Representation and Warranty Insurance
Introduction
Merger and acquisition processes are one of the legal processes that most seriously affect the identities and legal status of companies. After the completion of legal, tax, financial and operational due diligence reports, the parties initiate the negotiation process in case they reach an agreement on proceeding with the transaction. In almost all of the negotiation processes, the buyer and seller parties have contradictory demands (e.g. purchase price, liability of the seller, scope of representation and warranties and disclosure letter). Due to the desire of the parties to persuade each other into these contradictory demands, the arising conflicts may even lead to “pencils down” in the project if the negotiation processes are not managed sensitively. “Representation and warranties” that are included in share transfer agreements, which is one of the most important components of mergers and acquisitions, is one of the most discussed topics in this process. Representation and warranties, which can also be considered as the commitments of the seller regarding the company, also determine the seller's area of responsibility within the scope of the transaction. If the parties cannot agree on this area of responsibility, representation and warranty insurance (“R&W Insurance”) can be considered as an alternative solution.
Importance of Representation and Warranties in Merger and Acquisition Processes
After the merger and acquisition processes reach a certain maturity, the parties begin to negotiate on the share purchase agreement. Share purchase agreements, which constitute the promissory part of the merger and acquisition process, contains various regulations regarding the terms of sale and transfer, closing transactions, as well as the nature of the target company. The most important of these are the representation and warranties, which can be considered as commitments about the company.[1]
The representation and warranties are evaluated in two different groups as general and special ones. General representation and warranties are mainly related to fundamental matters such as that the shares subject to sale are duly issued by the target company, that the share certificates, if any, are duly issued and that the company's shares are free from any encumbrances. Special representation and warranties, on the other hand, are drafted in a "tailor-made" manner, according to the nature of the company and the company's field of activity. For example; in software companies, representation and warranties regarding the intellectual property rights of the software have a significant role. On the other hand, for energy companies, representation and warranties regarding their permits and licenses and environmental issues have a higher importance.
The most important aspect of representations and warranties is that they lead to liability of the seller. The seller is responsible for the representations and warranties given within the scope of the share purchase agreement.[2] For this reason, while the buyer party wants to receive as many representations and warranties as possible during the negotiation phase, the seller tends to narrow the scope of the declarations and warranties. If the parties fail to agree on the scope of the representations and warranties (and thus the seller's liability), the negotiation process may fall into danger or even terminated. For this reason, R&W Insurance can be evaluated in order to provide an assurance to the parties in terms of liability.
History and General Practice of Representation and Warranty Insurance
Various information is available regarding the origin of R&W Insurance. According to some sources, it emerged in London in the 1980s regarding taxation issues.[3] According to other sources, it is stated that it emerged in the United States in the 1990s and serves to reduce the liability of the seller.[4] This type of insurance, which has become increasingly widespread in recent years, is also frequently used in international mergers and acquisitions.
As stated above R&W Insurance covers the compensation to be paid in case of breach of the representation and warranties within the scope of the share purchase agreement. The insured party in the policy can be either the buyer or the seller. If the insured party is the buyer, insurance compensation shall be directly paid to the buyer in case the seller violates the representations and warranties. If the insured party is the seller, the relevant compensation shall be paid to the seller and the seller compensates the buyer under the terms of share purchase agreement.
It is of great importance to determine the scope of the insurance and the definition of loss while drafting the insurance policy. There are also certain issues that insurance companies generally tend to leave outside of the policy’s scope. Among these excluded matters are the matters known by the buyer and included in the data room or due diligence reports, environmental issues, bribery and corruption issues, future guarantees and commitments, violations arising from intent or fraud of the seller. Moreover, given that the loss is one of the conditions sought for the payment of the indemnity under the policy, it is also important how it is defined under the policy and the share purchase agreement.
Insurance companies may also consider a variety of financial mechanisms to pay compensation under the policy. For example, if an exemption amount is determined in the policy, a certain threshold shall be exceeded in order for the insurance company to pay compensation. In case the said threshold is not exceeded, the relevant party as determined under the share purchase agreement shall bear the losses.
Lastly, reviewing the statistics regarding the practice, it is seen that the most frequently violated representation and warranties that lead to the application to insurance are financial statements, tax, and compliance with the legislation.[5]
Representation and Warranty Insurance Within the Scope of Turkish Insurance Legislation
In Turkish legislation, insurance law is regulated by the Insurance Law No. 5684 (“Law”). The purpose of the Law is to ensure that the insurance industry operates effectively in a safe and stable environment. Pursuant to Article 5 of the Law, insurance companies and reinsurance companies must obtain a license from the Undersecretariat (Ministry of Treasury and Finance) in each insurance branch they want to operate in order to commence their activities. As it can be understood from the article, it is not possible for insurance companies to carry out insurance activities in branches for which they are not licensed. The said branches are regulated in the Communiqué on Insurance Branches (“Communiqué”).
Within the scope of the Communiqué, insurance branches are divided into two as life group and non-life group. Branches are listed under the said groups. In the current version of the Communiqué, R&W Insurance is not explicitly listed as an insurance branch.
This current status may be evaluated in two different ways. As can be seen from the practice, insurance companies generally do not provide a policy in this area, since this type of insurance is not explicitly listed in the Communiqué. On the other hand, it can be also interpreted that this liability can be insured under more general branches such as general liability insurance. Finally, it is possible to say that R&W Insurance is not being commonly used in Turkish Law and insurance companies do not actively provide policies in this regard.
Conclusion
The possibility of breaching the representations and warranties within the scope of share purchase agreements leads to the liability of the seller. If the buyers and sellers cannot agree on this liability regime, R&W Insurance can be considered as an alternative solution. This insurance, which can be executed in favor of the buyer or the seller, allows the damages to be covered by the insurance company as a third party. This policy, which is actively used in international mergers and acquisitions, is expected to find more use in Turkish Law.
- For more detailed information regarding the legal nature of representation and warranties please see: The Legal Nature of Representations and Warranties in Share Purchase Agreements (Access date: 01.04.2023)
- For more detailed information regarding the liability from representation and warranties please see: Liability from Representations and Warranties under Share Purchase Agreements (Access date: 01.04.2023)
- https://ir.lawnet.fordham.edu/cgi/viewcontent.cgi?article=1973&context=faculty_scholarship (Access date: 01.04.2023)
- https://corpgov.law.harvard.edu/2020/10/24/the-next-frontier-for-representations-and-warranties-insurance-public-ma-deals/#1 (Access date: 01.04.2023)
- https://www.aig.com/content/dam/aig/america-canada/us/documents/business/management-liability/aig-manda-2021-r-and-w.pdf.coredownload.pdf (Access date: 01.04.2023)
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