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Legal Diligence Reports and R&W Insurance

I’m helping a first-time client place Representations and Warranty (R&W) insurance, and it’s taking a bit of hand-holding on this first go-around as we get quotes from insurers and review other elements of the process.

We should all keep in mind that the primary thing Underwriters want to see is thorough due diligence. Otherwise, they are going to be a lot of exclusions in the policy.

To be clear, Underwriters are reluctant to exclude—nobody wants to have a reputation for placing a lot of exclusions on R&W policies. But, it happens, and you need to be prepared.

Information for Insurance Underwriters

Unfortunately, Underwriters feel they have no choice if they don’t have enough information.

This can be an issue in smaller deals, where the Buyer and Seller might not have the capacity or resources to complete thorough due diligence. Thankfully, my current client is a believer in being prepared and has already taken steps to make the Underwriters happy.

The client is putting a legal diligence report together to, hopefully, give the Underwriters all the answers they need—before they have to ask any questions. Essentially, Underwriters want to know who’s looking over the reps, what are their credentials, and then what, if anything, did they uncover? I’m hoping this will make the underwriting process smoother for everyone.

Build a Legal Diligence Report

I’d recommend putting together a legal diligence report for your next deal. But what does it entail? What should be in this report?

Here are my recommendations for what to include based on my interactions with Underwriters who craft R&W policies. The report should show that:

1. The Seller does indeed own the target company.

2. The attorneys conducting the diligence vetted that the company is properly licensed, permitted, and is operating legally—and that there is no pending litigation out there.

3. The target company has solid human resource policies/procedures and any independent contractors are documented and treated appropriately.

4. The target company owns its intellectual property. Nobody else has a claim on it.

5. That there are sufficient cybersecurity protections and protocols in place to protect their IT systems and databases.

6. With material contracts, how are the top clients and vendors treated and viewed?

7. The target company is in compliance with local laws.

8. The target company is in compliance with “operation-specific” laws or regulations, such as environmental statutes. This can be especially important when a transaction involves real estate. (Discovering hazardous contamination at a site can involve an expensive cleanup.)

This is where insurers and underwriters want to see the attorneys conducting due diligence, focusing on red flags in the target company. And, if red flags are found, the Underwriters want to see what was done about them.

R&W Insurance Exclusions

With this information, Underwriters can feel confident in not excluding at least some of these elements from the R&W insurance policy.

For example, when it comes to permits, Underwriters would rather “laser out” some problematic permits rather than exclude coverage for all permits.

On a basic level, the objective for the Underwriters is to eliminate the knowns and just deal with the unknowns.

When it comes to R&W insurance, the biggest exposures out there are breaches of financial reps, followed by breaches of material contracts and legal representations, and finally, HR-related employment practices.

Naturally, a mature insurance market is looking to limit those big red flags where they can, but this is a good place to start. If you can deal with these issues, you’ve knocked many of the most problematic items.

If these red flags are identified prior to closing, the parties have a way to remedy the issue that spirals out of control. A Buyer can go to the Seller with something found during the diligence process, which often catches the Seller by surprise, and ask what they are willing to do about it (setting aside money to deal with the issue, for example.)

The Buyer doesn’t want to be left holding the bag after the deal is closed—the Seller should deal with these issues first, but it’s important to know the details, which is where the diligence report comes in.

Strengthen Deals With Due Diligence

In any case, the objective is to identify and deal with issues before closing.

Really, if you think about it, a thorough diligence process actually strengthens a lot of deals. It enhances communication and trust between the two parties. Many attorneys actually think of Underwriters as “proofreading” their due diligence, and it can be quite an amicable and friendly process. Plus, I’ve heard attorneys admit that Underwriters have found things they missed.

So it’s clear there is no reason to think of Underwriting an adversarial process. And in M&A transactions, providing Underwriters with the information they need, as early in the process as possible, always helps.

Contact Rubicon Insurance for More Information on Due Diligence

It’s essential to note, Underwriters are looking for exposures beyond legal diligence. This page is intended to address only the legal diligence. Other key areas of due diligence—financial and tax—will be covered in the future.

I’m happy to share my experience with legal diligence reports and other ways to smooth out the Underwriting process. Please contact me, Patrick Stroth, for more information on R&W and other M&A insurance options below.
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