This article is taken from GTDT Practice Guide: Germany M&A. Click here for the full guide.

Introduction

Warranties and indemnities (W&I) insurance is an insurance for losses arising in particular from the breach of warranties in sale and purchase agreements (SPAs). A W&I insurance can either be concluded by the seller (seller side) or by the buyer (buyer side).

In the decade since 2010, the product has undergone a rapid development in continental Europe.2 In certain transaction areas, W&I insurance is designated best practice, new normal or market standard.3 Currently, almost 20 insurers and managing general agents are active on the German market. This was accompanied by clear increases in capacity so that sums insured for more than €500 million per transaction are now on offer.

W&I insurance as insurance of warranty risks ties in with one of the most virulent points of the underlying transaction process, as the catalogue of warranties is regularly one of the most intensively negotiated areas of a company purchase. W&I insurance has established itself above all in cases where the parties of a transaction are unable to reach agreement regarding risk distribution. Further reasons for the conclusion of W&I insurance are, for example:

  • small warranties and caps due to extremely strong negotiating position of sellers (seller’s market) or in distressed M&A transactions;4
  • deal differentiation in auction procedures;
  • clean exit in private equity transactions;5 and
  • de-escalation and corporate peace if, in future, both parties to the deal act as co-shareholders.

The clear focus for the application of W&I insurance is in private M&A (ie, acquisitions of companies in private hands).6 As a form of insurance for transaction-related risks, W&I insurance is necessarily linked to transactions. The focus of these transactions is on classic company purchases, but also on real estate transactions. Due to the close link between W&I insurance and warranties from SPAs, the basics from this area have a special relevance for insurance products.

Warranties in SPAs

Disclosure and knowledge

There is a close relationship between the seller’s warranties and the information basis of the buyer that the buyer has gained in the course of the due diligence procedure. Following the legal rule of caveat emptor, common in the Anglo-American sphere, it is the task of the buyer to get an idea of the state of the purchase matter and to examine it for possible defects. If such an examination does not take place, the company is considered to be sold as examined and inspected.7 This understanding in itself is foreign to German warranty law.8 Nevertheless, due to strong Anglo-American influence, the principle of caveat emptor has become widely established for company transactions in the German sphere.9 However, the German Federal Court of Justice affirms a general increased duty to inform the seller during company purchases.10 With this, the requirements concerning the seller’s behaviour were significantly increased and, at the same time, buyers’ protection in the purchase of companies was strengthened because sellers are principally obliged to inform about circumstances that are essential to the contract without being asked to do so.

As a rule, pursuant to the approach that is predominant in Germany, the buyer’s knowledge shall lead to an exclusion of the seller’s liability. In most cases, there is a regulation in the SPA that the knowledge of the buyer is to be assumed if the corresponding circumstances were disclosed. This leads to the question of how the disclosure should be made. To date, various contractual disclosure concepts11 with different risk distributions have developed in which, besides form and scope of the disclosure, the decisive factor is who is the carrier of knowledge and what degree of knowledge applies.

With regard to the manner of disclosure, usually, as a compromise, reference is made to a fair disclosure according to which whether a circumstance was disclosed to the buyer before the conclusion of the contract in an adequate, sufficiently clear way is the decisive factor. A further parameter is the time of disclosure. Principally, the disclosure takes place at the time of the conclusion of the contract (signing). In some cases, however, the seller is contractually granted the option to update his or her disclosure at closing (bring-down disclosure or true-up) and thus to exclude liability for the disclosed circumstances. A buyer will often only accept this if it is accompanied by the possibility of a purchase price adjustment or a withdrawal from the contract.

The contractual warranty catalogues are individual and look different in each transaction. In particular, the specific circumstances of the target company, the findings from the due diligence and other specialities of each transaction (such as economic interests and negotiating power of the parties) are taken into account. Warranties may concern all areas of a company, although certain warranties are to be found in most SPAs. These include, for example, warranties on the circumstances in terms of company law (fundamental warranties) or in terms of finance (financial statement warranties). Besides these warranties, tax warranties, warranties on essential contracts and compliance warranties have a particular significance for W&I insurance.

Structure of warranty

The breach of a warranty lies in its incorrectness. This may objectively refer to a circumstance that actually exists or does not exist (objective warranty). Objective warranties are opposed by subjective warranties, in which the seller assures that the warranty promise is only correct according to his or her knowledge (knowledge qualifier). In particular, contractual warranties in relation to circumstances that are beyond the control of the seller or the sold company are usually made subject to a knowledge qualifier. In the case of objective warranties, the seller is thus liable for the objective accuracy of the warranties. However, in subjective warranties, liability is only given if – according to the seller’s knowledge – certain characteristics do or do not exist.

A further qualifier – a qualification or limitation of the warranty – is the materiality qualifier. The purpose of materiality qualifiers is to limit the facts of a more broadly worded warranty by only including material aspects. Facts that are not material are not considered. This is in the interest of the seller as it allows him or her to limit the disclosure and reduce his or her liability risk under the warranty.12

Seller warranties need a temporal point of reference (ie, the point in time at which the condition of the company must correspond to the warranty promise of the seller). This, in the end, determines the risk-relevant question of when the economic consequences of a deterioration of the target company pass from the seller to the buyer. Corresponding regulations can be found in the relevant SPA. Frequent points of reference are signing and closing. Depending on the warranty, individual points in time may also be determined.13

The contractually agreed duration of the period of limitation for claims of breaches of warranty can diverge depending on the warranty. Often, the buyer wants to have the opportunity to draw up the annual accounts independently at least once and to have them audited. Common limitation periods for warranty claims with regard to operational warranties are between six and 36 months. The limitation period for claims from the breach of fundamental warranties is regularly longer, and lies mostly between three and seven years.

The legal consequences of breaches of warranty are generally contractually stipulated. Contractual regulations concern especially the scope of the damage to be compensated, caps, deductibles and baskets as well as de minimis amounts.

Typical warranties

Financial statements

Within the scope of warranties in M&A transactions, financial statements are of particular importance because many cases of loss are connected to them. As the parties of the SPA are free in how they design the financial statement warranty, in practice, the content and scope of financial statement warranties diverge strongly. Thus, to which point in time reference is made must be determined. Principally, the financial statement warranty refers to the date of the balance sheet, which, at the time of signing and closing, may have been quite some time ago.

A distinction is made between soft and hard financial statement warranties. In individual cases, the distinction may be difficult and therefore clear contractual provisions are advisable. A soft financial statement warranty is given if the seller assures the legality of the financial statement and it is expressed that the financial statement has been prepared in accordance with accounting law. On the other hand, with a hard financial statement warranty, the seller promises the absolute correctness of the figures stated in the financial statement or of the indicated results and financial status.14

Taxes

Agreements on the circumstances in terms of tax law have a high practical relevance because the buyer (especially in cases of share deals) takes over the target company with all the tax risks that belong to it. The contractual regulations include, in particular, tax indemnities and tax warranties. With tax indemnities, known tax risks are divided between the parties in temporal terms, mostly in such a way that the seller has to bear the taxes for periods before and the seller the taxes for periods after the cut-off date. On the other hand, with tax warranties, the seller guarantees a certain status that is relevant in terms of tax whereby the buyer wants to obtain security with regard to the tax history.15 Typical warranties concern, for example:

  • the complete submission of tax declarations;
  • the payment of tax liabilities due until closing; or
  • the pendency of appeal or lawsuit proceedings.

Material contracts

Seller warranties on material contracts have the background that such contracts (for example, customer or supplier contracts) may be among the material company bases. For this reason, their existence is important for the value-creating continuation of the company. The aim is, therefore, to grant the buyer protection against economically disadvantageous contracts. Moreover, the existence and correct fulfilment of such contracts are to be secured, which has considerable significance for the future success of the company in question.16 As far as their content is concerned, such warranties on material contracts in most cases refer to their correct and complete disclosure as well as to their existence and compliance.

Compliance

Compliance is the adherence to laws and regulations. As such, companies must fulfil high, continually changing and continually increasing compliance requirements. Even with careful due diligence, breaches against this can often hardly be detected, even more so since unlawful conduct is often not designed to be discovered. This is accompanied by a need for protection on the part of the buyer, especially in international matters because, abroad, compliance risks are even more difficult to foresee than in one’s home country.

Compliance risks in Germany can be significant. Penalties, skimming of profits17 and claims for damages by third parties18 are especially important to consider. The maximum amount of a fine is principally €10 million, however, in cases involving the skimming of profits, the fine may be significantly higher as the maximum amount of the fine is not limited in these cases.19 Recent examples due to breaches of the General Data Protection Regulation are, for example, the fine by the Hamburg Data Protection Authority against H&M in the amount of more than €35 million for spying on employees or the fine that was first set to €9.55 million and then reduced to €900,000 against 1&1 Telecom GmbH for deficiencies in the identification process (a woman called the 1&1 service hotline and was given the new mobile number of her former husband even though she had only given his name and date of birth).

W&I insurance

W&I insurance is a legally independent contract that, however, is typically related to the regulations regarding the liability of the seller as agreed in the SPA.

The seller-side policy has to be classified as liability insurance.20 Here, the seller is the policyholder and thus primarily protected. The risk of the seller that, in case of a breach of warranties, the buyer will assert claims against him or her is covered. The buyer-side policy, on the other hand, is primarily a first-party insurance.21 Here, the buyer is the policyholder and thus primarily protected. On the basis of this policy, the buyer can immediately assert against the insurer his or her losses that result from the breach of warranties by the seller. As a rule, the buyer-side policy also contains liability components, namely if third-party claims are covered. Thus, in essence, the buyer-side policy is not subject to the specifications on liability insurance and therefore enables more flexible insurance solutions.22 In Germany, the buyer-side policy is the market standard and the seller-side policy is used in exceptional cases. Stapled insurance23 is a hybrid because it requires a strong involvement of seller and buyer to exist already upon the conclusion of the policy. In conclusion, however, it must be classified as a buyer-side policy.

One advantage of the buyer-side policy is that the buyer can directly approach the insurer with his or her compensation claim without having to approach the seller first. As such, the seller’s risk of insolvency or the risk of the assertion of claims against the seller is excluded. Particularly with regard to cross-border transactions, litigation risks of the buyer that are hard to calculate can be eliminated24 because the insurer that is located in Germany will take the place of the seller that is located abroad.

In addition, compared to the seller-side policy, the extent of coverage is broader because intentionally incorrectly issued warranties are also insured. The reason for this is that, in this case, it is not the policyholder (the buyer) who is responsible for the intentional misdeclaration, but the seller. A (partial) release from liability of the W&I insurer therefore usually only occurs if the buyer himself or herself has caused the insured event at least in a grossly negligent way.25

Along with the advantages that the buyer-side policy offers the buyer, there is at the same time a coverage module in favour of the seller, namely a waiver of recourse of the insurer. In this respect, the insurer undertakes, in principle, not to assert the claims against the seller that have been transferred to it pursuant to section 86, paragraph 1 of the Insurance Contract Act, although this does not apply (at minimum) if there is an intentional breach of warranty by the seller. Therefore, the buyer-side policy is always also in the interest of the seller.

Interaction between W&I policy and SPA

The interaction between W&I policy and SPA concerns the factual preconditions as well as the legal consequences of a breach of warranty. Here, a precise coordination of the content of the two contracts that principally exist independently of each other is important to reflect, in the best possible way, the interests of the participants and to avoid later difficulties of interpretation as well as unintentional coverage gaps or extensions.26

Because of the transfer of risk to the insurer, there is a tendency for the seller to be tempted to apply another standard of care in the case of insured transactions. Normally, SPAs provide that the seller is only liable where the corresponding claims are not covered by W&I insurance.27 A seller might be inclined with regard to his or her very limited own liability to issue warranties in an easier and more carefree way.28 However, this might soon prove to be a false conclusion because, in the case of careless statements without a verified basis, malice can be assumed. This, in turn, would result in unlimited liability. Pursuant to German law, liability for intention cannot be limited in advance.29 The seller would thus lose exactly those privileges that might have induced him or her to prematurely issue a warranty and, in doing so, dramatically worsen his or her own risk situation. In addition, the insurer’s recourse against the seller would be opened. When issuing warranties, sellers should therefore not differentiate according to whether W&I insurance is involved and apply the same standards to themselves as in an uninsured transaction.

The broader design of the seller’s warranty declaration may also be strongly influenced by the existence of W&I insurance. Thus, it will be often easier for a seller to accept high caps and low deductibles, baskets and de minimis limits as well as long limitation periods if W&I insurance steps in primarily. On the other hand, it is easier for the buyer to accept low caps and high deductibles, baskets and de minimis limits from the seller if a W&I insurer is prepared to assume coverage that goes beyond that.

Factual preconditions

On the factual level of a warranty, the decisive parameters are the knowledge qualifier, the materiality qualifier, the buyer’s knowledge, the point of reference of the warranty and the duration of the warranty.

If a warranty is issued as a subjective warranty (with a knowledge qualifier), this is a seller-friendly design that reduces the risk of the warranty event. On the other hand, an objective warranty is buyer-friendly. The manner in which objective and subjective warranties are insured under the W&I policy may be different or even in opposition to one another depending on the individual case. Thus, in the warranty spreadsheet, an objective warranty can only be taken with a knowledge qualifier if the insurer does not see a sufficient basis for the assumption of the objective warranty risk. On the other hand, it also happens that the insurer is prepared to insure subjective warranties without a knowledge qualifier. A knowledge scrape is a form of hybrid insurance solution, in which the buyer is put in a better position in the W&I policy than in the SPA because the insurer assumes a further risk than the original seller.

The same topics result with regard to warranties with or without a materiality qualifier. Thus, warranties without a materiality qualifier can be insured with such a qualifier. On the other hand, however, warranties without such a materiality qualifier can also be insured in a materiality scrape, which is also a form of hybrid insurance solution.

In Germany and continental Europe, regarding disclosure and buyer’s knowledge, the data room and the due diligence documents are deemed to be disclosed, and therefore known and excluding liability. In most cases, the provisions of the SPA on disclosure and buyer’s knowledge are reflected in the insurance contract correspondingly so that, on the W&I level, the continental European concept also applies. W&I insurers are sometimes prepared to reflect a fair disclosure concept in the SPA accordingly.30 When comparing this to the US concept of specific disclosure, the liability of the seller or the coverage of the W&I insurer is thereby limited. Occasionally, however, W&I insurers are prepared to transfer the US concept to European or German transactions and to accept the buyer-friendly specific disclosure standard.31 In particular in transactions with participating US companies, this may be reasonable to make the US party feel better. However, compared to German standards, this represents a significant risk increase for the insurer (or the seller).32 Further parameters on the level of the buyer’s knowledge are the degree and time of the knowledge as well as imputed knowledge or circle of knowledge carriers. In the W&I policy, these usually mirror the SPA, but can also be structured differently.

As far as the temporal point of reference of a warranty is concerned, principally, W&I insurances do not include any forward-looking statements because this would be accompanied by risks that can barely be calculated. Principally, warranties relating to the time of signing are therefore not problematic so that these can be reflected in the W&I policy. Forward-looking statements that concern the time of closing may, by way of exception, be acceptable for an insurer provided that the time between signing and closing remains within a certain time frame. From the point of view of the insurer, it is elementary that the issuance of a closing warranty is accompanied by a bring-down disclosure of the seller to ensure that circumstances that have become known in the meantime are excluded from the insurance cover.

As far as the duration of the limitation of the warranty is concerned, the regulation in the W&I policy can reflect the regulation in the SPA one-to-one. However, it can also go beyond that, for example if the seller is not satisfied with the negotiation result that was reached from the SPA and wishes for longer term promises.

Level of legal consequences

The legal consequences of a breach of warranty provided for in the SPA are not per se insured in an identical way as under the W&I contract. Often, however, there are insurance contract regulations that reflect the regulations in the purchase contract on loss, cap, deductible, basket and de minimis amounts. Here, creative insurance solutions can be found that deviate from a back-to-back solution.

The provisions on the loss from the SPA can be reflected one-to-one, but can also be drafted in a broader or narrower way. If the SPA contains a wide concept of loss that includes, for example, indirect losses, losses on the level of the target company and buyer-friendly regulations on the determination of damage, from the insurer’s point of view, limitations may be necessary.

The cap of the seller serves to limit the seller’s liability. One can often observe a limitation to a very small, symbolic amount if a W&I insurance is involved so that, for the seller, no liability risk of his or her own remains. In such cases, the sum insured by the insurer is decoupled from the cap and exceeds it many times over.

Deductibles and baskets in the SPA lead to a situation where the buyer has to bear losses from breaches of warranty himself or herself until the respective threshold is reached. Here, in the interaction with the cap of the seller and the retention of the buyer, in W&I insurance most different designs are conceivable so that the interests of the involved parties can be reflected in each individual case.

With regard to the determination of the de minimis amount, it might principally be appropriate to include parallel threshold values in the SPA and the W&I policy. In this way, disputes and discussions with regard to minor losses are easy to avoid. Naturally, this only applies if it was not merely due to the conclusion of a W&I insurance that a de minimis amount in the SPA was set very low. In such a case, the W&I insurer would have a legitimate interest in a higher de minimis amount.

W&I trends

The dynamic development of M&A business in the 2010s led to increasing competition as well as increasing capacities in the W&I insurance market in Germany. Consequence of this were not only decreasing premiums but also a certain willingness for innovation on the part of the insurers so that enhancements and completely new products can be observed. This development was supported by the predominant sellers’ market, although now it remains to be seen whether and how the ongoing acts of war in Ukraine will affect this. With regard to premiums in Germany, in any case, it can be observed that the long ongoing trend of decreasing premiums has currently stopped and that now there is – in line with the risk – a rising premium level.33

Cover of known risks

According to its basic concept, W&I insurance comprises exclusively unknown risks. Disclosed risks and risks that were known to the buyer upon conclusion of the policy are therefore principally excluded from cover. On the other hand, there is a strong demand for insurance products to cover identified risks and insurers are prepared to make suitable offers for this at increased premiums.

Against this background, contingent risk insurance, litigation buyout insurance and tax indemnity insurance have continually increasing importance. Calculable tax or litigation risks are often the basis for this. One exception from the principle that W&I policies do not cover known risks is in this context (affirmative cover). Pursuant to this, certain known risks can be insured directly under the W&I policy, if they have only a low probability of occurrence or only a low economic relevance.34 Here, the risks may only arise in a legal perspective but not on the level of facts. This means that the underlying facts must be clear and, in some cases, the insurer requires the policyholder to guarantee this.

Blind spot cover

Just as in the case of known risks, a W&I insurer is principally not prepared to assume warranty risks with regard to facts that could not be reviewed or not sufficiently reviewed within the scope of due diligence (blind spots). The corresponding examination is a core element of the underwriting process because, in those cases, there is regularly not a sufficient basis for a valid risk assessment. Now, however, insurers are increasingly offering blind spot cover that includes risks that were not reviewed. It appears reasonable to grant such cover – if at all – only in a limited way and against an increase of premium provided that, in this way, the unclear risk situation can be reflected in an economically appropriate way. The seller’s own noticeable liability, for example, makes the situation much more calculable for the insurer.

Synthetic coverage

Synthetic coverage means that the insurer fulfils a warranty promise in respect of the buyer that only the insurer makes, but not the seller. Thus, synthetic coverage in the insurance contract has no basis in the SPA at all because the seller was not willing or not able to issue the insured warranty (not even with a very small cap). Consequently, in such a situation, the W&I insurer makes a bilateral warranty promise to the policyholder regarding certain properties of the sold company. It is obvious that such promises by the insurer are associated with special risks, especially as the insurer is the party least familiar with the target company.

Nevertheless, synthetic warranties are becoming considerably more relevant. A precondition for this is, however, that the insurer is able to assess the synthetic warranty risk well, which in turn usually requires comprehensive disclosure and information. In particular in the case of insolvency situations (distressed M&A), synthetic coverage is of great importance because the insolvency administrator as seller usually has only limited knowledge about the target company and is, therefore, principally not prepared or not in a position to make (considerable) promises regarding the properties of the target company. Additionally, there is a risk of personal liability for him or her.35 36

Synthetic elements of coverage are regularly used also beyond the context of insolvency. This applies for example to synthetic tax indemnities. Further, semi-synthetic coverage in the form of hybrid insurance solutions can be observed, which are linked to a real existing warranty promise of the seller. The hybrid character results from the fact that, on the level of factual preconditions or of legal consequences (or both), extensions of the warranty promise are made in favour of the buyer. From the point of view of the insurer, hybrid coverage compared to (full) synthetic coverage appears favourable. On one hand, it gives a certain comfort if the seller who is considerably closer to the target company makes a promise regarding his or her company. On the other hand, the seller still bears an original liability risk for (conditionally) intentional or malicious warranty promises, which offers the insurer the additional comfort regarding the reliability of the promise.37 It should be noted that, in the case of synthetic coverage, a recourse of the insurer against the seller does not come into consideration on a regular basis.

Conclusion

Despite the strong growth of the market for W&I insurance, there are indications that there is still relevant potential for the insurance product in Germany, as there is much to suggest that the benefits of the W&I insurance are recognised by M&A players and that, so far, it is the mere lack of knowledge of the product that stands in the way of widespread market penetration. Apart from that, it will become apparent whether the hardening market that can be observed in industrial insurance will also include W&I insurance, which would lead to further rising premiums and tighter coverage. In such an event, however, a lasting slump of the market is not to be expected.is reduced to a minimum.