Insights

Material Contracts and Representations and Warranty Insurance
POSTED 2.15.22 M&A

As Representations and Warranty insurance matures as a product and comes into wider use, Underwriters are taking lessons learned from past claims to equip future policyholders on ways to either identify pre-closing trouble-spots, or to mitigate their impact post-closing. They’re looking for patterns or “danger areas” where breaches are more likely to occur.

Many such breaches result in losses far exceeding the R&W policy limit. So, it’s essential that Buyers take action so that they can catch any issues before a deal closes. That way they can address the issue with the Seller. (Read to the end of this article for key questions to ask in this regard during the due diligence process.)

The cynical view is that insurance companies are taking such an interest in order to exclude parts of the deal from the policies they provide so they don’t have to pay claims.

But I see it as an attempt to protect Buyers and give them the chance to go to the Seller for a remedy. That could be a lower price or having the Seller address the issue. This way the risk is transferred away and does not have an impact on the R&W policy for the deal.

All industry types are impacted by material contract breaches. But the biggest “hot spots” are manufacturing, tech, and government contractors.

Trouble Areas to Look Out For

Currently, material contracts are now the third leading cause of R&W claims overall worldwide, preceded by financial misstatements and violation of laws, and tied with tax issues. Material contracts represent 14% of reported incidents, as reported in AIG’s M&A Insurance Comes of Age report.

If a Buyer acquires a target company with bad contracts and it is not disclosed, the Buyer is left holding the bag. And that bag can be quite big. Damages in material contract claims can be sizeable.

Think a $20M material contract claim with a $10M R&W policy.

There are four leading types of material contract breaches.

1.  Issues around profitability of a contract (e.g. improper accounting for expenses).

2.  Target in breach of a material contract.

3.  Change in a customer relationship (e.g. termination or curtailing of purchasing levels). This could involve contracts with key customers where a customer is allowed to go to another provider for lower costs, leaving the new owner without revenue they expected. This is a major issue.

4.  Failure to disclose existence of a material contract or material term (e.g. undisclosed discounts)

Due Diligence Questions You Can Use

The below are questions regarding material contracts taken from actual due diligence calls with Underwriters. I would recommend you make this a standard part of due diligence in your deals.

1.  Discuss the scope of your diligence of Company contracts. Was this reviewed in house by the Buyer? What diligence was memorialized in writing, if any? Have you reviewed all material customer and vendor contracts? Confirm you’ve reviewed all form agreements and material deviations therefrom.

2.  Please confirm no issues were identified in the top 15 customer and service provider contracts.

3.  Please confirm that you did not identify any material vendor or supplier that cannot be readily replaced.

4.  Discuss any notable provisions (e.g. change in control, anti-assignment, most-favored nation, termination, preferential pricing, restrictive covenants, atypical indemnity, powers of attorney). How does Company ensure compliance?

5.  Describe the indemnification provisions in the material contracts. Have there been any breaches (actual or alleged) of any contract? Any other material disputes or declines in business under any contract? Are you aware of any other planned terminations or other issues with respect to the Company’s material relationships?

6.  Did you or any advisor conduct customer calls/surveys? If so, describe the results.

7.  Confirm Company is not a party to any government contract. If so, describe.

8.  Have any customers provided any notice of intent to terminate? Are there any concerns related to this?

9.  Any other concerns related to material contracts?

Material contract breaches can be a serious issue for any M&A Buyer. But armed with knowledge, it’s a problem easily avoided before a deal closes.

I’m happy to discuss this issue with you further. You can contact me

You can contact me Patrick Stroth, at pstroth@rubiconins.com.