International Restructuring Newswire
This issue features articles from four different countries of the Norton Rose Fulbright network.
Warranty and indemnity (W&I) insurance provides cover for losses arising from a breach of a warranty and claims under a tax indemnity arising from a merger or acquisition (M&A) contract. Over the past few years, this insurance product has matured with buyers gaining a better understanding of the benefits and how the product works.
This has led to a remarkable increase in M&A transactions making use of W&I insurance. Some statistics show that in 2017, 47 per cent of private equity sales and 27 per cent of all other deals in Europe had W&I insurance as part of the deal. This has increased since then.
In South Africa, however, this picture is somewhat different. Generally, M&A lawyers do not have favourable views of the product, largely because it is misunderstood. The fact that W&I underwriters who work on South African deals do so mostly from London, does not assist the South African market gaining insights as to the benefits of the product. This is slowly changing as there appears to be a growing interest and understanding of the benefits of making use of W&I insurance in South Africa.
AIG has reported that in 2019, claims notification frequency increased from 21 per cent to 26 per cent for deals ranging between USD500 million and USD1 billion. Put differently, the larger and more complicated the deal, the more frequent the claim notifications have become. Their data further revealed that the severity of claims have also increased from 8 per cent to 15 per cent, with claims valued at over USD10 million doubling, and one in five deals resulting in a claims notification.
The study further indicates that the majority of claims notifications arise from breaches of warranties and indemnities of financial statements, tax, compliance with laws and material contracts. From a tax perspective, tax breaches continue to dominate in Europe, the Middle East and Africa, and span a wide variety of issues, led by corporate income tax (34 per cent), employment taxes (23 per cent) and inter-group arrangements (6 per cent). It may appear unusual, given the nature of the international deals taking place, that only 6 per cent of breaches relate to inter-group arrangements. What must be kept in mind, is that W&I insurance does not cater for every type of warranty and tax indemnity contained in the transaction agreements, and typically will exclude any transfer pricing risks from cover, such as management fees between group companies, as well as other exclusions relating to inter-group arrangements.
74 per cent of claims are brought within the first 18 months from the date of the policy inception, with an estimated 29 per cent of those claims being brought within the first six months. An increase in the claims frequency, coupled with a competitive market, has resulted in a decrease in profits for W&I underwriters, which may necessitate an increase in the cost of insurance premiums.
With the increase in claims notifications, together with the statistics relating to breaches of warranties and indemnities, it is understandable that we have seen an increased interest in W&I insurance products in South Africa, as well as globally.
Legal advisors acting for the purchaser or the seller in M&A transactions are not always privy to the goings-on behind the scenes when the underwriting decisions are made as to whether or to what extent it is viable to provide coverage.
In considering which warranties and indemnities should be covered by the W&I policy, Norton Rose Fulbright (as appointed legal advisors for the W&I underwriters), will look at whether each warranty has been subject to a due diligence and whether the scope of the due diligence matches the scope of the warranty. This inevitably means that a warranty that is not capable of being fully diligenced will usually not attract coverage. There are, of course, exceptions. For example, most warranty catalogues have a warranty for compliance with all laws. While this in itself is not necessarily capable of being diligenced, one can examine the compliance systems and structures in place within an entity. The effectiveness of this compliance system would ultimately mean a decreased risk which would in turn be favourable for coverage.
Once we have undertaken the necessary reviews, our advice culminates in a recommendations report setting out the reasons for including or excluding certain warranties and indemnities from coverage. At this point the underwriters make the decision whether to provide coverage or not.
Two common points of criticism in South Africa are that W&I insurance does not provide adequate cover and that it is too expensive.
The first point of criticism is often a misunderstanding of the insurance product and that it is not meant to replace a proper due diligence investigation of the target. Underwriters expect that the buyers and sellers still properly negotiate the content of the warranties. Looking at this content, the majority of warranties contain wording which relate to the actions and thoughts of third parties, which the warrantors will have no knowledge of. They can provide those warranties, but do so as a risk allocation mechanism, and not because they are comfortable to talk to the actions or circumstances of third parties. Similarly, some warranties refer to future performance of the target. Forward-looking warranties are excluded by underwriters and rightly so because the insurance product is not aimed at protecting the buyers against a bad bargain. Similarly, W&I insurance is not aimed at replacing, but rather complementing other insurance solutions, such as directors and officers liability insurance, professional indemnity insurance, and cyber insurance.
The second point of criticism, relating to costs, is perhaps more understandable given the pressure on the South African economy. But the reality is that one in every five policies attract a claims notification, which testifies to the benefit of the coverage in relation to the insurance premium.
Norton Rose Fulbright, both globally and in South Africa, have long been advising underwriters of W&I insurance coverage. This experience has led us to thinking of the W&I insurance matters much earlier on in the M&A transactions process, which not only affects the way in which we draft and negotiate warranties and indemnities, but also the manner in which we conduct due diligence exercises.
Despite the availability of the product, it is vital that a due diligence investigation is undertaken when considering a deal and ensuring that the warranties and indemnities are adequately negotiated between the parties. When deciding whether a party wants to make use of W&I insurance, the legal advisors counselling the underwriters must ensure that the scope of the due diligence, during the negotiation phase, matches the warranties and indemnities contained in the transaction agreements and correctly identifies the risks pertaining to the transaction.
Of concern is that when providing advice to the underwriters, we often see a large disconnect between the transaction and the actual drafting of the warranties and indemnities. Some internal and external legal advisors will attach a precedent warranty catalogue to the transaction agreements, without tailoring the warranties for the specific target. This leads for example to pages of environmental warranties for a small information technology service company where environmental matters are not necessarily relevant. Considering that the buyers did not see environmental issues as a risk, no environmental due diligence was conducted and yet the legal advisors still expected those environmental warranties to be covered. We have seen several pages of tax warranties included in the transaction agreements, but the tax due diligence was extremely limited in scope and it was clear that the warranties did not speak to any of the findings contained in the due diligence report, or alternatively, warranted aspects had not been diligenced.
It must be remembered that the rationale for W&I insurance is not to replace the due diligence investigation during the negotiation phase, nor is it meant to cover all warranties and indemnities in the transaction agreements. The due diligence and the negotiations which take place prior to the signing of the transaction agreements remain fundamental for M&A transactions. Bear in mind that when we provide coverage advice to underwriters, and critique warranties and indemnities included in the transaction agreements, the level of detail and accuracy expected when drafting warranties and indemnities for M&A transactions result in more bespoke warranties and indemnities tailored to the specific transaction.
Although only a portion of the South African market has had the opportunity to make use of W&I insurance products, the evolution of W&I insurance in South Africa is yet to be seen. The misconception that the product is not worth the money paid for it stems from a misunderstanding the offering and the benefits provided by coverage of certain warranties and indemnities.
It appears that larger M&A transactions which include increased risks for the parties, have spurred an increased interest in South Africa regarding W&I insurance products and the benefits provided when obtaining coverage. Those who have considered W&I insurance, or who have already purchased the product, will most likely have seen the value that the product can offer.
With the increased interest of W&I insurance products in South Africa, we can expect to see a decrease in the disconnect between the warranties and indemnities contained in these transaction agreements, and more bespoke transaction-specific warranties and indemnities being negotiated between the parties.
This issue features articles from four different countries of the Norton Rose Fulbright network.
South Africa’s President signed the National Credit Amendment Act (Amendment Act) into law on Thursday, August 15, 2019.