Introduction
In mergers and acquisitions, the seller and buyer enter into transaction-specific agreements, such as share purchase agreements or asset purchase agreements, tailored to the target company, shares, assets, business, or transaction. In these agreements, the parties make certain representations and warranties regarding the company, assets, business, or transaction they have designated as the target. Before proceeding to the contractual stage concerning the target company or asset, the buyer conducts legal, financial, environmental, tax, and/or similar due diligence on the relevant company or asset. Based on the findings of this due diligence, the buyer decides whether to proceed with the acquisition of the target company, shares in the company, or assets, and determines the purchase price accordingly.
The buyer, based on its due diligence findings, requests the seller to provide certain representations and warranties regarding the target company, transaction, shares, or assets. Similarly, the seller may also request the buyer to make representations and warranties specific to the transaction. Representations and warranties are among the most critical contractual provisions in merger and acquisition agreements. In practice, these representations and warranties can generally be categorized into two groups: (i) fundamental representations and warranties and (ii) operational or business representations and warranties. Fundamental representations and warranties cover essential elements of the sale transaction. For example, in a share purchase agreement, they may include assurances that the shares are free from any encumbrances and that the seller has the authority to execute the agreement. Operational representations and warranties, on the other hand, relate to matters such as the company's contracts, permits, and licenses. The primary reason for this distinction is to define the extent of liability in case of a breach of the representations and warranties.
The parties may determine the liability cap for breaches of representations and warranties in proportion to the purchase price. However, the specific ratio or scope of liability may vary depending on the nature of each transaction or case. One of the most critical aspects of mergers and acquisitions is the extent of the parties' liability and how it is defined. After the execution of the agreement, if the buyer identifies a breach of the representations and warranties, it is essential to have predetermined conditions regarding when, how, within what timeframe, and to what extent the liability will apply. Consequently, the buyer seeks to hold the seller liable for the broadest scope, with a high liability cap and for an extended period, whereas the seller aims for the exact opposite.
One of the solutions that helps mitigate this issue in practice is representation and warranty insurance (R&W insurance). R&W insurance serves as an alternative indemnification mechanism by providing insurance coverage for financial losses arising from breaches of representation and warranties undertaken by either party in merger and acquisition agreements, share transfers, or asset transfer processes. By offering an alternative security mechanism to the indemnification provisions set forth in the agreement, R&W insurance aims to eliminate potential difficulties in enforcing indemnification obligations. This type of insurance transfers the financial liability arising from false or breached representation and warranties to the insurer, thereby protecting the insured party (either the seller or the buyer) from potential financial exposure.
R&W insurance provides significant financial security to facilitate the successful closing of mergers and acquisitions. As a result, it is gaining greater recognition and becoming increasingly common in international M&A transactions.
What are the Types of R&W Insurance?
R&W insurance can be categorized into buyer-side and seller-side policies. In buyer-side representations and warranties insurance, if the buyer identifies a breach of the representations and warranties provided by the seller in the merger and acquisition agreement, buyer can directly file a claim with the insurance company instead of pursuing indemnification provisions under the agreement. In such a case, the insurance company conducts the necessary investigations to determine whether the loss incurred falls within the scope of coverage specified in the policy. If the loss is covered, the insurer compensates the buyer accordingly.
In seller-side representations and warranties insurance, if a breach of the representations and warranties provided in the transaction-specific agreement results in a loss for the buyer, and the seller is required to compensate the buyer for this loss, the seller may claim reimbursement from the insurance company under the coverage provided by the policy. However, it is important to note that in practice, buyer-side representations and warranties insurance is more commonly encountered than seller-side policies.
What are the Benefits of R&W Insurance?
- The buyer creates a financially secure environment by minimising its losses against the risk of any damage due to the fact that the representations and warranties provided by the seller do not reflect the truth.
- The seller minimises the risks that the seller may face in the future regarding the claims from the buyer and therefore, with the signing of the agreement, the seller exits the company smoothly by eliminating the potential claims that may be involved in the future. This benefit of the underwriting and indemnity insurance is especially attractive for private equity funds (private equity).
- If the buyer is in the process of a merger and acquisition in an unfamiliar sector and although the buyer has conducted a due diligence process, the buyer manages the risk by leaving the insufficiency of its knowledge of the sector to the responsibility of the insurance company.
- The buyer and seller can resolve issues without resorting to a dispute resolution process, saving time and avoiding delays. This is particularly important in cases where the seller has not transferred 100% of the shares and continues to have an ownership stake in the target company, as it helps to preserve their business relationship. In situations where a foreign law is chosen to govern the agreement and foreign courts are given jurisdiction, the dispute resolution process will likely be lengthy, and the decision will need to be recognized, enforced, and executed in the country where it will be applied. Such scenarios can lead to operational, managerial, and financial problems within the company. By utilizing R&W insurance, this entire process can be avoided.
- While the seller may prefer to keep the liability period short in the transaction-specific agreement, with R&W insurance, the insurance policy can have a longer duration, providing more comprehensive protection.
- The negotiation process between the parties during the agreement stage will be expedited, as they will not need to waste time discussing the limits of liability or the duration of liability. This allows them to focus on other important aspects of the agreement.
- Other mechanisms that could serve as assurances for breaches of representations and warranties will be eliminated. Instead of holding the purchase price in an escrow account, the seller can immediately access and use the purchase price.
How is R&W Insurance Regulated Under Turkish Insurance Law?
In Türkiye, matters related to insurance law are regulated under the Insurance Law numbered 5684 ("Law") and the Regulation on Insurance Branches ("Regulation"). Only insurance companies established in Türkiye and foreign insurance companies with branches in Türkiye are permitted to conduct insurance activities within the country. These companies and branches shall obtain an activity license in the branches specified in the Regulation to engage in insurance activities.
The Regulation does not contain specific provisions regarding R&W insurance, and as a result, insurance companies do not issue policies specifically under the name "representations and warranties insurance." However, in practice, this type of insurance is generally referred to as "liability insurance" or "financial loss insurance." Consequently, there is currently no legal framework under Turkish legislation specifically covering representations and warranties insurance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
