Market trends that we are seeing on transactions involving Warranty and indemnity insurance (W&I insurance):
- more private equity houses, some who had doubts about W&I insurance, are using it to deliver a ‘clean exit’
- increasing numbers of non-private equity corporate entities are utilizing W&I insurance, both as buyers and sellers
- sellers are taking control of a buy-side policy as part of the sale process to minimise time to signing
The hottest issue in W&I insurance at the moment is the difficulty in achieving coverage for ‘New Breaches’ where there is a material gap between signing and completion
W&I insurance 101: what is it and how does it work?
Before covering market trends and hot issues, let’s go back to first principles and summarise what W&I insurance is and how it works.
As the name suggests, W&I insurance is a contract of insurance in relation to loss that may arise under the warranties and/or indemnities in a sale agreement. It can be an asset or share sale. The insurance policy may be taken out by either the buyer (with the policy then being referred to as a ‘buy-side policy’) or by the seller (with the policy then being referred to as a ‘sell-side policy’). That is, either the buyer or the seller may be the insured party.
How does it work? The W&I insurance policy is structured so that in the case of:
- Breach of warranty: the W&I insurance responds to:
- buy-side policy: loss suffered by the buyer due to breaches of warranties given by the seller
- sell-side policy: loss suffered by the seller due to the seller having to pay the buyer for breach of warranties given by the seller
- Indemnity: the W&I insurance may also respond in circumstances giving rise to a claim under an indemnity given by the seller, most commonly a tax indemnity
- Fraud by seller: loss suffered by a buyer due to the fraud of the seller. (Seller’s fraud is only covered in a buy-side policy. This can also be difficult to cover in certain countries outside of Australia.)
While both buy-side and sell-side policies are available, the vast majority of policies will be placed as buy-side, even where it is the seller who makes W&I insurance a requirement in the deal. Key drivers here are:
- Duty of disclosure: as a fundamental matter of insurance law, the insured party has a duty of full disclosure to the insurer, breach of which may prejudice recovery under the policy. Placing the insurance on buy-side allows the buyer to ensure that this duty is discharged (aligning with its interest in ensuring that the insurance responds if required). The practicalities of complying with this duty are also more straightforward for the buyer, as most of its key information on the target asset will have been obtained from the buyer through formal due diligence processes.
- Credit risk: if the insurance is placed on sell-side, then the buyer must take credit risk on the seller (as well as on the insurer) – ie any claims proceeds will be paid by the insurer to the seller, to whom the buyer stands as an unsecured creditor. Where the insurance is placed on buy-side, by comparison, the buyer takes credit risk only on the insurer, and the seller’s creditworthiness becomes irrelevant.
Why do we refer to W&I insurance as an ‘M&A transaction tool’, isn’t it just insurance?
When negotiating the sale agreement in an M&A transaction nearly most (if not the most) amount of time is spent on negotiation of the warranties, indemnities and all the limitations on claims (e.g. monetary thresholds, time limits, exclusions, disclosures). In an M&A transaction that includes buy-side W&I insurance, a buyer’s rights for those crucial matters are no longer dealt with just under the sale agreement. The buyer’s ability to recover for breach of warranty or an indemnity event arise under the W&I insurance. So as a buyer, seller or adviser, you must understand:
- what the rights and liabilities of the parties are (if any) under the sale agreement in relation to the warranties and indemnities
- the commercial context of the warranties and indemnities
- the rights of the buyer under the W&I insurance for warranties and indemnities (which are often very different to those under the sale agreement)
- how to negotiate the W&I insurance policy (e.g. what is negotiable, what is important), and
- how the sale agreement and W&I insurance interact.
It follows that W&I insurance, in our view, is not ‘just insurance’. It is an M&A transaction tool, that can be used to your advantage if you understand it well. It can equally be to your disadvantage if you’re not aware of the pitfalls.
Increasing use of W&I insurance by private equity houses on exit and by corporate entities (Corporates)
We now look at the market trends.
Until recently in the Australian market, W&I insurance was primarily used by private equity houses selling an asset to deliver a ‘clean exit’. That is, the private equity seller would require the buyer to take out a buy-side policy. At the same time, under the sale agreement, the private equity seller would require the buyer to agree that the buyer’s only recourse, from the time of signing, for loss suffered as a result of a breach of warranty (with some exceptions) or an indemnity event would be under the W&I insurance (not against the seller). Together the W&I insurance and the provisions in the sale agreement would deliver the seller a ‘clean exit’ from the time of signing.
Over the last 12 months, however, we have seen a growing awareness and use of W&I insurance amongst Corporates, including on M&A transactions not involving private equity houses. Some of these Corporates had previously acquired businesses from a private equity house where they were required to use W&I insurance. Others turned to W&I insurance to address deal specific issues, such as the inability to recover proceeds from the seller in the future (swapping the credit risk of the seller for the insurer). A global insurance broker recently reported that 65% of the W&I insurance policies it placed in the Asia Pacific in 2012 were with Corporates and only 35% with private equity houses. (Interestingly throughout the rest of the world, the broker placed roughly 50% with Corporates and 50% with private equity.)
We are also seeing foreign private equity houses, who until recently had not used W&I insurance in Australia as it was less common in their home market, begin to use it on Australian transactions.
As sales processes gradually make a return and sellers stapling the W&I policy to the sale agreement, buyers won’t be able to opt out of using W&I insurance (particularly if they want their bid to remain competitive).
Seller taking control of a ‘buy-side’ policy on a sale
The next market trend is one that we at Herbert Smith Freehills are helping to set.
Traditionally, when a seller has required the buyer to take out a buy-side policy as part of a clean exit, the seller would unofficially engage with an insurance broker to seek pricing from various insurers and general terms for the W&I insurance policy, prior to the preferred bidder being chosen. Once the preferred bidder was chosen, the insurance broker would then ‘flip’ and be officially engaged by the buyer. The insurance broker would then work with the buyer to negotiate the W&I insurance policy, deal with the insurer and underwriters and put the insurance in place. The process to put the W&I insurance would generally take 10 to 15 days, but could take longer.
The disadvantages for the seller from this approach are twofold:
- to deliver a ‘clean exit’ from the point of signing the sale agreement, the W&I insurance policy needs to be put in place at signing (unless the seller accepts the buyer arranging W&I insurance as a condition precedent, which raises uncertainty). Consequently, signing of the sale agreement is delayed until the policy is ready, and
- as the insurance broker becomes officially engaged by the buyer, not the seller, the broker owes a duty of confidentiality to the buyer and cannot discuss the progress of the W&I insurance policy with the seller. Consequently, the seller loses direct line of sight into how the policy is progressing. This gives the buyer the ability to blame delay or changes to warranties on the insurer and to use this as a negotiation tactic.
So how do you overcome these problems? The following short case studies illustrate our solution.
In one matter, we were engaged to act for a seller on a competitive sales process, where W&I insurance was mandated by the seller. On this transaction there was a high sensitivity to the risk that the bidders would talk after final bids were submitted, potentially resulting in loss of competitive tension, if there was to be (as is common) a period of 10 to 15 days between selection of a preferred bidder and signing of the sale agreement.
To address this risk, the seller officially engaged the insurance broker prior to them ‘flipping’, and we then pre-negotiated the buy-side policies (for both primary and excess insurance layers) so that they were 95% ready when provided to the preferred bidder. This, together with steps to ‘forward start’ the insurer’s and underwriter’s due diligence timetable, reduced the time between selection of a preferred bidder and signing of the sale agreement (with multiple layers of W&I insurance in place) down to about 72 hours.
In another matter, we acted for a buyer where this same approach was taken by the seller. In that instance there were only five days between our client being invited into the final round and signing the sale agreement (again with multiple layers of W&I insurance in place).
While taking this approach is more intensive for the seller, it delivers a far superior result, overcoming both of the disadvantages discussed above. We expect to see well-advised sellers taking this approach more and more often.
Coverage for ‘New Breaches’ between signing and completion
The hottest issue at the moment in W&I insurance is obtaining coverage between signing and completion for ‘new breaches’.
What are new breaches? This is a slightly more technical question, ie:
- the seller wants a ‘clean exit’, so under the sale agreement the seller will not be liable to the buyer for loss arising from warranty breaches or indemnity events from the point of signing the sale agreement (the timing is important)
- there will be a period between signing and completion of the sale agreement, and
- if the buyer discovers a breach of warranty or an indemnity event after signing but before completion (New Breach)1, the risk for the loss arising from that New Breach sits with the buyer, unless it is covered by the W&I insurance. (That is because the buyer has agreed under the sale agreement that they cannot recover such loss from the seller from signing.)
Until about six to nine months ago, it was possible to negotiate with an insurer to achieve coverage for New Breaches (although this was not their starting point). Around that time, however, W&I insurers in Australia started to push back against providing this coverage. The insurers’ rationale was that seller had control of the business between signing and completion, but it was the W&I insurer (not the seller) who carried all the risk for a breach of warranty or indemnity event. We understand that insurers also received a number of claims relating to New Breaches. This lack of coverage became a real issue on transactions with significant periods between signing and completion, e.g. where ACCC or FIRB approvals are required.
Fortunately, the tide appears to be turning. Our recent experience is that coverage for New Breaches is achievable with certain insurers. Coverage of extended periods is also achievable, depending on the risk profile of the business, although the insured may need to negotiate a bespoke coverage structure. We do note that while New Breach coverage was once available without an increase in premium, it now carries a material additional cost.