Introduction
India Inc. has witnessed an enormous boom in the number of corporate marriages, causing a paradigm shift in investor sentiment, both in domestic and international markets. There was been a large number of deals witnessed in the recent decade. Although we lost a couple of years to a direct hit from the Covid virus, and we are spending the next years reviving the economy, dealmaking can rebound, helping cash-strapped businesses acquire fresh capital, or, have investors acquire them at a delicious value.
While corporate investors and retail investors look for opportunities in the Indian M&A market, there are risks associated with such inorganic investments. Behind the reams of papers spent conducting due diligence and adequate controls being in place by company secretaries conducting the merger, few issues remain in the blind spot. This article talks about representations and warranties in these M&A in share purchase agreements.
Prelude
Before jumping into what exactly representation and warranty insurance (RWI) is, let us acknowledge that every organisation wears a jacket of risk while playing on the ‘level’ playing business field. That is to say, any organisation faces a lot of risks, internal and external risk during their business operations. Even the parties on the other side of M&A table – be it private equity buyers or strategic acquirers also carry a certain degree of risk. In a traditional M&A transaction, the transferor company agrees to indemnify the transferee company for breaches of the seller’s representations and warranties. Practically speaking, the interests of the parties to an M&A contract do not align with respect to the representations and warranties clause of the contract. While the seller prefers to cut the scope of the representations and warranties to reduce the potential miss hits for inaccuracy and claims of breach, the buyer prefers to widen the scope of the representations and warranties to insulate itself from any possible risk events. Since these representations and warranties are backed by indemnity clauses from the party providing them, any breach of the same results in indemnity claim by the counter-party.
Representations
The Indian Contract Act, 1872 does not define the word “representation”. However, it defines what “misrepresentation” is. Misrepresentation can be fraudulent and innocent depending upon the mala-fide intention of the party from where the misrepresentation took birth. The intention of the misrepresentation cuts a fork in the road when it comes to awarding a remedy to the counter-party. In a misrepresentation where there was no intent to deceive, the counter-party gets the right to claim damages, however, the right to repudiate the contract is subject to whether or not the misrepresentation could have been discovered with ordinary diligence. On the other hand, fraudulent misrepresentation bestows upon the innocent party the right to claim damages and repudiate the contract. However, the right to repudiate the contract does not arise in a case where the misrepresentation was not an inducement to the contract for the innocent party.
Let us talk about fraud. Fraud is an active concealment of a fact by the party having cognizance of the same. It gravitates towards materiality element of the fact so concealed, as discovery of the same often swings the decision pendulum towards the other side by the counter-party discovering such fraud. Provided there is a duty to speak, silence is not a fraud. Thus, there does exist a legal duty to disclose. But somewhere, the blanket does not cover the entire body – that is why, parties undertake due diligence exercise to unearth any possible frauds – that is why ‘caveat emptor’ – let the buyer beware.
Warranties
The Indian Contract Act, 1872 does not define the word “warranty”. It is a promise that an assertion of fact is true and is supported by an implied promise of indemnity if the said assertion was false.
What and Why?
RWI is a contract between the transferee company or the transferor company and an insurance company whereby, the insurance company will indemnity the buyer for loss resulting from a breach of representations and warranties made by the seller. RWI is, ergo, a risk allocation tool intended to protect the insured against losses arising from unanticipated and unknown breaches of the seller’s representations and warranties in a purchase and sale agreement. It provides the sellers a tool to shift the risk of financial loss arising from breaches of representations and warranties to the insurance company, giving the sellers a certainty over proceeds from sale of business. Interestingly, while the contract can be triggered by a breach of representations and warranties, it provides a tool to protect both transferee company and transferor company.
RWI is available to protect both buyers and sellers from losses suffered from inaccurate representations and warranties, by shifting the indemnity risk to the insurer.
Key Elements
There are four key elements of a RWI policy, which are as follows:
- Policy Coverage: Practically, the limit is the value of an insurance coverage the counter-party would receive from the insurance company.
- Retention: This implies, a specific amount of losses must be incurred before the insurer’s obligation to pay the claims under the policy is triggered.
- Survival: The survival period is the term of the insurance policy. Obviously, the buyer would want the same to be long, and the seller would want the same to be short.
- Exclusions: These are provisions in the business purchase agreement which the RWI policy does not cover. It is mostly for breaches for which the parties had cognizance to – at the same of agreeing to the said agreement.
Costs of the Policy
There are generally few costs associated with obtaining the RWI policy. These are the underwriting fees, the premium and the retention amount. Different insurance companies can levy additional costs depending upon the nature and style of the M&A deal and RWI contract. The concept on retention implies that a specific amount of losses must be incurred before the insurer’s obligation to pay the claims under the policy is triggered. Nowadays, insurers offer a drop-down feature on the retention amount, which gets lower as the survival period of the insurance contract approaches completion. The underwriting fees typically is the fees paid by the insurer company to a legal professional to review the due diligence process or report conducted. It may order further due diligence as well. The premium can either be one time, or like in case of a credit default swap, can be periodically concurrent payments.
Benefits of RWI
There are multiple benefits arising from an RWI contract – both for a transferor company and a transferee company. Let us look at them separately.
Benefits for transferor company:
- Reduction in exposure to contingent liabilities
- Elimination for indemnity for breach in representations and warranties
- Protection to passive investors is obtained
- Strategic reasons, as RWI safeguards any possible financial obligations arising out of indemnity
Benefits for transferee company:
- Desired level of indemnification amount or duration of indemnification is obtained
- Risk of collection from financially distressed seller is eliminated
- Reduction in negotiations arising out of any possible breach
- Deadlock in negotiations for regular indemnifications can be avoided
No-Survival Deals
In a no-survival deals, the seller absolves all liability for any possible breaches in representations and warranties made on course of a M&A deal. But this comes at cost of an extensive coverage of representations and warranties over the wider scope of the M&A deal. The insurance company will want to confirm that the transferor company has populated the disclosures without any regard to the materiality of the qualifiers in their representations. Nevertheless, this significantly reduces the negotiation time between the transferor company and transferee company.
Limitations of RWI
RWI is not the medicine for all ills, i.e. it is not a fool-proof method to totally eliminate risk events arising out of any breaches in misrepresentations and warranties. RWI contracts only cover breaches in representations and warranties, it does not cover breaches in covenants breaches under a business purchase agreement. Also, it doesn’t cover any price adjustment issues which could arise as a prejudice to any buyer of the organisation.
Conclusion
Even though RWI contracts have their pros and cons, there are certain methods which can be adopted by the parties to an M&A deal. The transferee company can reduce the purchase price upfront while negotiating for the merger or amalgamation. The seller can deposit certain money in an escrow account, to cover for special breaches in any representations made. This, of course, depends upon case to case. We hope that RWI can at least, make the M&A negotiation battle less violent than what it is currently. It is pertinent to mention that as the insurance market is widening to entry of competitors, there may be certain insurers willing to provide favourable terms to the parties to an M&A deal. As we say, in a rational market, for every demand, there is a supply, even in provisioning of services.
Bibliography:
- A Guide to M&A Representations and Warranties Insurance in Mergers and Amalgamations: Forbes
- Harvard Law School Forum on Corporate Governance
- Revisiting Representation and Warranty Clauses by Obhan and Associates
- Concise Law Dictionary by P Ramanatha Aiyar
- Black’s Law Dictionary by Henry Campbell Black
- Representations and Warranties by Chubbs
- Representations and Warranties Insurance in LexisNexis Corporate Law Advisory
Disclaimer: The contents of the article has been jointly authored by CS Akshita Surana and CS Rajat Agrawal both practising company secretaries. The content of this article is intended to provide a general guide to the subject matter. Every effort has been made to keep the information cited in this article error-free. Suggestions and feedback to improve the task are welcome. The article and opinions therein are based on our understanding of the commercial and transactional laws and provisions prevailing as on date. The contents of this article are for information purposes only and does not constitute a professional advice or a legal opinion and are personal views of the authors. The opinion may vary according to one’s interpretation of the law. It should not be relied upon as the sole basis for any decision which may affect you or your business. The authors can be approached at akshitasurana@gmail.com or csrajatagrawal@gmail.com.
