The landscape of mergers and acquisitions (“M&A”) is constantly evolving, with deal structures becoming increasingly sophisticated to mitigate risks and optimize outcomes for all parties. A critical element of any M&A transaction is the allocation of risk associated with potential breaches of representations and warranties made by the seller regarding the target company and its business operations. Historically, this risk was primarily managed through a traditional indemnity structure negotiated between buyer and seller parties in the purchase agreement governing the M&A transaction. However, in recent years, Representations and Warranties Insurance (“RWI”) has emerged as a powerful alternative, fundamentally reshaping how M&A deals are negotiated and closed.
When planning an M&A transaction, both buyers and sellers of all sophistication levels should think about how to best allocate this risk and whether a traditional indemnity structure or RWI is preferable. This article provides an in-depth analysis of both traditional indemnity structures and RWI, outlining their fundamental mechanics, key differences, and the respective advantages and disadvantages for both sellers and buyers.
The Traditional Indemnity Structure
In a traditional M&A transaction, the seller provides representations and warranties to the buyer regarding the target company's business, assets, liabilities, and operations in the purchase agreement governing the M&A transaction. These representations are statements of fact at a specific point in time (usually the closing date), and warranties are promises that those facts are true. If a representation or warranty proves to be untrue, and the buyer suffers damages as a result, the seller is obligated to indemnify the buyer for those losses.
Key components of a traditional indemnity structure include:
Representations and Warranties (“R&Ws”): If an R&W made by seller proves to be untrue, this triggers an indemnification obligation that buyer can pursue against seller. They cover a wide range of areas and typically consist of “basic” or “general” R&Ws and “fundamental” R&Ws that are allocated and negotiated between the parties:
- Fundamental R&Ws: These are considered critical and are often subject to longer survival periods and higher or no caps (as summarized below). Common examples include corporate existence, authority to transact, capitalization, and title to shares. A buyer may propose for other R&Ws that are traditionally viewed as general R&Ws to be elevated to fundamental R&Ws if they are considered to be high-risk areas based on diligence findings or otherwise crucial to the business given the specific industry a seller operates in. For example, if the target company develops and sells software, a buyer may want to propose intellectual property R&Ws to be fundamental R&Ws given the importance of ensuring the target company owns the software it develops and sells.
- General R&Ws: These cover all other aspects of the business, such as financial statements, material contracts, litigation, employment matters, data privacy and security matters, environmental matters, intellectual property, insurance and compliance with laws.
Indemnification Obligation: This is the seller's promise to compensate the buyer for losses arising from breaches of R&Ws, as well as other specified matters outside the scope of this article (e.g., pre-closing taxes, certain litigation).
Survival Period: This defines the timeframe during which the buyer can make an indemnity claim. Fundamental R&Ws typically have longer survival periods (e.g., 5-7 years, applicable statute of limitations or even indefinitely) compared to general R&Ws (e.g., 12-24 months).
Baskets: Refers to a threshold dollar amount of losses arising from breaches of R&Ws that must be met before a buyer can make a claim for indemnification against a seller, typically around 0.5-1% of the purchase price. This limits the seller's initial exposure, ensuring that only claims which exceed a certain financial limit will trigger the seller’s obligation to indemnify the buyer. Think of it like a minimum claim amount.
