular case are acceptable to the applicable insurer.
- Contingent Exclusions.
- Uncustomary due diligence should drive early discussions between buyers and insurers. As referenced above, the proliferation of shelter-in-place orders and mandatory remote work policies has begun to make certain customary due diligence processes like site visits and environmental testing inappropriate or even prohibited. As a result, because buyers may not be able to undertake fulsome due diligence at the outset of transactions (e.g., in-person site visits), buyers should be prepared for RWI policies that contain a list of contingent exclusions that relate to specific diligence items, some of which may even be unrelated to the pandemic. Buyers should discuss with their insurers the efficacy and appropriateness of virtual site visits, videoconferences and similar procedures for conducting necessary due diligence and otherwise prepare to proactively and creatively address expanded underwriting due diligence requirements to get insurers comfortable with certain risks and attempt to dispense with any such contingent exclusions between signing and closing.
- Who should bear the back-end risk of liabilities excluded from coverage? As a general matter, contingent exclusions are borne of diligence issues. Most often, contingent exclusions are due to incomplete diligence. Typically, which party bears the risk of that contingent exclusion is based on the nature and reason for the incomplete due diligence. Because contingent exclusions relating to the COVID-19 pandemic are a result of the rapidly changing global environment and are not the “fault” of the buyer or the seller, who bears the back-end risk of associated liabilities is a matter of leverage and deal dynamics. Therefore, transaction parties should be prepared to negotiate regarding who will bear the risks associated with pandemic-related losses subject to any contingent exclusion.
As the pandemic continues to unfold, parties relying on RWI should closely scrutinize and carefully consider, among other things, (1) the potential impact of COVID-19 on the target business, (2) the appropriate scope of any COVID-19 exclusions and (3) practical underwriting due diligence limitations and expanded underwriting due diligence requirements. If buyers are not able to secure RWI protection for COVID-19-related losses, they should prepare to negotiate with sellers regarding how to allocate pandemic-associated risks among themselves and the appropriate scope of corresponding risk allocation provisions to be included in definitive transaction documents.
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