Buyers and sellers have diverging interests when it comes to the negotiation of warranties and indemnities in a sale and purchase agreement (SPA). Buyers will want the warranty and indemnity protection to be as comprehensive as possible, whereas sellers will want to seek to limit the scope of such protection.
Buyers and sellers have diverging interests when it comes to the negotiation of warranties and indemnities in a sale and purchase agreement (SPA). Buyers will want the warranty and indemnity protection to be as comprehensive as possible, whereas sellers will want to seek to limit the scope of such protection. Warranty and indemnity (W&I) insurance is one mechanism that buyers and sellers can use to reconcile these different expectations and facilitate the successful completion of M&A transactions.
We are seeing an increase in the consideration and use of W&I insurance in M&A transactions both globally and across Asia. Although the popularity of this product has grown significantly in recent years (and it has become the norm in auction transactions in Australia), we are finding its function and effect on M&A transactions are not commonly well understood in Asia. In this Legal Quick Tip, we look at some of the key features of W&I insurance and discuss several relevant issues that buyers and sellers should consider before deciding whether W&I insurance should form part of the deal.
What...is W&I insurance?
W&I insurance is a form of transaction liability insurance that protects a buyer and/or a seller from financial loss resulting from either a claim for breach of warranty or under an indemnity. W&I insurance attempts to provide “back-to-back” coverage by mirroring, to the extent possible, the warranty and indemnity language in the SPA.
Why...is it used?
W&I insurance is used to facilitate a transaction in circumstances where a particular liability exposure is not acceptable to either the buyer or the seller.
For sellers, we see W&I insurance used to:
- minimise any long tail of liability and provide sellers with a “clean exit” from the target business;
- bridge a “warranty gap” left by sellers (e.g. private equity) who are willing to give only limited warranties;
- in an auction process (where the W&I insurance may be pre-arranged and offered to bidders in the same way as a stapled financing package), so as to limit the negotiations and allow for more direct comparisons of bids to be made;
- make sale proceeds available by eliminating the need for warranty-related escrow; and/or
- eliminate potential obstacles to completion of the deal.
For buyers, we see W&I insurance used to:
- address concerns over a seller's financial status and ensure the enforceability of any warranty or indemnity claim;
- provide greater protection, through increasing the warranty cap to the agreed insurance cover limit and/or extending the duration of the warranties;
- create greater certainty in valuation and negotiations; and/or
- provide a competitive advantage in an auction process.
What...do the policies do?
Both sellers and buyers can take out W&I insurance, although buy-side policies are far more common. Broadly speaking:
Seller policies protect a seller against financial loss for a claim made by a buyer for breach of warranty or under an indemnity in the SPA. Typically the insurer will pay out to the seller the amount of any valid warranty or indemnity claim for which the seller is liable, subject to the terms of the policy. However, the seller does not have a true “non-recourse” position as it still retains primary liability for the claim, meaning it remains liable:
- for the amount of any excess or deductible under the policy;
- if the insurer fails to pay;
- to the extent the policy affords the insurer a valid defence or an exclusion of liability; or
- to the extent that any cap under the policy is exceeded.
Buyer policies protect a buyer against financial loss it suffers as a result of a breach of warranty or under an indemnity in the SPA with the buyer being able to claim directly under the policy. Buyer policies can provide insurance coverage:
- for a part of or up to the amount of the seller's liability;
- for losses a buyer suffers above the warranty cap (“top-up” insurance); and/or
- to extend the warranty period.
What...do the policies cost?
The premiums for W&I insurance across Asia vary quite significantly depending on a range of factors including the geographical spread of the target business, the nature of its operations, the complexity of the transaction and the amount of insurance coverage sought (both in dollar terms and as a percentage of the transaction size). Premiums in Hong Kong and Singapore tend to be at the lower end of the cost spectrum in Asia averaging between 1% and 2% of the insured limit, whereas other countries in South East Asia, China and India typically attract higher premiums. This compares with the average premiums of 1% to 1.5% in Western Europe and the 2%+ premiums in the US. Other costs such as underwriting fees, additional lawyers’ fees, insurance premium tax and broker’s commission will usually also need to be factored in as additional charges.
Who...pays for the policy?
Responsibility for payment of the cost of W&I insurance is usually a matter of negotiation. In a competitive auction process the buyer may be willing to bear the cost of the policy (especially if the W&I insurance is a stapled package), although ultimately the cost of the policy is likely to be reflected in the ultimate purchase price.
What...can the policy protect against?
W&I insurance can be taken out for claims relating to a breach of warranty and for certain indemnities arising out of matters which have not been fairly disclosed and are not known to the insured. Ordinarily, only losses arising from unknown and unforeseen liabilities are protected under the policy. This is consistent with the usual terms of the SPA which prevent a claim being made under a warranty if the buyer has knowledge of a breach or if disclosure has been made in the disclosure letter. Standard W&I insurance will usually provide cover for repeated warranties at completion but will not cover a breach of these warranties if the facts or circumstances occasioning the breach arise between signing and completion. If the buyer is anticipating a protracted period between signing and completion (e.g. because of regulatory approvals) then “new breach” cover could be considered to extend the policy to cover that period. Other common exclusions from the policy include consequential loss, loss relating to forecasts or forward looking warranties, loss relating to civil or criminal fines or penalties, issues arising out of any post-completion purchase price adjustment and (for seller policies) fraud of the insured party.
As with all insurance policies, purchasers of W&I insurance will need to be careful in determining if the policy marries up with the warranty and indemnity wording in the SPA. In particular, cover for tax and environmental liabilities under standard W&I policies tends to be extremely limited.
Can...coverage extend to identified risks?
Yes, buyers can purchase separate or additional insurance to cover specifically identified tax, intellectual property and environmental liabilities, if required. Insurers will generally expect these liabilities to be contingent and quantifiable, and a legal opinion may be required. Premiums are higher and range anywhere from 4% to 12% of the insured limit although this will vary significantly on a case by case basis.
What...is the process and timeframe to put a policy in place?
The broker will begin by collecting information about the transaction which is used to obtain quotations from insurers. The broker will select the most competitive insurer(s) who will then appoint its own lawyers and carry out a limited due diligence exercise which may involve looking at the transaction documentation, vendor and purchaser due diligence reports and/or obtaining access to the data room. The timing to put a binding policy in place depends on the insurer’s assessment of the business and the documentation, in particular, the quality of the due diligence information and disclosure exercise. In Asia, the timeframe from when the broker is first engaged to a binding policy being in place is typically longer than in other regions, with indicative guidance being 2 to 3 weeks on average. For a policy which requires multiple underwriters in the syndicate, settling the final terms with every insurer can further push out this timeline.
Do...claims actually pay out?
Historically this has been a concern, as claim history was largely untested until fairly recently. However, we are now seeing insurers pay up as they see W&I insurance as a profitable business line and valid claims need to be paid out for the product to remain credible.
What...impact will W&I insurance have on the SPA?
Although W&I insurance sits outside of the SPA and is an external risk management mechanism, its use in the deal process gives rise to certain legal and commercial issues for sellers and buyers to think about in relation to the SPA, including:
- Will there be any price adjustment in respect of the cost of the premium?
- What coverage will there be between signing of the SPA and completion?
- Will the buyer be able to claim under the policy before going after the seller? Will this be acceptable to the insurer?
- As the seller will wish to avoid exposure to any potential liability gap, how will the buyer deal with losses it is unable to recover under the policy?
- Will the limitations on the seller's liability apply to a claim under the buyer policy? Are these limitations enforceable?
- Will the buyer bear the costs of the excess or will the seller put an amount equal to the excess in escrow? Will the excess be equivalent to any basket or deductible under the SPA?
Is...it really necessary?
W&I insurance is a product that, if used appropriately, can facilitate negotiations and make life easier for buyers and sellers in financial terms. While it may be tempting to suggest W&I insurance as a mechanism to bridge a liability gap, consideration should be had as to whether it is commercially necessary in the first place. Is the target business one where unknown and unforeseen liabilities are likely to arise? For simple businesses, W&I insurance may be a distraction. In a competitive auction process, a buyer trying to impose W&I insurance on a seller in exchange for increased warranty protection may seem uncommercial if others are willing to proceed with a limited warranty package without W&I insurance. Building W&I insurance into the sale process needs to be carefully considered given the timing implications and possible effects on deal certainty (e.g. by requiring a disclosure exercise at the end of an auction). The quantum and scope of available W&I insurance coverage will vary from deal to deal, and so W&I insurance may not meet the needs of a particular transaction. Finally, some buyers dislike W&I insurance as they prefer a seller to have “skin in the game” when it comes to the warranty and indemnity package.
We recently advised a Hong Kong listed company on an acquisition of an Australian business where the W&I insurance was pre-arranged by the sellers and offered as a stapled package to bidders in the auction at the bidders’ cost. This was also attractive to bidders, as the sellers were a group of individuals (including some continuing members of management) and were to retain a minority stake in the business post-completion of the deal.