Representations and warranties insurance (“RWI”) provides coverage for unanticipated losses arising out of breaches of the seller’s representations and warranties in an acquisition transaction. RWI offers a number of key advantages over traditional risk allocation methods. While RWI was originally developed for use in private equity transactions, RWI is now being used in a variety of transactions, including those involving nonprofit hospital and health system acquisitions of physician practices. This article provides an overview of RWI and key issues to consider when evaluating whether RWI might be a good fit for a particular physician practice acquisition transaction.
Background
In physician practice acquisition transactions that do not include RWI, the parties usually negotiate a number of key terms around risk allocation, including scope of the seller’s representations and warranties, survival of those reps and warranties, scope of the seller’s indemnity obligations, limits on those indemnity obligations (such as baskets and caps) and the use of an escrow account or holdback. The buyer wants more expansive reps, a longer survival period, unlimited indemnity and a larger escrow or holdback amount, while the seller wants narrowly tailored reps, a shorter survival period, limited indemnity and no escrow. These dynamics can lead to difficult negotiations that can add additional time and expense to the deal and can even result in the parties abandoning the deal.
Risk allocation can also impact important relationships between the parties. When a hospital or health system acquires a physician practice, it typically will employ the seller physicians and other practice employees after the closing. An indemnity claim by the buyer against the seller, who is now employed by the buyer, could negatively impact this key relationship and potentially undermine the strategic purpose underlying the transaction. The buyer, therefore, will need to carefully consider whether to pursue the indemnity claim or forego recovery in the interest of preserving the relationship.
RWI can be an effective tool for mitigating the impact of many of these issues and offers advantages to buyers and sellers.
From the buyer’s perspective, RWI provides a predictable source of recovery for unexpected losses arising out of a breach of the seller’s reps and warranties. Coverage is often more fulsome, and available for a longer period post-closing, than the buyer might otherwise be able to negotiate. RWI can also eliminate the need for the buyer to seek indemnity from an employee post-closing.
From the seller’s perspective, RWI can significantly limit, and perhaps eliminate entirely, the seller’s risk exposure for post-closing indemnity claims. The need for an escrow or holdback can also often be eliminated, or at least the escrow amount can often be significantly reduced, thereby allowing the seller to receive more of the purchase price at or shortly following closing.
RWI can help better align the parties’ interests with respect to many key risk allocation provisions that would otherwise need to be negotiated. When the buyer is willing to rely on RWI as the sole, or predominant source, of recovery, the seller is more likely to agree to provide more expansive reps under the purchase agreement to afford the buyer more fulsome coverage. Other risk allocation terms, such as indemnity baskets and caps, also become less important. As a result, the parties can reduce the time spent negotiating materiality qualifiers, lookback periods, baskets, caps and other terms.
While RWI can help reduce the scope of issues to be negotiated, a number of key terms related to the RWI policy will need to be agreed upon by the parties, including: (i) the extent to which the RWI policy will be the sole source of recovery; (ii) whether the seller will be responsible for any portion of the retention or premiums; (iii) the mechanism by which the retention is to be funded (such as through an escrow or holdback); and (iv) any other special indemnities for certain matters excluded from coverage under the policy, such as taxes and payor reimbursement issues.
RWI Key Terms
Key coverage and pricing terms for RWI coverage include:
- Limits and Retention:
- Coverage limits are most often 10% to 20% of the purchase price, but additional coverage may be purchased.
- The retention, or deductible, is usually 1% of the purchase price. The retention is often reduced during the term of the policy.
- Price:
- Premiums have decreased in recent years and are currently in the range of 2-4% of purchased coverage, although market and deal dynamics can affect premiums.
- State taxes are 2-4% of the premium.
- Underwriting fees are commonly between $20,000 to $75,000 but can vary based on the particular deal.
- Based on current market pricing, coverage is not believed to be cost effective for transactions with a purchase price of less than $20 million.
- Coverage Period: Coverage is typically available for a minimum of three to six years after closing for general reps and warranties and six years for fundamental reps and warranties and taxes.
Scope of Coverage and Exclusions
The scope of coverage aligns with the scope of the seller’s reps and warranties in the purchase agreement, subject to buyer’s diligence and certain common exclusions.
Coverage is contingent upon the buyer completing sufficient due diligence to confirm that the seller can stand behind its reps and warranties. During the underwriting process, the underwriter and its advisors will review the diligence materials, including the buyer’s diligence reports, and will interview the buyer and its counsel about the scope of diligence and key issues that have been identified. If the underwriter is not satisfied as to the level of diligence conducted with respect to particular reps, then coverage for those reps may be excluded. It is important that the buyer completes sufficient diligence and produces clear and comprehensive diligence reports in order to obtain fulsome coverage.
Medical malpractice and billing and coding coverage are excluded from most policies. However, certain underwriters might be willing to consider billing and coding coverage if a billing and coding audit is performed.
Practical Takeaways
- RWI offers many advantages for both buyers and sellers in physician practice acquisition transactions.
- RWI can help streamline negotiations, provide a predictable source of recovery for losses arising out of breaches of reps and warranties, limit or eliminate the seller’s indemnity risk exposure, and help preserve the relationship between buyer and seller.
- Based on the current RWI market, coverage generally is not cost effective for smaller transactions where the purchase price is less than $20 million.
- Buyers who are considering RWI should be prepared to conduct comprehensive diligence into all matters covered by the sellers’ reps and warranties and should produce clear and comprehensive diligence reports in order to facilitate the underwriting process and obtain fulsome coverage.
If you have questions or would like additional information about this topic, please contact:
- Bobby Hamill at (919) 447-4970 or rhamill@wp.hallrender.com;
- Joe Kahn at (919) 447-4966 or jkahn@wp.hallrender.com;
- Alec Mercolino at (919) 447-4962 or amercolino@wp.hallrender.com; or
- Your primary Hall Render contact.
Hall Render blog posts and articles are intended for informational purposes only. For ethical reasons, Hall Render attorneys cannot—outside of an attorney-client relationship—answer specific questions that would be legal advice.
