W&I insurance has increased in popularity in recent years. This briefing considers W&I insurance from a buy-side perspective, including when W&I insurance coverage may be most relevant for buyers, as well as practical and legal issues relating to, and the process for arranging, a buyside W&I policy.
Warranty and indemnity (W&I) insurance provides cover for losses arising from a breach of a warranty and claims under a tax indemnity (and, in certain cases, other equivalent provisions) in connection with a corporate merger or acquisition (M&A) transaction. The warranties given in the sale and purchase agreement (SPA) play an important role in the transaction. Properly drafted, they aid the information gathering process and clarify the position of the target company by requiring disclosure of certain key characteristics and issues. Failure properly to disclose against warranties can result in large compensation claims enabling the purchaser to recover the diminished value of the company it has purchased.
W&l insurance has increased in popularity over the past 5-10 years. Initially viewed as too expensive and inflexible, it has developed an increasingly solution driven approach. Brokers and underwriters have recruited M&A specialists (including financial advisers and commercial lawyers) making product and policy negotiation more adaptable to deal requirements and more compatible with deal timelines. Initially found only in the UK, US and Australia, W&l insurance has developed an increasingly global reach, with a growing presence in Asia, Africa and the Middle East. The advent of the ‘buyside’ policy in recent years has provided greater certainty for buyers, and this has arguably resulted in an increase in the use of W&l insurance.
The warranties given in a SPA are often heavily negotiated and form one of the most contentious parts of a transaction. Under heavy negotiation and time pressure, there is always the risk that factual matters are overlooked during the disclosure process that could lead to a claim for breach of a warranty. There are a number of reasons why a buyer may seek to gain additional protection by taking out W&l insurance, these are explored further below.
Reasons for coverage
Buy-side W&l insurance is particularly relevant where the buyer doubts the seller’s financial standing post-closing of the transaction, or the seller caps its exposure at a lower level or insists on a shorter claim period than the buyer is prepared to accept. Specific scenarios in which the buyer may seek coverage include where:
- the seller(s) consist of either: individual selling shareholders, a financial investor such as a private equity house, employee trusts or liquidators acting in trust. The seller(s) may be unwilling (for example, a financial investor) or unable (individuals) to assume liability over a certain nominal amount for a breach of commercial warranties given;
- the seller requires a ‘zero recourse’ policy such that all of its potential liability under an SPA is offset. On a ‘zero recourse’ policy, the excess/retention (discussed below) will still apply but the buyer will not be able to recover these amounts from either the seller or the insurer (the buyer will only recover for any claims which exceed the amount of the excess/retention). ‘Zero recourse’ policies are common in certain jurisdictions (for example, Australia). While this ‘zero recourse’ concept is less common in the UK (and is not expected to become commonplace), W&I coverage on a ‘zero recourse’ basis will in appropriate circumstances be available in the UK;
- the seller is only willing to provide the warranties for a limited amount of time (e.g. 12 months) and the buyer requires/wishes to have a longer time period in order to detect and report problems that it may discover in the target;
- the sellers represent the management of the target company and the buyer wishes to protect the ongoing business relationship post-closing;
- the additional comfort of adequate warranty coverage is required for debt financers of a transaction;
- a potential buyer wishes to appear more attractive in an auction bidding process for the target. Buy-side warranty coverage results in less sell-side exposure and would therefore be beneficial to the seller of the target.
Exclusions need to be carefully reviewed
As with other insurance policies, careful consideration needs to be paid to the wording of the insurance contract, particularly the exclusions and conditions. W&l insurance aims to offer as close as possible to ‘back-to-back’ cover with the warranty language in the SPA. However, insurers will seek to exclude warranties and/or areas of risk that they do not deem appropriate for their policy. A list of some of the most notable exclusions is included in the FAQ section below. Not all exclusions are uniform across insurers and it is important for a buyer seeking a policy to look past the price being offered to ensure the areas they believe to be important are included in the policy that they choose. A buyer should ensure that the insurer has not carved out risks that are material to that transaction.
Insurance is not a ‘guarantee’
It is important that the prospective buyer understands that an insurance policy is not equivalent to a guarantee for a number of reasons.
First, W&l insurance will not offer complete protection against all costs that may be involved in bringing a claim under the policy. The buyer will initially need to show that the claim brought falls within the insurance coverage, and initial research costs and time issues (or, indeed, resolving any disagreement with insurers as to coverage) will not be covered by the policy. Most insurers include a de minimis (i.e. small claims) amount within the policy which corresponds to the equivalent provision in the SPA.
Second, there will be a policy attachment point before the policy takes effect. A party (typically the seller but sometimes the buyer) will be expected to bear some financial risk and therefore suffer some loss before the policy provides cover. The attachment point is not uniform across insurers and is a variable subject to negotiation and price, but the starting point is typically around one per cent of the transaction value as a rule of thumb.
The first tranche of risk (or ‘deductible’) is typically reflected in a seller escrow, designed to ensure the seller is focused on due diligence. The policy starts to pay once claims exceed the escrow. The effect is that the buyer has to ‘finance’ the deductible (unless the seller pays out) before the policy kicks in, and then recovers/refinances after that.
Finally, as with any commercial insurance policy, there is a duty on the insured (i.e. the buyer) to disclose all material facts to the insurer. Failure to do this could result in the policy being unenforceable.
Proper due diligence
There are a number of legal issues that should be addressed when considering buy-side insurance. W&l insurance is designed to cover unexpected issues that arise after a deal has completed; however, this assumes that the buyer has performed thorough due diligence (both financial and legal) into the target rather than relying on the policy it is considering buying (and that the seller has carried out a thorough disclosure exercise – it will help in this context if the seller has retained some ‘financial skin in the game’). Insurers will expect that there has been a balanced negotiated agreement and that the due diligence exercise has been robust and complete. Indications that the due diligence process has been skipped or over rushed could lead to a high premium, lowering the scope of the coverage or denial of a policy entirely.
Key indicators of a thorough disclosure process include:
- full and proper disclosure of all material documents relevant to the business;
- all senior management and the target companies’ directors being given the opportunity to read, consider and make due enquiries about each of the warranties contained in the SPA and ensure that any breaches of the warranties are disclosed in writing to the buyer;
- access to a well ordered and complete dataroom (including all corporate documents of each target entity);
- formal Q&A process undertaken in writing on queries raised during the due diligence process with adequate answers to each of the questions raised (any indication that an answer to an issue is to take out W&l insurance will be treated with great suspicion by the insurer); and
- a detailed disclosure letter (ideally dealing with each warranty in turn and giving relevant disclosures where applicable).
The seller’s ‘knowledge’
Knowledge qualification of certain warranties given by the seller plays an important role in the scope of that warranty given. The insurer will expect that a number of warranties (such as pending or threatened litigation) are given such qualification. Warranties qualified by knowledge is a position favourable for the seller. This limits the warranty by reference to the knowledge of the seller at the time the warranty was given. It is important to review the definition of ‘Knowledge’ in the SPA as, depending on the negotiations between the parties, knowledge may include the knowledge that certain parties would have after ‘due and careful enquiry’. If such wording is present, a breach of such warranty could be argued if the seller feigns ignorance to circumstances that would have been clear if it had made such enquires.
The buyer’s knowledge
Insurers will also be unwilling to provide coverage against circumstances that were within the buyer’s knowledge before it entered into the transaction. A buyer cannot therefore enter into a transaction knowing that there was an issue in respect of which it intended to bring a claim. The practical implication of this is that a buyer will never be able to bring a claim in relation to a matter which was disclosed by the seller, or which it discovers during the due diligence process.
Arranging the policy (the process)
An insurer will need to consider and review a number of things when deciding whether to provide a W&l policy for a transaction. One successful claim could result in a multi-million pound pay out and potentially wipe out the insurer’s book of premium. Most critically the insurer will need to understand: the transaction, the nature of the negotiations re the warranties and the thoroughness of the disclosure and due diligence exercise.
The insurer will typically achieve this by instructing external legal counsel to:
- review the disclosure process;
- review the due diligence process and due diligence reports;
- review the SPA and disclosure letter; and
- comment on any other transaction specifics that appear abnormal.
Ideally, the documents (most notably the SPA) will be in a final form prior to the instruction of counsel; however, if the transaction negotiations are still on-going, additional cost may be incurred by counsel having to review and comment on updated draft documents.
Counsel will typically prepare a report for the insurer, summarising its position on the warranties, the due diligence/disclosure exercise and any material areas of concern.
Following this report the insurer will host an underwriting call (typically between 1 hour – 2 hours) between all transaction advisers on the deal and other relevant parties (e.g. other insurers if there are multiple layers of insurance). The insurer will seek clarification from the buyer and buyer’s advisers as to how they got ‘comfortable’ with transaction issues that have been discovered. These explanations will aid the insurer in determining whether there are any further risks to the deal requiring additional policy wording and ultimately if the policy can be offered and issued.
Following negotiations on the policy wording, the insurer and the insured will execute the policy and give the date at which the insurer is ‘on-risk’ for any claims that are received. This risk period will end on the limitation time period of the SPA (or policy if different).
Frequently Asked Questions
How much will a W&l policy cost and what are the influencing factors?
W&l insurance is paid via a premium, payable in full when the policy is taken out. Typically a premium is calculated as a percentage of the total limit of insurance coverage (known as the ‘rate on-line’) ranging from 1-3% (but the average of buy-side premium has recently tended to be around 1.3% including insurer’s and brokers’ costs). Factors which may affect the level of premium include: amount of excess, limitations on the warranties in the SPA, industry sector, geographic risk (for example Australia attracts lower rates than the US), identity and credit worthiness of the parties to the transaction, complexity of the transaction and competence of the transaction advisers.
Can a policy be bought after the transaction has completed?
Yes, although a policy is typically bought prior to completion to ensure that the risk is covered as soon as the transaction has occurred, a policy can be bought after completion. This is viewed favourably by insurers (assuming the risk is unknown and insurance is not being sought for something that has been discovered) as it indicates that the parties were happy to complete without the insurance ‘safety net’ and thus suggests that a full due diligence has taken place.
Is it possible to extend the coverage period?
Yes, a main advantage of W&l insurance is that it can extend the warranty coverage period past the limitations set in the SPA. This may provide additional comfort to a buyer that is unable to negotiate a longer period of warranty coverage against the seller. Typically, insurers will be willing to provide coverage on fundamental warranties for a period of 7 years, general warranties between 2-5 years and tax warranties to the statutory time limit for such claims.
How long does the process take?
Insurers will work to tight deadlines in order to minimise the commercial impact of the transaction; however, from initial indicative offering to policy inception a minimum period of around 7 days is required and typically will be 2 to 3 weeks.
What are the likely exceptions that will be excluded from policies?
Insurers will not cover all of the warranties in the SPA (note, different insurers will exclude different risks). Typical warranties that insurers may not cover include: bribery and corruption, certain environmental issues, certain regulatory issues and financial warranties (including ‘leakage’) and pensions underfunding. In addition, the policy will not provide coverage for certain tax risks such as those resulting from transfer pricing arrangements.
If insurers are unwilling provide coverage it may, however, be possible to purchase additional specialist cover for such warranties.
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