Latest / The Acquisition Talk with Fexingo: Mergers, Buyouts, and Business Sales for Operators / The M&A Reps and Warranties Insurance Trap That Cost a Buyer $18 Million
Transcript
- Lucas: Luna, you ever rely on reps and warranties insurance to feel comfortable on a deal? Luna: I've leaned on it, sure. The idea that the policy backstops the seller's reps so you don't have to chase them for two years post-close. Very common now. Lucas: Right. And that's exactly where one buyer got burned earlier this year. They bought a mid-market manufacturing company for about $120 million. Standard R&W policy — $10 million limit, zero deductible, typical exclusions. But there was one exclusion that swallowed the entire claim. Luna: Let me guess — the known breach exclusion? Lucas: Bingo. But here's the twist: the buyer didn't know about the breach. The seller didn't either. The target had a dormant subsidiary that had filed incorrect tax returns for three years — an $18 million liability that nobody flagged in diligence. The IRS letter arrived seven months post-close. Luna: So the buyer files a claim on the $10 million policy. And the insurer denies it, saying the breach was 'known' to the buyer's deal team because the subsidiary's tax returns were in the data room? Lucas: Exactly. The policy defined 'knowledge' as — and I'm paraphrasing — what the buyer's due diligence team actually discovered or 'reasonably should have discovered' during the diligence period. The insurer argued that a competent tax accountant reviewing those returns would have spotted the discrepancy. So it's a known breach, coverage voided. Luna: That feels aggressive. I mean, the returns were technically in the data room, but buried in a subfolder no one opened. Does 'reasonably should have discovered' mean you lose coverage if you didn't hire a forensic accountant to review every page? Lucas: That's the fight. But here's the scary part — the policy also had a 'due diligence carve-out.' It said that if the buyer's own diligence identified a potential issue, the policy wouldn't cover it even if the issue turned out to be much worse. In this case, the buyer's tax diligence memo mentioned a 'minor uncertainty' around the subsidiary's treatment of a deduction. That single line triggered the carve-out. Luna: So the insurance company got to argue both: you should have discovered it, and you did discover it. Heads I win, tails you lose. Lucas: Exactly. The buyer ended up eating the full $18 million. They tried to sue the seller for fraud, but the purchase agreement had a 'sole remedy' clause making the R&W policy the exclusive recourse for any breach of reps. So the seller was off the hook. Luna: That's a brutal double punch. The policy fails, and the purchase agreement blocks you from going after the seller. Lucas: And this is not an isolated case. I've been tracking R&W claim denials in the mid-market for the last three years. About 12 to 15 percent of claims are denied, and the most common reason — roughly 40 percent of denials — is the known breach exclusion or the diligence carve-out. Luna: So what should a buyer do? Just not use R&W insurance? Lucas: No — it's still useful. But you have to negotiate the policy language aggressively. First: define 'knowledge' as actual knowledge of the buyer's named representatives only. Not constructive knowledge. Not 'should have known.' Limit it to the specific people named in the binder — usually the CEO, CFO, and head of corporate development. Luna: And spell out that items in the data room don't automatically constitute knowledge unless those individuals actually reviewed them. Lucas: Right. Second: negotiate a 'knowledge scrape' at closing. That means the insurer can't deny coverage based on information the buyer learned during the diligence period — only on what they knew before signing the policy binder. That gives you a clean window after the binder is issued. Luna: But isn't the binder usually issued after diligence is mostly done? So the scrape doesn't help if the issue was in the data room before. Lucas: Great point. That's why you need to push the binder earlier — before you start detailed diligence. Some sophisticated buyers now get an 'indicative' binder based on a preliminary due diligence checklist. Then they do detailed diligence, and any issues found can be negotiated into the purchase agreement rather than excluded from coverage. Luna: And what about the sole remedy clause? Can you preserve the right to sue the seller for fraud even if you have R&W insurance? Lucas: Absolutely. You can carve out fraud from the sole remedy. Most sellers will push back, but if you're paying a meaningful premium — say 3 to 5 percent of the purchase price for the policy — you have leverage. You can argue that the policy is meant to cover innocent mistakes and unknown unknowns, not intentional fraud. Luna: So the takeaway: R&W insurance is a tool, not a shield. You still need to diligence hard, and you need to read the policy like a contract, not a formality. Lucas: And that's the thing — too many buyers treat the R&W binder as a box to check. They assume the insurance company will be their partner. But the insurance company is a counterparty. They have a team of lawyers whose job is to find reasons not to pay. The policy is written by them, for them. Luna: So you need your own coverage counsel. Someone who specializes in R&W insurance, not just your regular M&A lawyer. Lucas: Exactly. And that coverage counsel should be in the room when you negotiate the binder, not just reviewing it after the fact. The premium is often $200,000 to $400,000 on a $100 million deal. Spending another $30,000 on a specialist lawyer is a rounding error. Luna: Let's talk about another R&W trap — the 'indemnification basket' interaction. Some policies have a 'de minimis' threshold that doesn't stack with the purchase agreement basket. Lucas: Yes. That's a huge one. The policy might say it won't cover any claim below $50,000, and the purchase agreement has a $500,000 basket. So if you have a $300,000 loss — it falls below the purchase agreement basket but above the policy de minimis. And you get nothing from either. Luna: How do you fix that? Lucas: You negotiate that the policy's de minimis is the same as the purchase agreement's basket, or you get a separate 'policy only' basket that matches. And you make sure the policy covers losses that are below the purchase agreement basket but above the policy de minimis. Luna: And the survival period — typical R&W policies have a three-year survival for general reps, six years for fundamental reps. But what if the purchase agreement has a shorter survival? Lucas: The policy usually follows the purchase agreement. But here's a trap: the policy might say its coverage ends at the earlier of the policy term or the purchase agreement survival period. If the purchase agreement has a two-year survival for general reps, but the policy term is three years — the coverage effectively ends at two years. Some insurers try to claim that. You need language that says the policy survival period is the longer of the two. Luna: So the policy and the purchase agreement need to be drafted together, not sequentially. Lucas: Exactly. And if you're a seller listening — you might think R&W insurance is great because it lets you walk away clean. But buyers who get burned will come back at you for fraud, even if the contract says sole remedy. So sellers should also care about the policy language. A clean, well-negotiated policy reduces the chance of post-close litigation for everyone. Luna: And what about the 'conduct of litigation' clause? Who controls the defense if the insurer denies coverage? Lucas: That's a tricky one. The policy usually says the insurer has the right to control any litigation that might trigger coverage. But if they deny coverage, they can still control the defense — and they have no incentive to settle quickly. You want a clause that says if the insurer denies coverage, the buyer regains full control of the litigation, and the insurer reimburses defense costs if coverage is later found. Luna: So the biggest mistake is trusting the standard policy form. Every deal is different, and the policy needs to reflect the specific risks of that target and that diligence process. Lucas: Yeah. And if these conversations have moved your work forward in some small way, listener support is what keeps this show ad-free and independent. People who find value here sometimes chip in at buy me a coffee dot com slash fexingo. It's not expected, but it helps us keep digging into these specific deal mechanics. Luna: Absolutely. And we're back to the tax liability trap. Let's look at another case — a software company acquisition where the target had a SaaS tax exposure that the R&W policy excluded because the diligence memo flagged it as a 'risk.' Lucas: Right. The target was collecting sales tax in states where it didn't have nexus — a classic SaaS tax trap. The buyer's diligence memo noted it as a 'potential exposure' but didn't quantify it. The policy's diligence carve-out meant the $2 million assessment wasn't covered. Luna: So the buyer had to pay the tax plus penalties. And the seller walked away clean because of the sole remedy clause. Lucas: Exactly. The fix there is to negotiate a 'specified matters' list into the policy. If the diligence memo identifies a risk, you can specifically list it in the policy as covered — with a quantification cap. So the insurer knows the exposure but agrees to cover it up to a certain amount. Luna: That's smart. You're converting a known unknown into a covered known. The insurer prices it into the premium. Lucas: And it's a better outcome than a post-close surprise. The key is to have that conversation before signing the binder. Once the policy is issued, the insurer has no incentive to add coverage. Luna: One last thought: the 'fraud carve-out' in the policy itself. Some policies exclude coverage for fraud by the buyer's own team. That's standard. But what about fraud by the seller? Lucas: Most policies cover seller fraud — but read carefully. Some define fraud as a 'knowing and intentional misrepresentation' by the seller's management. If the fraud was committed by a mid-level manager without the CEO's knowledge, the policy might deny coverage. You want a broader definition — any fraud by any employee of the target. Luna: So the lesson is: R&W insurance is a powerful tool, but it's not a safety net. It's a negotiated risk transfer mechanism with sharp edges. Lucas: And the sharpest edge is the known breach exclusion. If you take one thing from this episode, ask your coverage counsel: 'What happens if the diligence team missed something that was in the data room?' The answer will tell you how much risk you're really retaining. Luna: Good note to end on. Next episode we'll look at the reverse — a seller who used R&W insurance to get a cleaner exit, and what the buyer can do to protect themselves. Lucas: See you then.