The use of warranty and indemnity Insurance in commercial transactions has grown considerably in recent years. In particular, “Buyer Side Policies” have become prevalent. In this Corrs In Brief we examine how Buyer Side Policies operate, and explain that the position of the Insurer may actually be far stronger than many may realise. This can give rise to risks for both the Buyer and the Seller.
WARRANTY AND INDEMNITY INSURANCE IN COMMERCIAL TRANSACTIONS
In recent years, warranty and indemnity insurance (WI insurance) has been developed as a product to mitigate and apportion risk in commercial transactions. Wi insurance can provide cover to Buyers and Sellers in respect of warranties given by a Seller in a commercial transaction such as a Share Sale Agreement. The products available are Buyer Side Policies and Seller Side Policies.
Buyer Side Policies: A Buyer Side Policy provides cover to a Buyer if there is a breach of the warranties given by a Seller. Effectively, the intention is that the Insurer will step into the shoes of the Seller and become liable for any breach of the specified warranties. Of course, this is subject to any terms of the transaction document and the WI Insurance policy.
Seller Side Policies: A Seller Side Policy provides cover to a Seller for a Breach of Warranty. While this type of policy may provide some comfort to a Buyer that there is a solvent insurer standing behind a Seller, the Buyer does not have direct recourse under the policy.
BUYER SIDE INSURANCE – RISKS FOR THE BUYER
In our experience, the use of Buyer Side Policies is becoming increasingly prevalent.
One reason for the growth in the use of Buyer Side Policies is private equity sales. Private equity sellers often wish to limit their exposure on the sale of an asset. In order to achieve this, sale transactions are structured on terms which provide that the Buyer’s sole recourse for the breach of a Seller’s warranty will be under a WI insurance policy.
Additionally, Buyer Side Policies can be attractive to Buyers, as there is often uncertainty surrounding the ability to recover from a contractual Seller if there is a breach of warranty.
However, there are risks for a Buyer in limiting their recourse to a Buyer Side Policy. This is because it may be more difficult to recover from an insurer for a breach of warranty than it otherwise would be from a Seller in the absence of insurance.
THE POSITION OF THE WI INSURER
An understanding of the risks associated with a Buyer Side Policy starts with an explanation of the position of the WI insurer.
Typically, a Buyer Side Policy will provide cover to a Buyer for specified warranties given by a Seller. These warranties may include express warranties in relation to assets and employees. They may also include more subjective warranties, such as warranties which state that, as far as the Seller is aware, there are no misleading statements contained in due diligence materials. At first glance, a Buyer Side Policy places the WI insurer in a position where it must provide cover to the Buyer in respect of a wide range of Sellers’ warranties.
The position of the WI insurer may be further constrained by the fact that a Buyer Side Policy generally also contain limitations on the right of a WI insurer to exercise any rights of subrogation against a Seller unless there is fraud. If this were not the case, then once the WI Insurer had paid out a Buyer, it could step into the shoes of the Buyer and pursue the Seller. This would be inconsistent with the Buyer’s sole recourse for a breach of warranty being under the WI insurance policy.
The WI insurer’s position is also potentially compromised by an inability to carry out proper due diligence and investigation in order to assess the risk. Admittedly, WI insurers will be given access to the Buyer’s due diligence investigations and material so that they can conduct some limited due diligence. However, in our experience, this often occurs over a shorter period of time towards the end of a transaction.
POLICY TERMS WHICH PROTECT POSITION OF THE INSURER
In light of the above, it is not surprising that Buyer Side Policies often contain a number of exclusions or limitations which protect the position of the WI insurer. These exclusions and limitations may involve the following:
The WI insurer will only be liable if the Seller would have been liable under the transaction document. This means that the WI insurer will have available to it all of the defences, exclusions and limitations that would have been available to the Seller, if recourse was available against the Seller under the transaction document;
The WI insurer may be concerned about the risk that it is warranting information given by the Seller. As a result, Buyer Side Policies may contain additional exclusions in respect of any forecasts, predictions or other specific information referred to in the warranties (over and above any exclusions or limitations that exist in the transaction document);
The WI insurer will impose obligations of disclosure on the Buyer. The Buyer will be asked to confirm that it is not aware of any potential breaches of warranty prior to the policy commencing. The policy may also go further, and ask the Buyer to confirm that it is also not aware of any issues that will be relevant to the insurer’s assessment of risk prior to the inception of the policy; and
Obligations may be imposed on the Buyer to mitigate any loss suffered as a result of a breach of warranty post completion. The WI insurer may also argue that this obligation extends to the proper conduct of the due diligence process prior to completion.
These exclusions and additions can put the WI insurer in a stronger position than a Seller under the transaction document. This will mean that the WI insurer will be in a stronger position to defend any warranty claims.
LAYERED POLICIES FURTHER COMPLICATE THE POSITION OF THE BUYER
If a large amount of WI insurance is required for a transaction, it is likely that a range of insurers will provide cover. This is achieved through layered policies, which comprise a primary policy and then excess layers which sit above that policy.
However, excess policies typically contain a term providing that an excess insurer is not required to pay any amount in respect of the claim unless the policies which sit below the excess insurer’s policy have been exhausted.
Where a claim is made under a “tower” of layered policies, this can give rise to difficulties for a Buyer, as the excess insurers may claim that they do not have to provide cover until the primary insurer has exhausted its cover. This kind of structure can make it challenging for a Buyer to negotiate a global settlement of a warranty claim with all insurers.
THE PROBLEMS OF THE BUYER MAY BECOME THE PROBLEMS OF THE SELLER
The challenges for Buyers identified above may cause a Buyer to look for recourse against the Seller in the event that there are difficulties claiming against a WI Insurer under a Buyer Side Policy.
The fact that there is a an agreement that the Buyer’s sole recourse for breach of warranty will be under a Buyer Side Policy will not of itself prevent a Buyer from bringing an action against a Seller for misleading or deceptive conduct under the Australian Consumer Law. Such a claim may become attractive when a Buyer Side Policy does not provide readily accessible or enough cover for the loss claimed.
This means that a Seller may still face an exposure, notwithstanding the existence of a Buyer Side Policy (for which it may well have paid the premium).
KEY LESSON – BUYERS AND SELLERS SHOULD APPROACH WI INSURANCE CAUTIOUSLY
The lesson for Buyers outlined above is that a WI insurer is likely to have a greater opportunity to defend a warranty claim than a Seller would under a transaction document.
Indeed, if a sale transaction is structured in such a way that the Buyer’s sole recourse for a breach of warranty is under WI insurance, a Buyer may actually face greater hurdles in recovery under WI insurance than it would face in a claim against the Seller. A Buyer will be facing a dispassionate and experienced litigant with many defences available rather than a Seller who may have reputational issues in respect of the claim.
Therefore, a Buyer should carefully review the terms of the sale contract and the WI insurance policy before completion so as to ensure as much as possible that the Insurer will not have additional rights to defend a warranty claim over and above those available to a Seller under the sale contract.
Of course, WI insurers will resist this. But what often goes unnoticed is that Sellers actually have a stake in this. The fact that WI insurers may have greater rights to defend a warranty claim may only encourage a Buyer to pursue a claim against the Seller and related parties directly, in conjunction with any insurance claim.
Although WI insurance is becoming a more increasingly used product, there is little case law guidance on the interpretation of WI insurance policies. The recent Asahi litigation which involved nearly all of the above issues was settled without any judgment.
Nevertheless, it seems obvious that Buyers should approach WI insurance on the basis that the position of the WI insurer can often be stronger than they anticipate, and that it may be preferable to have recourse against a solvent Seller.
At the same time, a Seller should approach WI insurance on the basis that the strength of the WI insurer’s position may mean they are not removed from exposure to direct claims in relation to the transaction.
In all cases, it is clear that the position of the WI insurer should not be underestimated or overlooked. The policy documents and their interaction with the sale documents should be carefully reviewed.