Introducing Rep & Warranty Insurance to Section 363 Sales
As inflation and interest rates rise, many businesses begin to restructure their balance sheet, which will, in many cases, include selling assets. When a distressed sale is carried out under bankruptcy court supervision, it is called a Section 363 Sale. Since the last down-market cycle when Section 363 Sales were more plentiful, a form of private third-party insurance has emerged in the M&A context to provide post-closing coverage to buyers for seller breaches of representations and warranties. While this is relatively new to the restructuring world, it presents interesting opportunities for savvy buyers and sophisticated sellers.
Section 363 Sales
Debtor businesses often use Section 363 Sales (named after the governing section of the U.S. Bankruptcy Code) to sell sometimes discrete assets and sometimes entire business units or divisions. This presents a unique opportunity for buyers to purchase the assets at a distress-sale price and with the protection of a federal court order that transfers the assets free and clear of liens and protects the buyer from certain liabilities associated with the assets.
Section 363 Sales procedures can vary, but a usual feature is that the final sale follows a short auction process during which buyers typically have a limited period for due diligence and bid using a pre-negotiated sale contract with no due diligence out. While the sale contract may have already been negotiated with a lead bidder (called a “stalking horse”), which would have had more time for due diligence, representations and warranties are generally very limited. Moreover, recourse for breaches of representations and warranties are likewise limited, given the insolvent nature of the seller and the interest of its creditors1. As a result, buyers need to be comfortable that the price paid for the assets, combined with the protection from liabilities afforded by the court order, represents a reasonable exchange for rushed sale process and limited recourse. Developments in the insurance market over the past decade may prove helpful to both buyers and sellers in Section 363 Sales.
Rep & Warranty Insurance
The past decade has seen an explosion in the popularity of rep & warranty (“R&W”) insurance in M&A deals, particularly in the private equity space. This specialized insurance product provides coverage, typically to the buyer, for financial losses that arise post-closing resulting from breaches of representations and warranties made by the target or seller in the transaction. Because it preserves deal value by shifting the risk of loss to the insurer and permits the reduction or, increasingly, elimination of seller indemnities in purchase agreements, R&W insurance can make a bid more attractive to sellers. This is tailor-made for bankruptcy sales where seller indemnities are not really feasible or must be very limited in scope.
The costs – a premium of a few percentage points of the deal size paid up front and a retention amount that must be met before coverage kicks in – can be allocated between buyer and seller. Although underwriters will require satisfactory diligence of the acquired business before issuing a policy, this can typically be fit into the pre-signing process of most deals, and where time is short, underwriters may be willing to bind a policy with conditional exclusions, where coverage may be initially excluded but then provided upon satisfactory completion of post-signing diligence.
Insuring Reps & Warranties in 363 Sales
Because the emergence of R&W insurance has occurred primarily in the lengthy M&A boom that has followed the last recession, bankruptcy practitioners may be less than familiar with its use, and the practice of insuring reps & warranties in 363 Sales remains primarily theoretical. But as the possibility of a rise in distressed asset deals looms, it becomes increasingly important for players in the space to understand the potential benefits of transactional liability insurance. Though the 363 Sale process alone provides protection against subsequent fraudulent transfer claims and allows the purchase of assets free and clear of most liabilities, the ability to insure against breaches of reps & warranties of the seller, particularly with respect to the condition of purchased assets, makes the purchase of assets in a bankruptcy sale that much more attractive. In turn, this can help sellers achieve higher sale proceeds.
R&W insurance is a complicated product and the Bankruptcy Court procedures that overlay Section 363 Sales only add to the complexity as compared to the more typical private equity context. It is also relatively new to the restructuring arena. As a result, education for underwriters and practitioners alike is needed. Sophisticated counsel can help buyers and sellers of distressed assets assess whether the potential benefits of R&W insurance make sense in light of the nature of the assets being sold and the level of due diligence available, as well as how best to deploy it in the bankruptcy context.
1 While it is not unheard of for a 363 Sale to include a holdback for a limited duration in some circumstances, these are not common and heavily disfavored by debtors and their creditors. The same is true for indemnities.