Alethea Au of Stikeman Elliott LLP on Representation & Warranty Insurance and its use in M&A

Tim: [00:00:13] Hello and welcome to Lexpert TV. I'm Tim Wilbur, the managing editor of Lexpert magazine. Joining me is Alethea Au, a partner in the mergers and acquisitions group with Stikeman Elliott in Toronto. Alethea will be speaking to us about representation and warranty insurance and its use as a transactional risk management tool. Welcome, Alethea.

Alethea: [00:00:39] Thanks, Tim. I'm happy to be here.

Tim: [00:00:41] My first question is, can you give me a synopsis of the current M&A market? 

Alethea: [00:00:46] I am happy to do that. I think the current M&A market is the year started out very much like the previous year. There's been lots of activity, still very active, cross-border and domestically. I think we have gone past the COVID and pandemic sort of uncertainty over the last two years, which really were did not detract from M&A activity at all. I think the current scenario in Ukraine is, is something that everybody is trying to assess. But it seems like, at least in the immediate effect, it does not seem to have had on an overall level much impact on the M&A side. I think growth investment continues to be very active too. So we're seeing cross border wise a lot of activity in that space. Even if it is not an outright acquisition, there's certainly a lot of interest in Canadian tech companies.

Tim: [00:01:47] Can you tell me why representation and warranty insurance is an increasingly important tool for managing transactional risk?

Alethea: [00:01:54] Yeah, it's been rep and warranty insurance has been around for a while, but I think in the last really in Canada, especially in the last four or five years, it's really picked up and there are a few reasons for that. One of which is just the maturity of the market. It's become that the insurers are more sophisticated as to what the insured is looking for. Another piece is price. The price of the insurance has dropped from when it was first introduced quite a few years ago. I think that the the the flip side of that is because there's been so much demand on it, the pricing for that has actually increased over the last 12 to 18 months. But in terms of their utility to M&A transactions. It speeds up the transactions significantly. There used to be a lot of time spent negotiating the rep and warranty package between buyer and seller in terms of the allocation of risk. Being able to introduce and ensure into the process has allowed buyers and sellers to get to the closing and the end point a lot faster. There's a lot more familiarity now with products. So I think both buyers and sellers are used to, to, to having this product kind of backstop some of that risk. So it helps in the negotiations between them on the risk allocation. It's also been helpful that insurers have generally, I think, been. Quite responsive to claims made, which of course is a big part of actually having the insurance because nobody's going to buy it if the claims aren't going to be paid out. So that's been helpful as well to to sort of the the integral nature of this product for these transactions. And one last thing is that because a lot of our clients and buyers and sellers are private equity funds, the ability for them to disburse these funds to their limited partners and their investors is important. And this product allows them to do it much quicker because they no longer have any escrow period they need to worry about.

Tim: [00:04:09] Thank you. And what are the most significant trends you're seeing for this kind of insurance?

Alethea: [00:04:15] I think in terms of trends for the insurance, there's, like I mentioned before, a lot of sophistication when we first they've been able to tailor the product to the M&A market quite a bit. And we've seen this especially during the pandemic, they were able to respond to the risks that were posed to to the to the the product itself in terms of what they were able to insure with the COVID risk. So we used to see the insurers used to provide these broad exclusions from COVID related risks. And we've seen a lot of tailoring and a lot of their responsiveness from it. They also much more sophisticated, especially for tech companies and looking at the key areas of risks. So things like for tech companies, which is most of my my, my space that the work, the space that I work in cyber and privacy is very important. Tax is another area and then sometimes export compliance and sanctions compliance is also another important area for these companies.

Tim: [00:05:22] Great. So you identified some of the key risk areas for due diligence. Can you elaborate a bit on those?

Alethea: [00:05:28] For tech companies, I think because it's so software related and so a lot of information sort of related and dense type of businesses. Cyber and privacy are key and these breaches tend to have a lot of bad publicity associated with it. And we are also aware that the attacks and hacks are increasingly sophisticated. So for a buyer, the it's really important to know the scope of this risk and it could depend on on the target. If the target doesn't actually have much personal information, then, you know, the risk resulting from a breach from a privacy perspective is probably relatively low if and this happens for a lot of software SAS companies where they're really just providing a platform, they don't own the information, they don't store the information, they don't handle the information. So that helps. And the insurers are sophisticated to enough to kind of assess that risk accordingly. The other piece is like nowadays they really expect a lot of companies to have cyber insurance and their coverage on the and warranty side is usually no broader than and only an excess of the existing cyber insurance. So that gives the insurers a bit of comfort as well. Another area is tax. So for a lot of software companies, they use a lot of contractors and there's also a very international workforce.

Alethea: [00:06:56] People typically can work anywhere, especially with what COVID has, has, has, has, of how that has affected the way we work. So there are sometimes tax risks associated with it. So if you misclassify a a contractor, so instead they really are an employee, then you may be liable for certain withholding taxes depending on the jurisdictions you operate. There could be specific tax implications. Insurers tend to shy away from jurisdictions where they think there's a bit of risk and where there hasn't been a lot of due diligence. And the last one is a little bit unique, and it's it's come up a couple of times, but mostly in the context of software companies that I've dealt with. And this is in the area of sanctions compliance and export compliance. So if your software has encryption involved, you need to be aware of certain compliance obligations. And then for a lot of software companies, they are kind of startup and they grow very, very fast. So when they're looking for capital, they may not always be aware of kind of sanctioned entities or sanctioned countries. And if your capital comes from those countries, there could be kind of ongoing liability arising from it, especially if they remain still an investor in the company.

Tim: [00:08:14] How should lawyers advise their clients considering this kind of insurance for the transactions?

Alethea: [00:08:19] I think the one thing to assess is the likelihood of any exclusions to the policy and the insurance that the insurer is able to provide to the reps and warranties. If you are in a highly regulated industry or if you're involved in certain industries that are, let's say, have a higher risk profile, getting rep and warranty insurance may not be that useful for you because the insurer would typically carve out those kinds of risks because they can not themselves get comfortable with it. So areas like that are like biomedical type areas, pharmaceuticals, cannabis is some insurers shy away from cannabis. Not all, but some do. So those ones, I think, is something that the counsel can discuss with their client, if that's an appropriate route to go to to factor into their risk allocation. And then the other piece is, given the how robust the market has been and how how much M&A activity there is, especially in the last, I'd say, 6 to 12 months, the time to get rep and warranty insurance has increased. The insurers and the brokers themselves have resource constraint issues like they it's hard to it's hard to have the time to place all the policies. And so it may just take more time to get a policy in place. So something to keep in mind as we as as counsel kind of factor in the transaction timeline.

Tim: [00:09:50] What are your predictions for this market in the short and long term?

Alethea: [00:09:54] I think in the short term we'll continue to be very busy. I think the pricing increase in the cost of these policies, which have gone up in a material way, I'd say in the last six months, we probably will continue to see that over the next 3 to 6 months as well. But I think there will be a new equilibrium that will come into play perhaps in the longer term, as what I'm seeing is strategic buyers who have done the diligence, who know the space, who know the industries, who know the kind of customers there are. They are now trending towards self-insurance. So they say before the product was great and it was it was at a lower cost and price point. But now, because of the factors I mentioned, such as a longer time to put a policy in place and the higher cost, some of them are willing to just self-insure and renegotiate the traditional kind of indemnification packages. So I think in the long term, I think we'll see continued sophistication by the insurers, and that comes from additional claims history. They're seeing where they are, where their risk is, and where they're less now willing to step up depending on the nature of the target and the diligence performed. And because of this. The ability of strategic buyers to self insure. I think we'll see a new equilibrium towards a stabilization of the pricing and increased sophistication from the from the insurers.

Tim: [00:11:25] Thank you for joining us today, Alethea, and thank you for watching Lexpert TV.