Tracing the growth of representations and warranties insurance in Mexico
Federico Scheffler and Andrea Trejo of Galicia Abogados explore the tax impact as the Mexican mergers and acquisitions (M&A) market attempts to streamline transactional processes.
Representations and warranties (RWs) insurance is gaining popularity and is being used more frequently in the US and other developed jurisdictions. It has become a key part of deal structuring in the highly competitive M&A market because it enables deals to close faster by helping reduce negotiation processes.
Due to particular regional challenges, RWs insurance is still seldom used in the context of Mexican cross-border transactions. However, there are reasons to believe that the Latin American M&A practice is gradually shifting towards the usage of this product, making room for more competitive and efficient transactions.
This article aims to highlight some key aspects of RWs insurance structures and its advantages and disadvantages, with focus on a Mexican tax perspective. This article will compare between RWs insurance structures and other prevailing traditional indemnity mechanisms, while providing analysis on why these type of practices will likely become more frequent in Mexican M&A practice.
Traditional RWs indemnity mechanisms in the Mexican market
Representations and warranties by both the seller and buyer are among the key components in the negotiation of acquisition agreements.
Traditional RWs refer to statements of fact or disclosures that a party makes to induce another party to enter into a certain agreement, such as a business acquisition. The receiving party may rely on these assurances and statements as factual, and claim misrepresentations where false statements have been made after concluding the transaction.
In the majority of deals, there are certain RWs that are deemed to be more relevant than others. For instance, fundamental representations are those deemed critical to the buyer's consent to close the transaction and often involve equity ownership, title to assets, capital structure, power and authority and other decisive issues such as taxes.
As fundamental representations imply a greater liability for the seller upon breach, often their survival period is matched to the applicable statute of limitations of the underlying claim (e.g. typically around five years with respect to tax claims), whereas non-fundamental RWs' survival periods may last for varying periods of time, more commonly between 12 and 24 months. Although this is considered as the average timeline, this may be agreed upon by the parties on a case-by-case basis, depending on the findings of the due diligence performed to the target entity.
Additionally, in contrast with other RWs that are capped to a percentage of the purchase price, fundamental representations are usually limited to an amount equal to the aggregate purchase price of the transaction, or subject to no caps at all. Indemnity caps are usually heavily negotiated as they limit the risk and the amount the buyer can recover from a seller's breach of RWs.
Other ways to limit indemnification obligations derived from breaches of RWs is through tipping baskets and deductible provisions. These provisions prevent the indemnifying party from being liable for breaches of certain RWs until the indemnified party's losses exceed a minimum amount. If the losses exceed the fixed amount, and depending on the agreement between the parties, the indemnifying party will pay for either all losses, or only those exceeding the deductible amount, thus limiting the indemnifying party's liability.
Accordingly, as representations and warranties insurance has gained market acceptance, there has also been an increase in the number of insurers entering the market, providing lower premiums, retention amounts and more competitive options and flexibility in both the underwriting processes and claim procedures.
Although it is not standard per se, it is common practice to include knowledge disclaimer provisions, which are commonly known as a 'sandbagging' provision. This prescribes that the rights to indemnification will not be affected or limited by the buyer's knowledge of any inaccuracy or non-compliance with a representation or warranty acquired before or after closing, either by the seller's disclosure or by the buyer's due diligence.
In accordance with the above, when negotiating indemnity payments in Mexican M&A transactions, purchase price adjustments and indemnification mechanisms are set to provide the parties with certainty and control over the purchase price, cash availability and indemnification payments.
Normally, indemnity payments are treated as purchase price adjustments, since indemnity payments would be otherwise treated as a taxable income for the indemnified party and a non-deductible expense for the Mexican indemnifying party. This applies in the case of share deals and not necessarily to asset deals, since the latter being structured as an adjustment would represent certain complications regarding the reissuance of electronic invoices, Mexican value added tax and registry of the investments for purposes of their depreciation.
Another common practice is to include holdback provisions, whereby the buyer retains a portion of the purchase price, allowing it to have free access to the funds and to deduct indemnity payments, as opposed to having to file a claim in respect of disbursed funds that may no longer be available after closing. This type of arrangement usually involves the execution of escrow agreements in which the holdback amount is held until a later date or until certain conditions are met.
Including an escrow agreement offers the advantage of providing certainty that the funds to cover indemnification payments are available and that they are specifically allocated for such purposes in a third party account (escrow agent). Additionally, multiple obligations, disbursement dates and other terms and conditions relating to the escrow agreement may be set forth by the parties in accordance with and depending on the RWs terms, survival periods, caps and other limitations stated above.
The use of RWs insurance has increased exponentially over the past decade in the US and other developed jurisdictions. The estimated amount of M&A deals where RWs insurance is considered and used has risen up to approximately 45% of all private transactions in the US. Furthermore, in accordance with AIG's Mergers and Acquisitions 2019 Claims Report, in the past year there has been an increase in claim notifications for M&A deals from $500 million to $1 billion (from 21% to 26%).
Accordingly, as RWs insurance has gained market acceptance, there has also been an increase in the number of insurers entering the market, providing lower premiums, retention amounts and more competitive options and flexibility in both the underwriting processes and claim procedures.
Generally speaking, a RWs insurance policy is used in M&A transactions to protect the buyer from losses arising from certain breaches in the seller's representations in an acquisition agreement, which are limited to a certain monetary amount or cap.
Representations and warranties insurance policies are usually procured by the buyer as the insured party. After having negotiated the package of representations and warranties with the seller, the buyer will hire the insurer who will be given access to all material information and due diligence reports regarding the acquired business, in order to undertake its own due diligence process. Once such a process has concluded, the parties (buyer and insurer) will then negotiate the specific terms of the policy (which will last from three to six years), such as the scope of losses included and excluded from coverage, and issue the corresponding policy in exchange for a premium.
The premiums of RWs insurance in Mexico are usually between 4% and 5% of the policy limits, which tend to be around 10% and 20% of the enterprise value. Additionally, RWs insurance policies are also subject to deductible/retention amounts that go up to 1% of the value of the transaction or higher.
It is important to mention that there are various standard exclusions regarding RWs coverage that insurers are unwilling to assume, such as certain RWs by the seller (environmental, anti-corruption, net operating losses (NOLs), transfer pricing), the seller's covenants and/or purchase price adjustments. In addition to whichever other limits or exclusions are agreed by the parties, the policy will be subject to an anti-sandbagging provision. In terms of this provision, any liabilities that the buyer knew about or identified in the due diligence would, as a general rule, not be covered (if materialised) by the RWs policy.
In the event claims for indemnity do in fact arise, the rationale behind RWs insurance is that all of the buyer's losses under the acquisition agreement will be paid by the insurer, at least to the extent of the risks covered under the policy.
RWs insurance advantages vs. standard M&A mechanisms
The following are some of the most relevant benefits that RWs insurance can provide to the parties in an M&A deal:
Having a RWs insurance can simplify negotiations between parties by limiting the seller's indemnity liabilities and allowing the seller to better manage and reduce its exposure;
RWs insurance allows the buyer to recover post-closing liabilities from a third party as opposed to from the seller (former stakeholder of the acquired company). This is particularly valuable when, for example, the seller is a private equity fund with a need to close the fund at the end of a deal;
RWs insurance may be an optimal alternative to transactions that do not involve cash payments, in which the seller might not be in a position to cover its indemnification obligations; and
The use of RWs insurance reduces the need for more traditional arrangements like purchase price holdbacks and escrow provisions which prevent the seller from receiving the full purchase price at closing.
RWs insurance disadvantages vs. standard M&A mechanisms
Nonetheless, despite its many benefits, RWs insurance policies may present the following disadvantages:
RWs insurance does not generally cover purchase price adjustments or covenant breaches;
Considering most policies include broad coverage exclusions or limitations, the buyer could be substantially exposed to extraordinary losses caused by breaches in representations not included in the policy or exceeding the coverage limit;
Due to the conventional anti-sandbagging provision, the buyer will not be able to recover for liabilities it knew about when the policy was bound. Thus, any liabilities discovered while undertaking the diligence process will be excluded from the policy coverage;
RWs insurance does not cover the total consideration amount, but only a small percentage of it; and
Depending on the amount of the transaction, it may be too 'small' for an insurer company to be interested, or too expensive for the buyer.
Emerging RWs insurance market in the Mexican market
Historically, Mexican cross-border M&A transactions have been largely influenced by foreign practices (mainly the US) and local agreements tend to mimic those used in such jurisdictions, subject to the formalities required under Mexican law to be valid and enforceable.
Notwithstanding the above, although there has been an important development in the RWs insurance market in the US, there has been little insertion within the Mexican transactional practice.
Even with insurers having worked their way into the Mexican and Latin American M&A market, very few companies offer competitive RWs insurance policies. This is partly because of the broad exclusions insurers are likely to request due to specific obstacles that these markets present, such as concerns about government stability, lack of transparency and predictability in regulatory enforcement and challenges in proper due diligence data collection.
Consequently, the tax consequences derived from RWs insurance policies remain an underexplored territory by the Mexican tax authorities.
As a general rule, income derived from indemnity payments in favour of a Mexican tax resident company will be subject to a 30% tax rate under Mexican law. Therefore, a gross-up provision is normally negotiated, so that the indemnified party receives an amount equal to the sum it would have received had no such taxes been paid.
As a practical solution, it has been a common practice in share deals to have indemnity payments treated as an adjustment to the purchase price instead.
Likewise, payments under a RWs insurance policy will be subject to income tax under Mexican law as an indemnity income. Therefore, from a tax perspective, an indemnification in terms of a RWs insurance could be less efficient (70% net indemnity) than regular indemnity payments under an acquisition agreement. It can be understood that there are certain insurers that are able or willing to offer to cover the grossed-up amount, however this is likely to result in a higher premium for the acquirer.
Also, it is relevant to point out the fact that a standard practice in Mexico's M&A transactions is for tax indemnities to be limited to the total purchase price. The RWs insurance practice (at least in the US) is to cover an amount equal to a certain percentage of the purchase price (10% to 20%). This very relevant difference will most likely be an important item for purposes of analysing whether to hire the insurance or not.
It should also be noted that the tax treatment of RWs insurance (i.e. deductibility of the premium) could vary depending on who acquires the policy. The most common approach is to have the buyer acquire it, in order to avoid having the tax authorities challenge the deductibility of such an expense. For this same reason, it is believed that having the seller procure the policy would most likely increase the chances of the corresponding deduction being challenged.
Therefore, considering the advantages and disadvantages of RWs insurance described above, as well as the relevant tax implications, it can be concluded that there is no specific rule of thumb as to whether RWs insurance is more convenient than traditional indemnification arrangements, particularly in the underdeveloped Mexican and Latin American markets.
After all, transactions must always be analysed on a case-by-case basis in order to determine which indemnification mechanism should be implemented. In many cases, these arrangements will more likely than not complement each other when properly planned and structured.
Nonetheless, considering the various advantages that RWs insurance may provide from a transactional point of view, it should be considered as a viable option when structuring competitive transactions in Mexico, mainly in the context of those involving high amounts and which require an agile due diligence, speed up negotiation processes and post-closing certainty.
T: +52 55 5540 9200
Federico Scheffler is a partner at Galicia Abogados since 2018. He specialises in tax consultancy, focusing mainly on transactional tax. He has experience in international taxation, estate planning, corporate finance, real estate, mergers and acquisitions, venture capital and private equity.
Federico is a member of a number of institutions, including the Mexican Bar Association and the International Fiscal Association (IFA), where he is part of the Young IFA Network (YIN).
Federico has a master's degree in business administration (MEDEX) from IPADE, postgraduate studies in tax law from Universidad Panamericana, and a bachelor's degree in law from Instituto Tecnológico Autónomo de México (ITAM).
T: +52 55 5540 9266
Andrea Trejo joined Galicia Abogados in 2016 as an associate in the tax consultancy practice area. Her work is focused on transactional tax, corporate restructuring, family estate planning matters and charities.
Andrea studied law at Universidad Panamericana and also participated in an international tax programme at New York University School of Law, focusing on international taxation from a global perspective. She has also participated in an international political economy programme at the London School of Economics