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Should You Consider Representations & Warranties Insurance in Your Real Estate Deal?

George J. Kroculick, Meredith Carpenter
Duane Morris
Philadelphia, PA

Introduction

Representations and warranties insurance (“R&W insurance”) has been available for over 15 years, but only recently has it become commonplace in mergers and acquisitions (“M&A”) transactions. Now that it has been established in the M&A sector, parties to real estate transactions are beginning to realize that R&W insurance can play an important role in these deals as well.[1] Particularly as real estate deals have become more complicated, with real estate being traded as an asset owned by entities such as real estate investment trusts, R&W insurance can help facilitate these transactions. Indeed, what makes R&W insurance so attractive in M&A deals applies equally to real estate deals, and parties to complex real estate transactions may wish to consider obtaining an R&W insurance policy.

What Is R&W Insurance?

R&W insurance protects buyers and sellers from financial loss resulting from inaccuracies in the representations and warranties that were made as part of the transaction. In a transaction, parties often make representations and warranties about certain material facts in order to induce the other party to enter the transaction. For example, in complex real estate transactions where ownership in real estate is being transferred as an asset, typical representations and warranties may include information about the assets and the seller, including their financial status, and any liabilities that are being transferred in the transaction.[2] In more standard real estate deals, typical representations and warranties include:

  • The status and authority of the seller, such as its financial state and its ability to enter into the contract;
  • The current status of the property, such as compliance with applicable codes and ordinances and lack of any unrecorded liens against the property; and
  • The proper operation of the property, such as all leases being in effect with no current breaches and the accuracy of all rent rolls and records.[3]

 

R&W insurance is designed to provide insurance coverage for the breach of particular representations and warranties that are made as part of a transaction, protecting the other party in the event that a representation or warranty is untrue and the party is damaged by the inaccuracy of that statement. Because representations and warranties tend to be discoverable facts, R&W insurance essentially protects the parties against any deficiencies in conducting due diligence in the transaction.[4]

R&W insurance can be either buyer-side or seller-side. Although, typically, buyers want R&W insurance because they are more likely to be harmed by a breach in a representation or warranty, in certain situations R&W insurance may be desirable for sellers as well. Seller-side insurance is third-party liability coverage, in that a seller purchases the insurance to cover against any losses to the buyer.[5] Rather than having to maintain assets in escrow to insure an indemnification provision, a seller-side R&W policy can allow a seller to liquidate or end its operations after the closing. This might be the case when investors in a real estate investment trust wish to sell any remaining assets and fully distribute all of the proceeds from the transaction.

When Might You Need R&W Insurance?

Because R&W insurance shifts the risk of unknown breaches of representations and warranties in a transaction to an insurance company, it reduces the stakes on both the buyer and seller in negotiating the contract. However, R&W insurance generally makes sense in larger, more complex real estate transactions that involve transferring interests in entities, such as acquiring real estate through entity acquisition, asset purchase and corporate merger. In these transactions, R&W insurance would serve the same purpose and provide the same coverage as other types of M&A transactions.

Where an entire portfolio of real estate is being sold or ownership of a real estate holding entity is changing in a complex way, R&W insurance is useful, as the parties cannot easily monitor and verify the representations and warranties relating to so many properties, and there are more opportunities for something to go wrong. Similar to R&W insurance for M&A deals, the insurance in such a real estate transaction would cover entity-level representations, tax representations, representations related to the accuracy of financial statements and representations regarding any liens on the shares being traded.

R&W insurance generally would not be necessary in a simple purchase and sale of a single piece of real estate. Representations and warranties about real property can usually be discovered fairly easily through a title search on the property, and many concerns about the real property can be addressed through title insurance. Further, in most real estate transactions, the property is sold as-is, without representations or warranties as to the physical or environmental condition of the property, the property’s financial performance or other characteristics that could be important to the buyer. Instead, the buyer will have an opportunity to conduct due diligence and determine whether or not to proceed with the transaction.

However, in certain situations where due diligence could not provide the buyer with important information, R&W insurance could be desirable. For example, a real estate transaction could involve property with uncertain tax treatment, such as a transaction involving § 1033 of the Tax Code, dealing with the replacement of property taken by condemnation, or § 1031 of the Tax Code, dealing with like-kind simultaneous or deferred exchanges.[6] The tax treatment of such property may not be easily assured based on the existing law, and the buyer may wish to obtain representations and warranties from the seller in case the expected tax treatment is challenged.[7]

R&W insurance could also be useful when the property that is the subject of a transaction is an historic building and the deal involves investments in historic tax credits. To complete the investment successfully, investors may need to be induced into investing in the project through representations and warranties about the project and the historic tax credit implications.

Further, real estate transactions that involve the transfer of permits that allow the property to operate may benefit from R&W insurance covering a seller’s representations and warranties regarding the validity of those permits.

Moreover, R&W insurance can cover representations and warranties about particular environmental matters that environmental insurance or title insurance will not cover, or that would be very expensive to cover under those policies.

Why Might You Need R&W Insurance?

Most transactions include representations and warranties that are secured by indemnification provisions, an escrow account, letter of credit or some other form of security.[8] R&W insurance is desirable because it can reduce or eliminate the need for these workaround measures, which can hold up the negotiation of a transaction. Buyers and sellers often cannot agree upon whether a specific representation or warranty will be included in the transaction, what the precise scope of an indemnity provision should be and what size escrow account is necessary. R&W insurance can facilitate the transaction by supplementing or replacing an indemnity and ensuring that a breach of a representation or warranty will be protected, without the need for contractual workarounds.

As a result, R&W insurance can lower the cost of the transaction and let both parties maintain a more congenial relationship in the negotiation process. This can be of particular value where the sellers will remain affiliated with the property after the transaction—for instance, where a seller has been managing the property and will to continue to manage it after the sale. In shopping centers that are struggling financially, R&W insurance can entice potential buyers who might otherwise shy away from the transaction because of their concern about the strength of the seller’s covenants or because they fear they may not be able to recover from the seller post-completion of the transaction if the seller is liquidated.

Conversely, if a financially distressed seller wants to liquidate after the sale, R&W insurance can facilitate this process by removing the need for it to hold funds in escrow. By providing the security that the escrowed funds typically serve, R&W insurance lowers or eliminates the need for funds to be escrowed, and allows a seller to liquidate sale proceeds quickly.

Other Considerations

The terms of R&W insurance are flexible and tend to be tailored to the specific representations and warranties included in the transaction. However, R&W insurance generally will not cover any known liabilities at the time of the policy; it will only cover unintentional and unknown breaches.[9] If a buyer discovers a potential issue during due diligence, it is not entitled to coverage under R&W insurance. And, if a seller intentionally makes a false representation, a buyer may have other claims against it, but breach of that representation typically will not be covered by R&W insurance.

Although this is a relatively new insurance market, gains in the popularity and use of R&W insurance should result in price reductions. The insurance is not cheap and may not currently be suitable for all real estate transactions. The cost of the coverage and the amount of coverage that the insurance company will provide should be balanced against both the value of - and the risk associated with - the transaction. Still, for shopping centers under complex ownership structures or which are included in the shares of an entity’s portfolio, R&W insurance could be an important tool in facilitating transactions.

 

*George J. Kroculick is Co-Chair of Duane Morris' Real Estate Practice Group. Mr. Kroculick practices in the area of real estate law with a focus on eminent domain, including just compensation, right to take, relocation assistance and highway access management, as well as land use and land use litigation, and real estate tax relief matters. He has represented clients before local and county land use boards.

**Meredith Carpenter is an Associate in Duane Morris’s Real Estate Practice Group. Ms. Carpenter’s practice includes a wide variety of real estate matters, including land use and zoning, eminent domain, real estate tax litigation, acquisitions and dispositions, and commercial financing.


[1] See Andrew McIntyre, Reps & Warranties Insurance Creeping into Real Estate Deals, Law 360 (May 4, 2015), available at http://www.law360.com/realestate/articles/650115?nl_pk=d5a5ca65-5b60-49e1-ba81-9d93be91d2ef&utm_source=newsletter&utm_medium=email&utm_campaign=realestate.

[2] See 4 Appleman on Insurance § 32.02.

[3] See Lee A. Chilcote, Representations and Warranties Insurance: A New Insurance Product for Real Estate Transactions? —presentation at the American College of Real Estate Lawyers, Boston, MA (Oct. 12, 2000).

[4] See 4 Appleman on Insurance § 32.02.

[5] Id.

[6] See Lee A. Chilcote, Representations and Warranties Insurance: A New Insurance Product for Real Estate Transactions? —presentation at the American College of Real Estate Lawyers, Boston, MA (Oct. 12, 2000).

[7] Id.

[8] Michael A. Rossi, Insuring Representations and Warranties in Mergers and Acquisitions, 22 RISK REPORT No. 8 (Apr. 2000).

[9] See 4 Appleman on Insurance § 32.02; — see also Ins. Co. of North America v. Kayser-Roth Corp., 770 A.2d 403, 415 (R.I. 2001); General Housewares Corp. v. National Surety Corp., 741 N.E.2d 408 (Ind. 2000); Meridian Mut. Ins. Co. v. Majestic Block & Supply, Inc., 1 N.E.3d 173 (Ind. Ct. App. 2013).