Over the past year, there has been a noticeable increase in notifications involving third-party claims made under Representations and Warranties (R&W) policies, highlighting a growing trend with significant implications for insurers and deal makers alike. This article explores the drivers behind the surge in third-party claims and offers insights into navigating the challenges they pose.
In the context of R&W policies, a third-party claim arises when someone outside of the M&A transaction asserts allegations against the target company, which, if true, would constitute a Breach of a covered representation. In our recent Claims Briefing, we reported that in 2023, over half—56%—of non-tax-related notifications involved third-party claims, up from 49% in the previous year. This trend is particularly noticeable in the Americas where class action lawsuits are commonplace. Alongside the increase in frequency, we have also seen an increase in the size of these claims primarily due to soaring defense costs. Indeed, one of our largest payments to date relates to a third-party claim wherein we paid out nearly $30 million, some $20 million of which was purely for defense costs.
This upward trend in defense costs is exacerbated by the macroeconomic climate and inflationary pressures, prompting law firms to increase their hourly rates. The law firms used to defend third-party claims are oftentimes pre-approved in R&W policies—with their rates deemed reasonable—but it is not always the case that the pre-approved firm will be the most suitable or cost-effective choice.
The result is that it is becoming more common for defense costs to materially erode or exhaust retentions—a trend that is likely to be exacerbated by the pressure that retentions have come under recently, coupled with the fact that third-party claims frequently arise after the retention dropdown date, when the retention is generally halved one year post-closing.
IP and Wage & Hour Disputes on the Rise
We are witnessing a notable uptick in two categories of third-party claims: intellectual property disputes and wage-and-hour class action lawsuits. IP disputes, in particular, are aggressively pursued, with plaintiffs protective of their IP rights due to the competitive advantage they confer and the substantial resources invested in their development. These claims entail substantial litigation costs, given the high counsel fees coupled with the fact that these matters are not easily disposed of by early motion practice. Indeed, we have handled several IP claims where the target company is likely to incur more than $5 million in defense costs and achieving a sensible settlement is proving to be difficult given the entrenched position of the plaintiff.
Another factor fueling the increase in IP claims, particularly in the Americas, is the rise of “patent trolls,” who exploit patent litigation for settlements based on (often) frivolous claims. We find patent trolling to be less prevalent in EMEA, likely due to the loser-pays-costs regime.
The story is similar with wage-and-hour suits. Frequently venued in California, where the laws and courts are believed to be largely employee-friendly, these cases are also not easily resolved via dispositive motions, and with plaintiffs’ lawyers commonly working on contingency-fee arrangements, nuisance-value settlement offers are generally rejected. There is also a legal system abuse risk associated with these claims, raising the possibility for outsized jury awards. Finally, we often find that the target’s business-as-usual insurance program seldom provides coverage, as it generally excludes wage-and-hour claims (save for the occasional minimal sublimit for defense costs).
We are also keeping a watchful eye on other areas in which we believe the volume and severity of third-party claims may increase in the future, particularly contractual disputes between the target company and its customers and suppliers, and government investigations into past business practices. The latter, to date, are most frequently seen in the healthcare sector in the United States, where Stark Law violations—prohibiting physician self-referrals—are the basis for a number of claims.
Navigating the Challenges
As exposure to third-party claims becomes more frequent, we anticipate that R&W insurance carriers will apply more scrutiny at the underwriting stage around litigation risk in general, and start to take increasingly robust positions in respect of any potential exposures that are identified during due diligence, even if it is classified as being a low-risk item. This may mean that insureds may have to look at alternative ways of managing these risks, such as via a bespoke contingent legal risk insurance policy (a product which is designed to de-risk one-off identified low-risk issues).
R&W policies typically sit excess to any other valid, applicable, and collectible insurance coverage. Hence, insureds should avoid relying on R&W insurance in the first instance to address claims typically covered by other available insurance. Moreover, during their risk and insurance due diligence on a target company, insureds must comprehensively understand the existing insurance program’s scope and limitations, ensuring it adequately addresses key risks.
As a final note, we emphasize the critical importance of an insurer receiving prompt notice of a third-party claim and having the ability to closely associate in the defense. Our experience underscores that by maintaining active dialogue regarding a claim’s status and any key developments, an insurer is able to expeditiously reach a coverage determination—frequently aligning the interests of both carrier and insured in contesting the third-party claim—and assess the reasonableness of any key strategic decisions or settlement proposals. While rare, we have encountered instances where third-party claims were noticed after the dispute had already been settled. Delayed notification complicates the claims process, especially if key decisions have already been made.
We foresee third-party claims—given the wide range of underlying circumstances—continuing to make-up a substantial portion of R&W notifications in the years ahead. With a comprehensive understanding of the evolving landscape of third-party claims, Liberty GTS is well positioned to help our insureds navigate the various complexities and challenges that arise from these disputes.
