While warranty and indemnity insurance has been available in Australia through specialist insurance brokers for a few years, many advisers in the private equity and mergers and acquisitions space are unaware of the mechanics of these policies and do not appreciate the commercial benefits capable of being obtained for both buyers and sellers, through these policies.

Anyone ever involved in a significant sale or acquisition of either a business or of shares in a company knows that some of the most heated disagreements (which sometimes result in deals falling over) revolve around the scope of warranties to be provided by a seller, the minimum thresholds for warranty claims to be made, the maximum liability caps for a breach of warranties and the duration of those warranties.

A corollary to this issue is the discord that regularly arises between buyers and sellers relating to escrow amounts and escrow periods.

What are some practical benefits for both buyers and sellers?

Having a warranty and indemnity insurance policy in place can significantly “de-risk” a transaction for both buyers and sellers.

A comprehensive policy in place may avoid the need for a seller to provide a guarantor of the seller’s obligations under the sale agreement, which would be of significant value to the principals (“behind”) the seller.

A policy would also provide a buyer with a sense of comfort, knowing that the provision of a warranty is as only as “comforting” as the asset backing of the seller providing the warranty.

Further, if there are “passive sellers” from whom the buyer is insisting on the provision of warranties (which they are unwilling to provide as a consequence of their lack of involvement in the selling entity) having a policy in place can give these sellers the comfort required to provide the warranties sought enabling the transaction to proceed.  This may also ameliorate the need for the sellers to reach their own independent “selling pool arrangement” to satisfy the demands of the buyer, where there are some reluctant sellers who are unwilling to provide the warranties sought.

Sellers can take comfort that post-sale, with this type of insurance in place (absent any fraud on the part of the sellers) they can expend the sale proceeds with little cause for concern that the buyer can pursue them for breaches of any warranties provided.

This type of insurance however is not a complete panacea for reasons outlined below.

What residual liability does a seller have?

What is lost on many practitioners in this area is that a warranty provided by a seller has a dual characterisation, namely:

  • as a collateral obligation or promise to the other party (which is a warranty); and
  • as a representation to the party to whom the warranty has been provided.

If a seller breaches a warranty, while the buyer would have a breach of warranty claim against the seller, the buyer would, in addition, be able to bring a misleading and deceptive conduct claim arising from the same breach under the Competition and Consumer Act 2010 (formerly the Trade Practices Act) (“CCA”) which cannot be lawfully excluded from an agreement.

While the buyer may make a claim under its warranty and indemnity insurance policy in circumstances where there is a breach of warranty covered by the policy, the buyer could, if it wished (for example in circumstances where either the minimum threshold warranty claim was not met or if the breach of “warranty” took place beyond the warranty limitation provided for under the policy) bring an action against the sellers utilising the “misleading and deceptive conduct” provisions provided for under the CCA.

How do you ameliorate the dual characterisation of a warranty as a representation?

The warranties that would normally be sought by a buyer under a sale agreement can (subject to agreement) be “converted” into indemnities, which would compel the buyer to look to the insurer alone, where an event gave rise to an indemnity claim under the sale agreement.  If indemnities alone are provided by sellers, this would preclude the buyer from looking to the sellers in respect of that claim, as an indemnity in and of itself, is not a representation enabling the buyers to pursue the sellers for misleading and deceptive conduct.

While traditionally, insurers specialising in warranty and indemnity insurance have only insured Liquidators that do not wish to provide any warranties (for obvious reasons) to the buyers of the business that they have been appointed the Liquidators of, insurers in this area are becoming more comfortable with issuing indemnity insurance policies to other sellers – including those that were actively involved in the operation and management of the business being sold.

How does warranty and indemnity insurance impact upon due diligence?

The insurer will generally inspect the contents of the online data room and all due diligence reports prepared by a buyer in relation to the prospective acquisition.  The scope of the due diligence and the matters which impact upon the buyer’s risk which the due diligence reveals will obviously have a bearing on the insurer’s desire to insure the transaction and the premium payable in respect of the policy. Buyers contemplating this insurance cannot simply rely upon a policy of this nature and must still undertake extensive due diligence in respect of the prospective acquisition failing which, warranty and indemnity insurance may be unavailable.

How are the policies structured?

It is important that extensive contractual provisions relating to the party’s rights and obligations in relation to the policy be clearly set out in any sale agreement.

Further, all warranty and indemnity insurance policies, while following similar “themes”, are not the same and it is possible to negotiate amendments to these policies through the specialist brokers that procure this type of insurance.

The insurer’s right of subrogation from a seller’s perspective is possibly the most important provision in the policy, as the seller is generally not a party to the policy, it is imperative that the buyer hold the benefit of the contractual promises provided by the insurer to the buyer in relation to its subrogation position, on trust for the benefit of the seller.

Summary

A properly designed warranty and indemnity insurance policy, together with appropriately drafted contractual terms in a sale agreement between buyers and sellers, when combined with a comprehensive due diligence process, can, in addition to saving significant time in negotiating the terms of any sale agreement, provide both buyers and sellers with the comfort and protection needed to proceed with transactions that they may not, absent such insurance, be prepared to proceed with.