Drafting and Choice of Law Issues When Insuring Against Breaches of Representations and Warranties in an Acquisition
Representations and Warranties Insurance
Insurance against breaches of representations and warranties in mergers and acquisitions is an increasingly important market for buyers and sellers of privately held companies. The buyer obtains greater protection, with the backing of a highly rated insurer, should a representation or warranty prove untrue (and costly). A seller can negotiate protection for itself should it face a claim after closing.
Whether purchased by the buyer or seller, insurance of M&A breaches and warranties necessarily requires two contracts: the underlying acquisition agreement and the policy of insurance. The former defines the representations and warranties made by the seller to the buyer, and limitations on seeking redress for breaches, either in amount of recovery, time to bring suit, or otherwise. The insurance contract defines the obligations of the carrier to pay covered claims for such breaches. The contracts will be read in tandem: coverage depends on liability under the acquisition agreement and on adherence to the insured’s obligations under the insurance policy that dictates if, and how much, the insurer pays.
Both contracts will be interpreted under state law. As part of the insurer’s due diligence, it makes good commercial sense to understand the advantages and disadvantages of choosing one state’s law over another. These decisions may mean the difference between paying and not paying on a claim, and can be as vital as the substance of the representations and warranties themselves and the substantive due diligence on those promises. The choice of law provisions in the two contracts can point to the same state or different states, which can complicate matters, especially if a contested issue involves the incorporation of the provisions of one contract into another.
Choice of Law Ramifications
Ratajczak v. Beazley Solutions Limited, 870 F. 3d 650 (7th Cir. 2017), is a rare case that involves insurance of M&A representations and warranties, insofar as issues litigated in this arena are often confined to arbitration. The insured seller settled a threatened claim by the buyer of breach of representations. The insured seller made the cardinal error of settling without obtaining the carrier’s consent. The insured seller also did not notify the carrier until its settlement negotiations with the buyer were almost complete. Indeed, the notice was sent to the insurer after the close of business on Christmas Eve, allowing only two business days before the settlement between buyer and seller regarding the breach of representations claim closed. The insurer immediately asked for information so that it could evaluate its obligations under the policy. No reply was forthcoming before the insured closed on the settlement.
From the discussion of the alleged wrongs by the seller involving the adulteration of a product used in making food for calves and other young animals, the substantive claims against the seller were judged under Wisconsin law. But the insurance contract adopted New York law to govern insurance coverage. That mattered.
The insurance policy provided that the insurance carrier was not bound by settlements that it did not approve. The insured seller argued that Wisconsin law adds a prejudice requirement, even if the policy does not. The insured seller argued that Wisconsin law forbids clauses that give insurers authority to reject settlements if they have received notice of negotiations.
The appellate court did not have to evaluate whether there was effective notice under the circumstances of the Christmas Eve notice and rush to signature. The court reasoned that the insurer had every right to have New York law applied since it is based in the United Kingdom and its adjuster for U.S. claims is in New York. “It is understandable that [the insurer] prefers to designate one state’s law for all its business in this nation; it can become familiar with New York law more easily than it can master (and price) the intricacies of many states’ insurance laws.” The insureds “cannot escape the choice-of-law clause in this policy. New York permits insurers to insist on having control of settlements.” The insurer was deprived of settlement control. Insurer wins: no coverage.
Choice of law can hold similar significance in the acquisition agreement. An example is how a state interprets “survival” provisions for representations and warranties – the limitation on how long the buyer has to make claims for breaches of the representations and warranties after closing. Does the end of the survival period also act as a terminal point for filing suit, or does it just act as the end of the time when breach can be measured? In the former case, a filing after the survival date is dismissible; in the latter case, not (unless the suit is filed after the applicable state statute of limitations has passed). When the seller is the insured, a survival cut-off that acts as a suit-filing limitations period would have the effect of reducing the insurer’s risk. If the insured is the buyer, the time for filing a claim probably would default to the insurance contract.
Again, what it takes to turn a survival clause into a limitations cut-off depends on the state. California is tough. In Western Filter Corp. v. Argan, Inc., 540 F.3d 947 (9th Cir. 2008), a panel of the Ninth Circuit issued a unanimous decision reversing a grant of summary judgment by the trial court that was grounded on the one-year survival clause for representations and warranties in a stock purchase agreement operating as a one year limitation on filing suit. The appellate court gave a description of the function of representations and warranties and of the fundamental purpose of a survival clause: “The closing date itself triggers the contractual limitation on liability. Unless the parties agree to a survival clause—extending the representations and warranties past the closing date—the breaching party cannot be sued for damages post-closing for their later discovered breach.”
The court suggests that if it had its druthers, it would accede to the position that a naked survival clause acts as a contractual statute of limitations, discussing cases from the First and Seventh Circuits. But, alas, it is constrained by California law that obliges parties who choose to limit a statute of limitations be “clear and explicit” in the language employed. Moreover, the provision “is to be strictly construed against the party invoking the provision.” So, too, New York: a provision that states that representations and warranties survive for a stated period of time does not act as a time bar for filing an action in derogation of the applicable statute of limitations. The Ninth Circuit panel concluded: “[T][he one-year limitation [of survival] serves only to specify when a breach of the representations and warranties may occur, but not when action must be filed.”
Contrast Western Filter Corp. with Delaware Chancellor Strine’s unpublished opinion in GRT, Inc. v. Marathon GTF Technology, LTD., 2011 WL 2682898 (Del. Ch. July 11, 2011). The Chancellor employed core contract interpretation principles in analyzing the meaning of the one-year survival clause as it applied to the representations at issue. First, the survival clause used the term “terminate” to describe what happens to the representations after one year from closing. The contract also terminated (there is that word again) the sole and exclusive remedy for breach of the representations, simultaneously with the expiration of the representations. Finally, the Chancellor entered into a close reading of all the survival terms of each of the representations and warranties in the purchase agreement, not just the ones at issue: gaining meaning from understanding “the Survival Clause in full contractual context.”
What the Chancellor found was “[t]hat the parties to the Purchase Agreement designated three specific buckets of representations and warranties, each of which provides for a different survival period and one of which couches the survival period in terms of the ‘applicable statutes of limitations,’ confirms that the only reasonable way to read the Survival Clause is that it cabined the period of time in which” the party could file for a breach of the representations at issue to one year. Don’t try that in California.
Insurers are extraordinarily careful in setting out in policies the time limitations applicable for filing claims and when the event must have occurred to be covered. Those provisions are equally important in the acquisition agreement, and the dealmakers may craft a simple survival clause believing that it answers all questions. It doesn’t, and the risks being assumed by the insurer may well depend upon what that survival clause means.
First, know what you want and what the parties mean to agree to. Then, make sure the language explicitly sets forth that agreement. Finally, understand the degree of specificity that may be required by the state identified by the choice of law provision. Then, after evaluating the substantive risks and running down all the factors, you may be ready to accept the premium and issue the policy, hoping for a quiet and uneventful claims period.