Like chapters of a soap opera, the deal drags on with lengthy parallel discussions between the finalization of due diligence and the negotiation of indemnification provisions in the definitive agreements. Information — at times asymmetric — about the scope of the target’s liabilities and contingencies seems to make it impossible for buyer and seller to reach common ground. Then someone raises the question, in an attempt to mitigate these risks and find a middle ground: what if we used a representations and warranties insurance policy (“RWI”)?
This is possibly a scenario that nearly every M&A advisor in Brazil has faced. In the vast majority of cases — with or without a deeper exploration of the alternative — the conclusion has typically been along the lines of: “it doesn’t work in Brazil,” “it won’t address the problem,” or “the protections won’t be sufficient.”
Historically, a few factors seem to explain these responses.
The first, well known to all, is the very exposure that companies face in Brazil. It is not uncommon, for example, to identify significant materialized liabilities — or potential contingencies — of a tax nature, high labor litigation, environmental risk uncertainties, as well as anti-corruption/compliance issues and risks tied to shifting judicial interpretations.
Directly related to the above is the second reason: the approach traditionally used by the market to address such liabilities. It is also not uncommon in Brazilian M&A transactions — especially those involving private companies — for buyers to be indemnified for all acts, facts, or omissions related to the pre-closing period (in market parlance, “my watch, your watch”), subject to negotiable contractual limitations, regardless of any breach of the sellers’ representations and warranties. This largely undermines the protection offered by RWI, which is a product designed precisely to protect against hidden contingencies arising from a breach of representations and warranties.
A third factor lies in the set of historical obstacles to placing the product in Brazilian transactions — also influenced by the two points above — including: reliance on foreign products (underwritten abroad, governed by foreign law and jurisdiction), the exclusion of coverage for representations and warranties that are essential to the deal (such as those of a tax and environmental nature), and pricing.
However, recent developments in the domestic market appear to be contributing to a shift in this historical landscape — or at least prompting market participants to revisit the topic. Among these developments are: (i) the possibility of local issuance, governed by Brazilian law and subject to domestic jurisdiction (consistent with the law and jurisdiction of the transaction agreements); (ii) premium payments in Brazilian Reais directly in Brazil; and — without claiming to exhaust the details and nuances of the policy and its application to specific cases — (iii) coverage offerings for important risks that were previously excluded, such as tax and environmental risks.
The experience of Latin American countries close to Brazil, and the push from players such as Private Equity funds, may also play an important role in fostering the use of RWI in Brazilian M&A transactions.
There is no single or “magic” solution, but these changes appear to point toward a “new” alternative that, in certain specific cases — such as highly competitive sale processes, “clean exit” transactions for Private Equity funds, among others — can provide financial protection and facilitate negotiations.
It remains to be seen, therefore, how the market will evolve, with the necessary “tropicalization” of the product to suit the country’s needs — and how the next chapters will unfold.
