REPS & WARRANTIES INSURANCE AND POTENTIAL COVID-19 EXCLUSIONS
We wanted to share with the search fund community how reps & warranties insurers have been adding coverage exclusions relating to the COVID-19 virus to their non-binding indication letters when evaluating new deals.
Without this exclusion, a reps & warranties insurance policy theoretically could cover losses relating to COVID-19. For example, representations made about suppliers, customers, recent financial performance, inventory, accounts receivable, pending litigation, contractual obligations and the existence of a “Material Adverse Effect” (assuming that COVID-19 is not excluded from that definition) theoretically could be inaccurate if they don’t reflect the impact of COVID-19 on the business at the time of the acquisition.
There are a number of different variations of the COVID-19 virus exclusion, including:
- Loss “arising out of the COVID-19 virus”
- Loss “that represents the portion of Loss that is increased by the COVID-19 virus”
- Loss “arising out of supply chain interruption due to the COVID-19 virus”
- Loss “arising out of loss of key personnel due to the COVID-19 virus”
The first exclusion is, in our view, unacceptably overbroad. An aggressive insurer could apply the first exclusion to exclude coverage for almost any Loss that relates to the COVID-19 virus. For example, if the target’s historical financials don’t reflect a decrease in sales in a period prior to signing and that decrease in sales was partially caused by the COVID-19 virus, an aggressive insurer might try to deny coverage based on the COVID-19 virus exclusion.
The second exclusion is narrower than the first. In essence, the R&W insurer is attempting to avoid paying disproportionately large losses when the losses in question are exacerbated by the COVID-19 virus. As an example, if there is a breach related to the condition of the target’s manufacturing equipment, but the COVID-19 virus impacts the buyer’s ability to obtain replacement equipment, the second exclusion would protect the insurer from bearing the portion of loss caused by the inability to obtain replacement equipment. Nevertheless, in many situations, the second exclusion has the potential to introduce significant uncertainty into the determination of damages under the RWI policy, particularly where it is difficult to reliably measure the impact of the COVID-19 virus on the target company. If insurers are successful in inserting this type of exclusion, it may complicate the claims process with factual disputes about the extent to which the COVID-19 virus has increased the buyer’s damages.
The third and fourth exclusions are examples of more palatable and targeted exclusions that address a particular concern surrounding tangible and identified exposures.
Separately, there are open questions for R&W insurance policies placed on deals that have signed, but not yet closed. If the COVID-19 virus impacts the target business during the interim period, under what circumstances will coverage be available? Please note that the impact of COVID-19 virus on R&W insurance is evolving in real time.