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OP I N IO N BY CHERYL SATIN BANKING ON CORPORATE R&W insurance becoming more appealing R epresentation and war- ranty (R&W) insurance is offered as a means of supplementing or replac- ing traditional security arrangements in connection with the acquisition of, or investment in, a busi- ness. In a typical purchase-and-sale transaction, the buyer requires the seller to affirm various facts about the existence and operations of the target company, or the assets acquired. These affirma- tions take the form of representations and warranties in the purchase agree- ment. As security for its ability to collect from the seller for any losses incurred as a result of inaccuracies in these affirma- tions, the buyer may request a holdback of a portion of the purchase price, or that a portion of the price be placed in escrow. Alternatively, if the parties cannot agree on adequate security, the purchase price may be reduced. R&W insurance provides another alternative to buyers and sellers. It may be purchased by either a buyer or a seller, and insures the policyholder against the financial loss arising from inaccuracies in the representations and warranties. At the same time, it reduces the seller's expo- sure to potential liabilities post-closing, and frees up additional sale proceeds for reinvestment or distribution by the seller. The same holds true for an issuer under- taking a round of equity financing. In that scenario, it also gives the investor another avenue for recovery, rather than seeking a remedy from the company in which it is invested, or any founding or management shareholders who are actively engaged in running the business. R&W insurance is not a new product. It first became available in the United Kingdom and the United States in the 1970s. As it gained popularity, a few Canadian insurers started offering the product in the early 2000s, with awareness of the product only starting to take hold shortly before the credit crisis hit. Once the global financial crisis began, the level of M&A and investment activity decreased significantly due to tighter credit markets, less tolerance for risk, and decreased pric- ing and valuations. This resulted in fewer opportunities to use, or consider the value of using, this product. However, as we climb out of the reces- sion and M&A activity intensifies, we should not lose sight of R&W insurance as a valuable tool. For instance, its avail- ability in the global insurance market has increased, with the first policy issued in China in 2010. As more investors are look- ing to emerging markets (including China) for investment opportunities, R&W insur- ance may provide added comfort to those deciding to invest in foreign jurisdictions in which they have little to no experience, or that differ fundamentally from those juris- dictions in which they commonly operate. In addition, for a variety of reasons, we can expect a significant increase in pen- sion fund and private equity investment activity as the economy improves. Many pension funds and private equity groups in North America and the U.K. have large amounts of cash available for invest- ment since they delayed making invest- ment decisions during the last few years. In particular, those private equity funds nearing the end of their investment term are under significant pressure to identify and add to their portfolio of investments. Similarly, for those private equity funds nearing the end of their life cycle, we can expect a larger volume of secondary mar- ket activity, with existing portfolio invest- ments being traded among private equity firms. This secondary market activity will represent a relatively new type of M&A for Canada. Given that pension fund, private equity, and venture capital investors are generally reluctant to assume significant risk based on information provided by the founders or management team of a business; frequently require sale pro- ceeds quickly to fund other investments or make distributions to their investors; and wish to maximize their return on investment, traditional security arrange- ments for representations and warranties are often unattractive. R&W insurance enables these sellers to cap their potential exposure at a lower threshold and provide a faster return of capital to their investors at a more attractive rate of return, thereby greatly assisting with future fundraising efforts. As premiums under R&W insur- ance take the form of an upfront, one- time payment, the liability is quantifiable and the price of the insurance becomes part of the transaction costs offset against the sale proceeds. Historically, R&W insurance was expensive, inflexible, and had many limi- tations and exclusions. With more insur- ers offering R&W insurance globally, pre- mium rates are going down and the qual- ity and diversity of policies is growing. While the volume of claims made under R&W policies during the recent financial crisis may make the downward trend in premiums unsustainable, the continued growth in competition globally should keep rates from creeping up too much. With greater affordability and flexibility, the use of R&W insurance as a means of addressing risk allocation in transac- tions may have broader appeal, especially in a marketplace with increasingly risk- adverse participants. While use of this product is still not widespread in Canada, it is too early to rule it out as becoming a means of enhancing deal value in appro- priate transactions in the future. Cheryl Satin is a partner at Blake Cassels & Graydon LLP in Toronto practising in the business group. She can be reached at cheryl.satin@blakes.com. www.CANADIAN Lawyermag.com M A RCH 2011 15