Where a seller has limited or no liability in a M&A transaction, Simon considers options W&I insurers might have to better protect themselves.
The M&A market has seen a rise in the number of deals being structured as “nil recourse” transactions in recent years (a nil recourse transaction is where the seller’s liability under the transaction documents for breach of the warranties is set at nil or a nominal amount (absent of seller fraud)) and there is little sign of the trend abating. This stems both from the fact that they represent an attractive solution for sellers who are looking to achieve a “clean exit” and the increase in the number of sales via a competitive auction, which can result in buyers agreeing to such a transaction in order to seek to differentiate themselves from other bidders. However, these transactions also depend on warranty & indemnity insurance to get off the ground as otherwise the buyer would be left without a remedy in the event of a breach of the warranties by the seller. This article considers some of the risks as well as the advantages that can result from a nil recourse transaction, particularly from a W&I claims perspective.
Insurers tend to treat a nil recourse transaction with a degree of caution as the fact that the seller has “no skin in the game” gives rise to the risk that it may not be incentivized to carry out a thorough disclosure process (with the result that known issues may not be revealed to the buyer) or negotiate the warranties as hard as it might otherwise (with the result that the buyer may have a better chance of successfully establishing that there has been a breach of warranty). It is important that this risk is properly managed at an underwriting stage and, for this reason, insurers will typically scrutinise the disclosure process and the negotiated position on the warranties more closely and insist that the deal proceeds as if the policy was not being put in place. Further, in these situations, the insurer is less likely to agree to a low retention under the policy in order to provide it with added protection.
In the event of a claim under the policy, part of an insurer’s investigations may extend to making enquiries with the seller in situations where the warranty that is alleged to have been breached is qualified by the seller’s awareness (albeit, where the seller is a company, the transaction documents will typically state that the seller is deemed to have the awareness that it would possess if it made due and careful enquiry of specific individuals, usually comprising those directors and employees who report directly to the seller in relation to the relevant items being warranted). The risk for an insurer, particularly so far as nil recourse transactions are concerned, is that a liability free seller has little incentive to co-operate (or to encourage others to do so) which may impact on the quality of its coverage investigations.
However, a nil recourse transaction does remove a potential difficulty for an insurer when it comes to considering whether it can pursue a fraudulent seller to recover, via a subrogated claim, the losses that it has paid out to the insured (i.e. the buyer) under the policy. This is because of the difference in a buyer’s typical approach to a breach of warranty claim depending on whether the seller has retained any liability under the transaction documents or not (as illustrated below).
Where the deal has not been structured as a “nil recourse” transaction, it is common for the buyer to pursue a claim both against the seller under the transaction documents (up to the limit of its liability cap) and against the insurer under the policy. The seller will often look to settle the claim against it quickly on a “full and final” basis. The motives for this can vary and do not necessarily reflect a belief that the buyer has a good claim. In our experience, there are often commercial factors behind such a step. For instance, the seller could be part of a management team that is staying on with the target post completion. In this situation, a dispute could be disruptive to the business. Alternatively, the seller may be in the process of being wound-up following the sale. The buyer’s claim may hold up this process and thus prevent the proceeds of sale from being distributed to the shareholders. A view may be taken, therefore, that a quick settlement is desirable. Further, where the seller’s liability is capped at a relatively low amount, it may undertake only limited investigations before settling the claim against it. However, regardless of the motives behind it, a full and final settlement between the buyer and seller gives rise to a difficulty for the insurer because it will be bound by the settlement thus extinguishing any subrogation rights that it may have obtained against the seller in due course. This is because the insurer is placed in the position of the insured when bringing a subrogated claim and it is not entitled to exercise rights that are not available to the insured. This can create a tension between a buyer who wants to complete a settlement with the seller and an insurer who would like to keep open the possibility of a subrogated claim, at least until it can satisfy itself that there is no evidence of seller fraud. The ideal solution in these circumstances is for the settlement between the buyer and seller to carve out fraud, but this is unlikely to be accepted by the seller who will want to have certainty that it faces no further liability in return for making a payment. The reality, therefore, is that, in many instances, the only remedy that an insurer may be left with is a possible claim against the insured for having prejudiced its position in the event that it later emerges that there is evidence of seller fraud. However, this is not an attractive option for an insurer and the best course of action is to try and avoid such a situation arising in the first place by considering the issue of seller fraud at an early stage and raising any concerns with the buyer before it enters into a settlement with the seller with a view to discussing ways in which the insurer’s potential right of subrogation might be preserved.
Where the deal has been structured as a “nil recourse” transaction, it is common for the buyer to pursue a claim against the insurer under the policy only. Whilst it would be open to the buyer to pursue the seller too, the fact that it would have to prove fraud in order to bring a successful claim means that, in practice, this is rare. In these circumstances, the difficulty highlighted above does not arise. The insurer will, in the event that it makes a payment under the policy, be free to pursue a subrogated claim against the seller. Of course, fraud is not an easy hurdle to prove and it is not an issue in many breach of warranty claims, but the fact of the matter is that warranty and indemnity insurance is not immune from the risk of an unscrupulous seller deliberately withholding material information from the buyer. An insurer’s potential right of subrogation is, therefore, an important, if seldom used, tool at its disposal in the event that it makes a payment under the policy and the fact that nil recourse transactions, where the risk of seller fraud is arguably higher, are likely to result in a greater freedom to exercise this right compared to when the deal has not been structured in this way will be of some comfort to warranty and indemnity insurers.
