Introduction
Bankruptcy is active. Faced with multiple economic challenges—including persistent inflation, supply chain disruption, tightened bank lending, and rising interest rates— distressed companies are increasingly turning to bankruptcy as a restructuring solution. According to S&P Global, the number of companies filing for bankruptcy in 2023 is higher than the first four months of any year since 2010.
Transactional risk insurance, which has become a staple of private M&A transactions, should be considered as an alternative to traditional risk allocation for distressed assets. These are insurance tools that minimize transactional and litigation risk, unlock value, and provide a range of protections to parties involved in bankruptcy.
Representations and warranties insurance
363 sales
For both private equity firms and strategic purchasers, a potential new wave of Section 363 (named for the relevant section of Chapter 11 of the Bankruptcy Code) auctions can present significant opportunities to purchase businesses or assets at discounted prices. Section 363 sales also offer buyers protections that are generally unavailable outside of bankruptcy. Chief among those protections is the “free and clear” order given by a court in a 363 sale, which extinguishes substantial third-party claims and liens risk. But even with a free and clear order, 363 buyers may still bear the risk of first-party claims due to a breach of a seller’s representations.
The use of Representations and Warranties Insurance (RWI) in bankruptcies has grown in recent years. Because a 363 sale does not provide recourse for first-party claims, RWI can protect the buyer from unknown liabilities, including for customer and supplier issues, compliance issues, product liability, intellectual property, or environmental liabilities. With insurance as a financial backstop, buyers have additional comfort that risks will be mitigated. And that comfort leads to higher priced bids for distressed assets, which also benefits creditors.
Benefits to buyers
- Bidders with RWI can ring-fence a range of unknown first-party liabilities.
- RWI gives bidders a competitive advantage in an auction scenario.
- Buyers may benefit from a “synthetic” pre-closing tax indemnity in RWI policies where a traditional tax indemnity is not included in the underlying purchase agreement.
Benefits to debtors
- Debtors can market their distressed assets as a “safer” purchase to potential buyers because those buyers will be able to pursue a highly rated insurance company for future claims.
- Debtors can provide broader representations and warranties in the purchase agreement, while still avoiding indemnifying those representations and warranties directly.
Tax insurance
Tax insurance can assist lenders, creditors, investors, partners, and owners with structuring and securing bespoke tax insurance policies for a wide range of tax risks involving distressed businesses. The tax code provides many favorable tax laws utilized by distressed and bankrupt businesses to avoid triggering a significant tax bill. Many of these favorable tax laws contain subjective elements that businesses need to comply with, but the IRS has not provided sufficient guidance on how to comply, resulting in uncertainty. Tax insurance provides that certainty and protects the tax savings, credits, and refunds generated by distressed or bankrupt businesses, which may bolster the value of the business for sellers. Additionally, buyers should always consider tax insurance to protect their investment from a liquidity event following an adverse IRS audit and protracted litigation.
Contingent risk insurance
Contingent risk insurance—which covers known risks presented by legal and regulatory exposures—has a range of applications in bankruptcy. Credit investors and litigation funders have increasingly purchased litigation claims from distressed sellers, and contingent risk insurance can be used to drive up the price (and, from the buyer’s point of view, lower the risk) of those assets. And for debtors facing pending or threatened litigation, contingent risk insurance can ring-fence the risk of an adverse judgment and cap the debtor’s liability—protections that are invaluable for bankruptcy buyers.
Conclusion
Transactional risk insurers continue to compete for opportunities and new ways to adapt to the changing M&A environment, and the use of transactional insurance in distressed transactions is one key example. We expect greater flexibility and innovation in transactional insurance as underwriters strive to meet the needs and challenges that distressed investors and insolvent companies face.
WTW’s experienced team of dedicated transactional insurance professionals is committed to innovative risk solutions for our clients.
