The risk allocation landscape

Historically, escrows have served as a classic deal protection mechanism in mergers and acquisition (M&A) transactions. However, representations and warranties (R&W) insurance has emerged as an escrow alternative, offering seller-friendly terms and competitive premiums. Is there room for two products on the market? Is one better than the other? Bottom line, it all depends. We explore some areas to consider when evaluating the optimal deal protection mechanism for your transaction.

Escrows: A primer

Holdback escrows are generally used by buyers to segregate a portion of the purchase price for various reasons, with the most common reasons being:

• Provide a means for the buyer to claim back a portion of the purchase price for breaches of R&W from the seller.
• Secure post-close purchase price adjustments until finalization of such amounts.

Escrows can also be used for other M&A purposes:

• Good faith deposit: Can demonstrate serious interest and/or comply with regulations (e.g., if government approval is needed); can also be used to hold potential termination fees.
• Closing agent/paying agent: Can centralize funding sources and enable funds to be on hand prior to close; can also facilitate exchange of company stock from seller for payment of cash from buyer.

R&W insurance

While there are seller and buyer R&W policies, the latter is more common. Under a buy-side R&W policy, the buyer in an M&A transaction recovers directly from an insurer for losses arising from certain breaches of the seller’s R&W in the purchase agreement. By shifting the risk of such losses from the seller to an insurer, a policy can limit the seller’s liability for certain rep breaches. The buyer retains the risk of receiving payment from the insurer for any claims submitted.

^{*Escrow agent not involved in the claim resolution}

Claim coverage

For both escrows and R&W policies, claim coverage is particularly important for a buyer seeking to mitigate risk in its acquisition. In general, an escrow can provide a clear solution to resolve risks between the parties and may be customized to facilitate a comprehensive coverage model. Conversely, many R&W policies cover only specific, targeted areas.

Currently, in a typical R&W policy, known issues may be excluded, whether or not reported to the insurer or included in a due diligence memo. In addition, in many instances R&W policies will not cover breaches of covenants, forward-looking statements or purchase price adjustments. Depending on the specific policy, common indemnity claim types such as tax, litigation/product liability, collectability of accounts receivable, pension underfunding issues and environmental liabilities may require separate policies or increased premiums.

Claim payouts

Traditionally, claim payouts are not influenced by the escrow agent as it serves as a neutral third party, acting generally on joint instructions to release funds. Existing R&W insurance studies provide limited visibility on claim payouts and timing. This calls into question whether or not certain R&W providers will face increased pressure to pay on claims and potentially to increase premium fees to ensure claim payouts.

Costs

R&W premiums vary based on the level of coverage but are generally a certain percentage of required coverage. On the other hand, escrow fees are nominal, and larger escrow deposits generally do not result in higher fees. Escrow will likely continue to be a less expensive risk mitigation tool regardless of whether claims increase over time.

Due diligence

When circumstances change, escrow does not require a separate due diligence workstream like R&W insurance does, and it will typically be quicker and simpler to execute a new escrow agreement versus an R&W policy. As a result, escrow can provide much-needed flexibility when quick turnaround is needed or to resolve last-minute negotiation issues that come up between the buyer and seller.

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