The preparation of a business contract involves discussions that translate into a mere allocation of risks from one party to the other. In theory, the risk will be contractually allocated to the party that can bear it more efficiently (and by efficiency we mean the ability to both avoid materialization of the risk and bear risk in a less costly manner, in addition to the risk appetite of each party). Of course, any allocation of risk results in costs - the buyer, having to bear a greater risk, will propose a lower purchase price than it would if it had to bear less risk.

Legal advisors therefore have the function of adding value to the transactions on which they advise, since the more complex the transaction that is the subject matter of the contract, the more sophisticated the contract structures will be. This is precisely the case with M&A contracts, which use representations and warranties and indemnification structures for the allocation of risk between the parties.

Allocating a risk to the other party is not easy and is not always a simple task based on numbers and probabilities. Thus, such discussions, which are extremely relevant in the context of a business contract, may prove to be true bottlenecks in carrying out a transaction. Thus, a transaction that could be more expeditious ends up taking more time for closing, or closing does not even occur if there are deal breakers at the time of discussions regarding allocation of risks. Therefore, it is recommended that the parties seek alternatives that are better fit to the needs of the transactions, one of which is the purchasing of insurance against transactional risks, such as tax indemnity insurance (not yet available in Brazil), or insurance for representations and warranties (R&W insurance), already widespread and used in the United States and Europe. Although they were launched in the Brazilian market only about four years ago, they have been gaining popularity - searches for R&W insurance grew in the first half of this year. The increase was 35% compared to the prospection index for the year 2017.[1]

R&W insurance is a specialized product that provides to the buyer coverage exclusively for financial loss arising from noncompliance with the content of the representations and warranties provided by the seller, including those relating to tax contingencies, if applicable, and covered by the policy in the context of an M&A.

R&W insurance coverage does not, however, cover any breach of a representation or warranty, but only that which is related to a hidden liability, that is, that which is not known or expected by the seller and buyer. For example, risks known to the buyer, and those risks that are unknown because the matter in question was excluded from due diligence, are not insured. In addition, R&W insurance currently available in Brazil has a mandatory deductible, which is excluded from the insurance coverage or any losses related to the breach of representations and warranties in amounts equal to or less than a de minimis amount and the aggregate deductible (ranging from 1 to 3% of the value of the transaction) as provided in the policy.

Under R&W insurance, the buyer is compensated for amounts it is entitled to claim against the seller, as well as the costs of defending itself up to the maximum guarantee coverage limit of the policy purchased.

The policies are tailor made for the M&A in question based on an assessment of the typical risks of the activities carried out by the target company, the results of the due diligence, the financial statements of the target company, and, as the name already indicates, the representations and warranties provided in the M&A contract.

Thus, R&W insurance represents additional security for investors, particularly in M&A contracts in which the buyer does not have the desired level of indemnification for the post-closing period and/or the desired time frame, or the seller does not have the financial capacity to withstand any hidden liabilities. A potential buyer can even differentiate itself in competitive sales processes by submitting an acquisition proposal that includes the purchase of a R&W insurance. As a practical effect, this can be an advantage for all parties involved in an M&A by helping to reduce (or even eliminate) the use of an escrow account for any payment of indemnification.

As mentioned above, R&W insurance is intended solely to provide a guarantee of insurance indemnification to the buyer in the event of a loss resulting from breach of the representations and warranties provided by the seller in the context of an M&A transaction, but does not eliminate the risks altogether. It is not, therefore, a carte blanche that exonerates the parties from paying due attention to the representations and warranties section or to the due diligence process itself. This applies especially to the seller, against whom the insurer will have a right of recourse, especially in the event of fraud or bad faith in the provision of the representations and warranties.

[1] Seguro Total Magazine. “Search for insurance for risks related to mergers and acquisitions grows." São Paulo: PubliSeg. No. 191, 2018.