Warranty and indemnity insurance (W&I) provides cover for losses arising from a breach of a warranty in a corporate transaction such as a merger or acquisition transaction.
Use of W&I is on the rise, across Europe including Italy. Initially driven by the demands of private equity funds in high value deals, it is now common in deals of all sizes involving all types of buyers and sellers.
To foster the long term success of the product, W&I claims handling must be consistent and predictable, and judicial and arbitration authorities must adequately respond to the challenge of providing guidance for the most complex issues.
In Italy, jurisprudence on matters of W&I coverage and the assessment of losses for breach is still rather scarce. Moreover, the few decisions that have been handed down tend to generate more concern than practical guidance. In fact, they demonstrate an underlying lack of understanding of the fundamentals of the W&I product.
For example, in a recent case, arbitrators were called on to assess the insurers’ liability under a W&I policy taken out in connection with the purchase of a target company engaged in the energy services business (in particular, the operation, maintenance and contracting related to heating systems provided to residential customers). During the due diligence exercise, the Seller had informed the Buyer that the Target applied VAT to energy supply contracts at a reduced rate, based on the position that such contracts were subject to a preferential tax treatment available for energy saving programs.
The Buyer investigated the accuracy of this position. It obtained from the Seller the minutes of a tax inspection carried out on the Target by the Italian Tax Police (Guardia di Finanza) two years earlier. In those minutes, the Tax Police expressly stated that the application of the reduced VAT rate to the energy supply contracts complied with the relevant tax laws.
The question of the application of a reduced VAT was thoroughly considered by the Buyer’s tax advisors, who flagged that the legitimacy of such fiscal practices was debatable. In fact, they advised that, notwithstanding the favourable outcome of the assessment of the Tax Police, there was still a risk that in the future the Revenue Agency might reconsider the position, which, if modified, would give rise to a situation where the Target would be obliged to pay a considerable amount in respect of the unpaid tax payments as well as fines.
The sale and purchase agreement (SPA) subsequently signed between the Seller and the Buyer provided that the Seller’s liability for breach of the Seller’s representations and warranties was generally excluded in the event that the facts or circumstances constituting the breach of any of the Seller's representations and warranties were fairly disclosed in the due diligence exercise. The Seller’s representations and warranties included a fairly standard tax warranty.
The Buyer took out W&I coverage for this acquisition transaction. The policy’s terms and conditions included a standard exclusion for losses arising out of circumstances known to the buyer. With reference to the tax warranty, the policy’s spreadsheet marked it as “partially covered”, with certain subjectivities not relevant to the case at hand.
Following the acquisition, the Target was served by the Revenue Agency with a demand for payment of several million Euros, for having wrongfully applied a reduced VAT rate to energy supply contracts.
The claim was reported under the W&I policy but dismissed by the Insurer on the grounds that the Seller’s liability was not triggered, since the loss originated from facts that were fairly disclosed during the due diligence exercise. The insurer also raised further grounds for denial of cover.
The dispute was brought before an arbitral tribunal. Even though the claim made by the insured was for a large part dismissed on the basis of other objections raised by the Insurer, the arbitrators found in favour of the buyer/insured on the issue of the application of the “fairly disclosed fact” exclusion of liability.
On this specific issue, it was determined that even though “(Translated from the original in Italian) the issue pertaining to the correctness of the application of reduced VAT was certainly known to the Buyer and had been discussed between the parties… this does not allow to conclude that any possible liability be excluded in respect of losses originated from this issue, since no specific exclusion was included in the Tax Warranty set forth in the SPA… nor in the Policy spreadsheet. According to an interpretation which accounts for the reciprocal meaning of the clauses, we shall conclude that the generic exclusion of any Seller’s liability in respect of circumstances made known to the Buyer has a lower structural weight than the specific tax warranty”, which shall then prevail.
“Both parties knew that in the past the issue was raised and positively resolved by the Tax Police, but they did not follow up on this with an – at least express – derogation to the representation that the Target had always complied with the fiscal laws… it is one thing to be aware that a certain past behaviour could possibly be risky; but it is another matter to conclude, from such a fact, of the ineffectiveness of a specific and clear representation of compliance with fiscal laws.”
This decision raises an important question. It is counterintuitive to say that the more a fact is discussed and analysed by the parties with the assistance of their experts, the less the exclusion of liability for losses arising from fairly disclosed facts is relevant.
Indeed, following the award’s reasoning one might ask: What is the purpose of including the “fairly disclosed facts” exclusion both in the SPA and in the W&I policy, if such a generic (or rather general) clause shall always give way to any of the Seller’s representations, by definition more “specific” in its content?
It would be unreasonable to suggest that, in the last, generally hectic, days of negotiation, the Seller and the Insurer have the duty to list all of the issues discussed in the course of the due diligence exercise, and to specifically carve them out of the scope of the representations and warranties and W&I liability clauses.
In another dispute currently pending, the factual circumstances from which a loss originated were disclosed to the buyer, whose advisors however failed to spot a critical issue, which then caused a loss. In the dispute which followed with the W&I insurer in respect of coverage for this loss, the Insured argues that the “fairly disclosed facts” exclusion should not apply since the risk that occurred was not envisaged during the due diligence discussions.
As we await to see how this second matter develops, one solution which we would encourage firms to consider for the sake of clarity, is to apply the “fairly disclosed facts” exclusion only with reference to the awareness of factual circumstances and the risks connected thereto. The assessment of those risks falls within the exclusive responsibility of the Buyer and its advisors.
Usage of W&I insurance continues to grow and it is in the best interests of all providers to be focused on the sustainability of the product, which includes a shared understanding of its fundamental features above and beyond the interest of the party in any peculiar case.
