Article by Dimitrios Galatas
For corporate lawyers, the focus of an M&A deal is ensuring that the deal is legally sound and structured in the best way possible to achieve the client’s financial and business needs, though a trend that has become increasingly common within legal practice concerns itself with what happens once the deal has already been closed.
Warranty and Indemnity (W&I) insurance has become an increasingly common insurance policy to support both the buyer and seller within M&A transactions, with claim notifications for W&I insurance having increased by 300% across EMEA regions since 2016 and with an estimated 3000 deals utilising W&I insurance in 2017. This article will discuss what is meant by W&I insurance, why it has emerged as a popular insurance policy and the legal issues that could potentially constrain its effectiveness.
Upon the selling of a business, various warranties are given to the buyer by the seller regarding the state of affairs of a company. These are contractually binding statements as to the state of affairs of the target company which seek to protect the buyer through encouraging the disclosure of known risks, whilst giving the buyer a legal right to claim damages against the seller if the buyer demonstrates that the warranty was false and that the breach reduced the value of the company at that time. Alongside these warranties, promises to indemnify the buyer for a particular type of future liability, indemnities, are also provided. Warranties and indemnities will be incorporated into the main acquisition vehicle, the sale and purchase agreement, to provide the buyer with a range of remedies to cover financial loss.
W&I insurance is an insurance policy which can be moulded to protect either the buyer or the seller in a transaction against damages which the other party would be able to claim from them regarding breaches of a warranty or indemnity in the contractual documents of the deal (such as the sale and purchase agreement).
The main reason why W&I insurance has increased in popularity is due to its ability to give the seller a clean exit from their company upon closing, with no risk of a warranty claim against them. This clean break would also allow institutional investors (such as private equity houses) to promptly distribute their profits back to their investors. The usage of escrow accounts (where a portion of the deal price is retained until the expiry of the warranty period) also tied the seller to the business for a number of years following the deal, though W&I insurance prevents this from happening; once again facilitating a clean exit by the seller following the sale of the target company. This insurance will also be capable of increasing the value of a transaction – allowing the seller to sell the target company for a higher price – through guaranteeing a form of compensation for the buyer in an event where the sellers would be unwilling or unable to give warranties.
A buyer can equally benefit from W&I insurance if they do not necessarily wish to make a claim against a breach of a seller’s warranty in an effort to preserve their business relationships, particularly if the sellers continue to be employed by the business after the deal, or if the sellers are a management group. W&I insurance also removes any risk that the seller will be unable to compensate the buyer adequately in case of a breach of warranty. Particularly if the acquisition is one that is heavily leveraged, W&I insurance may be used within negotiations with lenders to offer peace of mind that they will be able to claim against a W&I policy to ensure they receive their returns in the case of a warranty breach. Finally, a buyer may utilise a W&I policy to differentiate themselves from other bidders in an auction process. The seller may be willing to accept a lower offer with the certainty that their takings will be available to them as a result of the clean break that W&I insurance offers (as opposed to the aforementioned escrow accounts which tie the seller back).
The main legal issue with W&I insurance can be found in the due diligence process. Whilst W&I insurance is intended to cover unforeseen issues post-deal, it is still crucial that the buyer has completed a thorough and robust financial and legal due diligence of the target company (and the seller has disclosed relevant risks) as opposed to blindly relying on the insurance policy to cover losses. Insurance companies will often charge higher premiums if they see that contract negotiations and the due diligence process have not been conducted to a sufficient standard; even outright refusing to supply the policy altogether or lowering the scope of coverage.
W&I insurance policies also sit alongside the seller’s liability cap. This is a restriction on the buyer’s right to bring a claim against the seller. This can be achieved by putting a cap with regards to value (i.e. the buyer cannot bring a claim unless the value of the claim is over 1% of deal value) or with time (the buyer cannot bring a claim if 6 months have passed since closing). This would mean a stringent negotiation process would have to be undertaken to sufficiently cap the liability of the seller post-deal.
W&I insurance is certainly a recent legal tread which offers many benefits to the current M&A landscape as demonstrated by the rise in claim notifications and the volume of deals backed by W&I insurance. It offers a clean exit for the seller to use their money immediately after closing as opposed to being tied back to the deal through the use of escrows. Regardless, it is important that firms must still operate to the same high standard when undergoing processes such as contract negotiation and due diligence in order to receive the full benefit that W&I insurance has to offer.