Companies’ increased use of representation and warranty insurance is speeding up M&A deals, but policyholders can be caught off guard by the complicated, time-consuming process of resolving claims, say attorneys who specialize in post-closing disputes. 

Companies on the buy side might think they can do less deal due diligence because the insurer will absorb the risk of seller contractual breaches, but you can expect the claims process to take as much as 18 months and the document demands to be significant, Sidley Austin Partner Frank Favia says in a podcast hosted by the law firm. 

“The process … is often faster and less expensive than pursuing a traditional indemnification claim in court, but there still is a fair amount of effort involved,” he said. “It’s not as simple as, we bought this product, we make a claim, and the insurance carrier pays right away.” 

The insurance typically covers seller misrepresentations on the liabilities they face, their adherence to generally accepted accounting principles, the validity of their receivables, their compliance with state and federal rules and other disclosures about their business. 

The long lead time required to get a claim approved is especially the case if the seller remains on the hook for indemnification in addition to what the insurance would cover. In these deals, the buyer needs to get consent from both the seller and the insurer when submitting a settlement proposal, said Alexis Cooper, a Sidley partner. 

In one case she worked on, the back-and-forth among the parties was drawn out because neither side wanted to move forward until it knew where the other party stood. “The sellers wanted to know that the insurer was on board [and] the insurer wanted to know that the seller was on board,” she said. 

Adding to the complications are the terms of the purchase agreement, insurance policy, and escrow agreement, which are typically the main contracts in the deal. “Those documents … all have time, mechanics and procedures you have to comply with,” she said.

To the extent possible, you want the documents to be consistent with one another. If the insurance policy includes a retention clause, for example, that puts the seller on the hook for a certain amount before the insurer pays. When that’s the case, problems can arise if the escrow terms aren’t in sync with the policy.

“Typically, a policy will have a deductible or retention that drops in half at the one-year mark,” said Cooper. “So, when the seller is negotiating the purchase agreement, they should be aware of the way the policy is written and have their exposure similarly cut in half at that one-year mark.”

There are other complexities when both the insurer and the seller are responsible for recoveries. In these cases, the seller typically releases money first. If that’s the case, the documents should make clear what further obligations the seller has, if any, once the money leaves the account.

“In a situation where you’re releasing those funds from escrow, it’s common that sellers will want to know, ‘If I release money to the buyer, am I done with this matter?’” said Cooper. 

There are fewer complications if the seller doesn’t retain any indemnification obligations, putting all of the recovery on the insurer in what’s known as a walkaway deal. But even here, if the claim involves an allegation of fraud, the parties can’t count on the insurer paying up.

“The insurer will tell us … that release [of money] cannot extend to fraud,” said Cooper. “So, it’s important that the buyer … knows what it can and can’t do in all of the steps along the way.”

Bottom line: The maturing market for representation and warranty insurance is helping to speed deals by giving buyers confidence they have protection should the seller not give them what they bargained for during negotiations, but the complexity of getting a claim paid means they can’t ease up on the diligence process. 

“We do see that the use of rep and warranty insurance allows the negotiation of the purchase agreement to go a little more smoothly between the sellers and the buyers,” said Cooper. “We’re finding less pushback overall about the scope of the reps. We still have a pretty detailed process for the disclosure schedule. So, sellers are still really engaged and involved, and the buyer has to really go through the due diligence, even to a higher level than they typically would.”