Sellers of securities or businesses that give warranties or indemnities bear the risk of losing some or all of the sale price in the event of future claims. For this reason warranty and indemnity clauses are always a focus of M&A negotiations for both buyers and sellers.
Until fairly recently warranty and indemnity insurance (W&I Insurance) was predominantly the domain of larger deals, especially those involving private equity sellers seeking a clean exit from investments. Recently though we have seen an increase in the use of W&I Insurance in middle market transactions. In this article we take a brief look at what warranties and indemnities are and the risks W&I Insurance policies are designed to address. We look at the different W&I Insurance policies available, their benefits and limitations, and raise some points that should be taken into account when considering W&I Insurance.
WARRANTIES AND INDEMNITIES 101
At a basic level warranties and indemnities are a contracted reallocation of risk between parties to a contract. They are a common feature of share or business asset sale agreements.
A warranty is a contractual promise by a party that, typically at a defined point in time, certain facts and circumstances are as they have been represented.
An indemnity is a contractual promise by one party to accept the risk of a loss the other party may incur due to the occurrence (or non-occurrence) of a specific event.
In M&A transactions, it is mainly the seller that provides the buyer with warranties and indemnities and accordingly bears the risks should a warranty or indemnity clause ultimately be triggered.
The consequence of a party breaching a warranty is that the other party has the right to claim damages. An indemnity event will give the innocent party the right to claim compensation on the basis stipulated in the contract. To be successful in a claim for indemnification, the claimant must demonstrate that the event on which the claim is based falls within the scope of the indemnity clause.
W&I Insurance policies insure against the risk of loss flowing from a breach of warranty or the occurrence of an indemnity event by transferring that risk to the underwriter. The two main types of policies in W&I insurance are sell-side and buy-side insurance.
In a sell-side policy the seller takes out the policy which covers it against the risk and potential liability of a buyer’s claim for breach of a warranty or an indemnity given by the seller. This means that, where a seller breaches a warranty or an indemnity event occurs, the buyer must first claim against the seller. The seller then claims against the insurance company to obtain cover to compensate the buyer within the parameters of the W&I Insurance policy. As a result, the buyer, in order to recover, is required first to claim against the seller.
A buy-side policy covers the buyer against the potential loss a seller’s breach of warranties or an indemnity event could cause it. Under this type of policy it is common for the buyer to forego its right to bring an action against the seller (at least in respect of claims covered by the W&I Insurance policy) and limit its recourse to the insurance company alone. One of the benefits for the buyer under a buyer-side policy is that it is not reliant on the seller in the recovery process.
Some benefits of W&I Insurance in M&A transactions follow.
Clean exit: If parties opt for a buy-side policy the seller gets a ‘clean exit’. This means the seller will (usually) be free of any liability arising from a breach of a warranty or an indemnity event. The degree to which a clean exit is achieved will depend upon the scope of cover of the policy including by reason of any exclusions. Fraudulent or wilful conduct is typically excluded.
To ensure the buyer has recourse against the insurer only, it is desirable (from the seller’s point of view) to include an express undertaking in the sale agreement that where a warranty or indemnity clause is triggered, the buyer will only take action against the insurer.
A key benefit for private equity sellers is that W&I Insurance can give them the confidence to close a fund following sale of its assets without the need to ‘wait out’ warranty and indemnity expiry dates before re-deploying or disbursing fund proceeds to investors.
Certainty and practicality: The buyer may feel more secure in closing an acquisition if potential loss from breach of a warranty or an indemnity event is secured through an insurance policy. The financial position of sellers can change significantly following completion and W&I Insurance manages the risk of a seller restructuring, becoming insolvent or simply disappearing.
Preservation of relationships: In M&A, it is not unusual for a founder and key employees to continue as employees post completion. Having W&I Insurance may be a useful tool for managing tension in such situations if claims under the sales agreement subsequently arise. If a claim materialises, the buyer can claim directly against the insurer for the loss suffered and avoid having to take action against the seller personally.
Shallow pockets: In certain circumstances a buyer may be reluctant to continue with a transaction if the seller’s securities or assets are uncertain or insufficient to secure any warranties or indemnities given by the seller. In these cases a W&I Insurance policy can provide the buyer the necessary confidence to complete the transaction.
Pricing risk: W&I Insurance and the applicable premium allows the parties to price the risk of a breach of warranty or an indemnity event in a way they may not be otherwise able to. An insurer, as opposed to a one-off buyer, has a far greater ability to put a price on this risk.
OTHER THINGS TO NOTE
There are a number of factors that both buyers and sellers should be aware of when considering W&I Insurance. These include:
Scope of coverage: Sell-side and buy-side policies will not protect a seller in all situations in which a warranty has been breached or indemnity triggered. For instance, sell-side policies will not provide cover where the breach of a warranty or an indemnity event is the result of a seller’s fraudulent conduct. Buy-side policies will generally cover the buyer where the breach of a warranty or indemnity event has arisen due to a seller’s fraudulent conduct, however the insurer will retain the right to pursue the seller directly. There may also be risks specific to the particular transaction that are identified during due diligence that the insurer is not prepared to cover.
For instance, in a recent W&I Insurance transaction McCabes acted in, the underwriter was not prepared to insure against potential asbestos contamination related risks within the target group or against the possibility of certain family law related claims amongst the vendor group. The underwriter’s position on such deal-specific matters can sometimes become clear only at the 11th hour once final due diligence reports are received by the underwriter, and so parties should be alive to the possibility of last minute discussions about the allocation of those risks.
Risks on agreeing to a full ‘clean exit’ for the seller: From a buyer’s perspective it may be a good idea, depending on the circumstances, to ensure the seller bears at least some risk in the event of a claim. This works to incentivise the seller to make more fulsome disclosure during due diligence and to make some effort to avoid breaching a warranty and prevent the occurrence of indemnity events. W&I Insurance underwriters will typically want access to the parties’ due diligence reports, in part to ensure each party has turned their mind to the circumstances of the target business and that they are not simply pushing all of the risk onto the insurer.
Liability Limits: It is fairly common to obtain warranty and indemnity cover up to an agreed liability limit which reflects the parties’ expectation of what their likely maximum exposure under the sale agreement will be. This is often a percentage of the total purchase price. Typically, the lower the coverage level, the lower the premium.
New Breaches: In M&A transactions, warranties and indemnities are usually given at the signing date and again at the completion date. In the event the agreement provides the seller a clean exit, the seller will not be liable to the buyer for loss as a result of a breach of a warranty or indemnity from the signing date. In a situation where a buyer became aware of an event occurring after signing but before completion, and that event would not constitute a breach of a signing warranty but would constitute a breach of a completion warranty (a ‘new breach’), the buyer will be obliged to disclose this new breach to an insurer and the new breach would be excluded from cover, potentially leaving the buyer without recourse against either the seller or the insurer.
To protect against loss resulting from a new breach a buyer can either include in the agreement a provision stipulating that the seller is liable for any new breach that may arise or seek additional and separate insurance cover for any new breach. It is worth noting that this type of insurance is not provided by all underwriters and, where it is, it is generally costly. Further, such insurance may only cover fixed periods of time. This may be a problem when the period between signing and completion is long or uncertain. From a buyer’s perspective the risk can, to an extent, be managed by retaining a termination right for breach of any material warranty prior to completion.
W&I Insurance has become a valuable tool in M&A transactions and can provide benefits to both buyers and sellers. It is important that the parties, in order that they gain these benefits, have a good understanding of the scope and limitations of any proposed policy and carefully review policy terms to ensure that the policy addresses the risks present in each case. As always, the devil is in the detail, and exclusions, sometimes late policy amendments by the underwriter following review of due diligence reports, can erode the benefits the parties set out to achieve.