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Risk Shifting: Rep & Warranty Insurance in Franchise Transactions

December 5th, 2023 by Sunny Sabuero

Representations and Warranties Insurance (“RWI”) has become a mainstream tool that is used in most M&A transactions, including transactions in which franchisors change hands. This type of insurance is not new, but as deals get more competitive it has emerged as a regular way to shift risk from the seller to an insurer, and thereby smooth out the transaction process and to increase trust between the parties. According to an American Bar Association study, RWI usage more than doubled in the past five years.

So what is RWI and how can it be useful in franchisor buy and sell transactions?

RWI is basically a type of coverage aimed at breaches of contract; in the case of franchisor sales, the contract is typically a stock (or asset) purchase agreement (“SPA”). Typically in a franchisor M&A transaction, a seller will make representations and provide warranties about the condition of the franchise system they are selling. Buyers, in turn, agree to the transaction based on a combination of what the seller has represented the business as, what the seller has warranted, and their own due diligence. The parties usually agree to some type of indemnification around unforeseen liabilities and may set aside money in escrow to cover surprises. RWI comes alongside representations and warranties to provide insurance in the event that a “rep” or warranty proves to have been wrong or inaccurate, and causes a surprise in the deal, and in most cases can help get buyers comfortable without needing an escrow.

The surprises we are talking about here are not usually enough to break a deal, but they could be annoying and have significant unforeseen costs. In the case of franchising, potential problems with a single franchisee unit or a number of units; or potentially some type of intellectual property issue could be covered. Coverage is also likely to exist for the typical reps that appear in SPAs for the sale of franchisors, such as reps that:

  • The Franchise Agreements are legally, valid, binding, and enforceable,
  • The franchisor has not received notice of material non-compliance from franchisees,
  • The franchisor has disclosed all outstanding notices of material franchisee default,
  • Consent to the transaction is not required to be obtained from franchisees,
  • The Franchise Disclosure Document complies with all applicable franchise laws,
  • There are no outstanding options, ROFRs, or rights to additional territory,
  • All required state franchise registrations are in place, and
  • There is no outstanding litigation other than that disclosed.

Without RWI, parties may spend a lot of time negotiating the right size of an escrow or how to indemnify against these surprises, because if a cost is high enough it can materially impact the economics of a deal. On the other hand, RWI to cover unforeseen circumstances enables the parties to avoid protracted or difficult and alienating negotiations, and to close the deal rapidly.

As a rule, insurers will take a close look at a potential transaction before agreeing to write a policy and once they do, that tends to create a level of trust for both sides.

Insurers will typically look at:

  • The stock purchase agreement (SPA) terms and conditions, including “Schedules” that provide for exceptions,
  • The scope of due diligence undertaken by the buyer,
  • Due diligence memoranda from franchise (and other) counsel for the buyer, and
  • Answers to questions presented to the buyers and buyer’s franchise (and other) counsel, and responses to interview questions presented to the buyer and such counsel.

RWI, as you might guess from its name, is designed to cover representations and warranties, but it is not all-encompassing. Even in the best deals, there are still things insurers won’t cover. Those include:

  • Known issues – if due diligence memoranda and interviews reveal existing and adverse high risk conditions, insurers aren’t going to cover those conditions,
  • High ticket items, like antitrust, FCPA, and environmental claims may be excluded if there are foreseen problems in these areas
  • Broad-based labor issues like joint employer, misclassification, wage and hour, and union violations are likely to be excluded if issues are identified in the business,
  • The risk of purchase price adjustments will not be borne by insurers, and
  • Forward-looking claims like future revenues or growth projections will not be insurable.

These policies are bespoke and tend to be expensive relative to other types of business insurance. Costs per policy will vary depending on the size and complexity of the transaction. Generally, premiums are approximately 3% of the total cost of coverage with an upfront additional fee to cover the cost of the due diligence. Either the buyer or the seller can pay for the cost of the policy. The decision to pay or not pay is typically separate from the escrow. Usually a seller with any leverage can avoid the escrow, and who pays for the policy is a separate consideration, where often it’s split between parties. Some buyers offer to pay, which can enable them to offer more competitive deal terms.

In the event of a claim, RWI works like most other insurance. There’s a deductible (aka “retention”) that has to be met and the insurer has to agree to cover the claim. The deductibles can be a consideration for these policies so it is sometimes the case that the cost of a surprise will have to be covered without help from the insurer. Parties can guard against some of this by using RWI as part of a constellation of insurance including environmental impairment liability policies, political risk policies, and policies that cover the failure to qualify for expected tax or regulatory treatment. There are pros and cons to using all of these policies but ultimately, they may be preferable to large and lengthy escrows or longer closings.

For franchise sellers, working closely with legal counsel and insurance advisors can help you understand the costs and tradeoffs of these policies and whether it makes sense for you to pay or to look for a buyer offering one or more of these policies.

Writer’s Bio:

Bret Lowell, Partner, DLA Piper

Bret Lowell is an internationally recognized leader in franchise and distribution law, and has counseled and represented clients across a broad spectrum of industries, including restaurants and food service, car rental, hotel and motel, health care, financial services, high tech, real estate and retail.

Bret’s experience includes extensive analysis as to whether arrangements constitute “franchises;” drafting and negotiating domestic and international franchise, distribution and license agreements; preparation and filing of disclosure documents; counsel and advice regarding the establishment and operation of franchise and distribution systems; counsel and advice regarding termination, transfer and renewal obligations; dispute resolution, including representation before federal and state government agencies; mediations; and trademark and other intellectual property matters.

Bret is heavily focused on the buying and selling of franchisors. He has worked on both sell-side and buy-side transactions, representing private equity, investors and strategic players. He regularly provides legal advice concerning strategy, document preparation and due diligence in connection with franchisor dispositions, acquisitions, mergers, public offerings, financings and investments. For more information contact Bret at bret.lowell@dlapiper.com, access more articles by Bret here

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