Australian M&A activity has had a solid start in 2017, with Mergermarket reporting 107 deals amounting to $28.3bn in value in Q1, up more than 50% in value compared to the same period last year. But in an uncertain world, it is crucial for buyers and sellers to limit their risk exposure when entering M&A transactions. Warranty and indemnity insurance seeks to address this, by pricing the risk and transferring it to an underwriter.
But is warranty and indemnity insurance the solution? In this update Moulis Legal Partner, Andrew Clark explains how warranty and indemnity insurance works, its key benefits, and what buyers and sellers need to look out for when considering a warranty and indemnity insurance policy.
Allocation of risk in the sale agreement
In an M&A transaction, the warranties and indemnities contained in the sale agreement play an important and multi-faceted role in the transaction process. On the one hand, they draw out from the seller known liabilities through the due diligence process, helping the buyer to better understand the business and establish price. On the other, they apportion risk between the buyer and the seller for unknown, and known but as yet unquantifiable, liabilities relating to past operations. And the risk of a liability arising under an M&A transaction is not remote. In a report prepared by AIG in 20161, 18% of M&A transactions it insured between 2011 and 2014 in the Asia Pacific region resulted in a claim.
With this in mind, security for these potential liabilities is also heavily contested, particularly where it is a distressed sale or there are multiple or overseas sellers. The most common forms of security offered by sellers are parent company guarantees and escrow arrangements, but the former is not always an option and the latter is unpopular with sellers looking to exit a business and apply their capital elsewhere or return it to investors.
What is warranty and indemnity insurance?
W&I insurance, as it is commonly known, provides protection against a defined liability arising under the warranties and indemnities contained in a sale agreement. The policy is usually negotiated alongside the sale agreement and taken out at the time of signing, coming into force on completion of the sale.
There are two options available:
- Buy-side policies: In the vast majority of transactions the buyer takes out a policy and the liability of the seller is contractually limited in the sale agreement. If a claim arises, the buyer’s recourse is against the insurer under the policy, with the exception of any agreed deductibles which, depending on the terms agreed, may be borne by either the seller or the buyer.
- Sell-side policies: In this situation the seller takes out a policy insuring themselves against any successful claim by the buyer. In this instance, the buyer would bring a claim against the seller in the usual fashion and the seller would rely on the policy to indemnify them for any loss in accordance with the policy terms.
Where sellers want to encourage the use of W&I insurance in a transaction, they can also do a sell-side flip, where the seller commences negotiations with the insurer and then flips the policy to the buyer prior to signing. In these circumstances, sellers need to be aware of what they disclose to the insurer in the initial stages as this information will be made available to the buyer once the insurance becomes a buy-side policy. However this should not be a significant issue if the parties have undertaken a vigorous due diligence and disclosure process.
As a general rule, W&I insurance will not cover known issues, fines and penalties, consequential loss, projections and forward looking statements, seller fraud (under sell-side policies) and liabilities specific to the relevant transaction. It is possible to obtain insurance against potential tax liabilities and specialist areas, such as environmental liabilities, but not all insurers will take on these risks so they should be discussed with the broker up front. In all cases, the insurer will expect that a vigorous due diligence and disclosure process has occurred.
W&I insurance is available in the Australian market for deals ranging between $5 million and $1 billion although it is typically only financially viable for deals exceeding $10 million. Historically a fixed deductable of one percent was common but insurers are increasingly accepting a tipping retention which, once the basket threshold for claims under the Sale Agreement is met, also covers anything up to 100% (although more commonly 25 to 50%) of the liability below the basket threshold. Liability caps range from 10% through to the full purchase price.
The policy term will generally mirror the negotiated liability period under the warranties as agreed between the parties, with up to six years being common for commercial warranties and seven for tax. Of note, AIG reported that 52% of all W&I insurance claims it received globally between 2011 and 2014 were made in the first 12 months, and 74% in first 18 months, following issue of the policy, making the first two years of cover the most effective.
Whilst pricing is heavily dependent on the terms of the policy and the transaction itself, average premiums range between 1% and 1.5% of the maximum insured amount, with premiums increasingly falling to the lower end of the scale.
W&I insurance offers benefits to both buyers and sellers
There are many advantages to a well negotiated and integrated W&I insurance policy for all parties involved. These include:
Clean exit for sellers: A clean exit for sellers without the need for additional security and retentions is an obvious advantage, and one that often results in sellers being willing to contribute to the cost of the policy. From a buyer’s perspective, the offer of a buy-side policy can enhance the attractiveness of a bid to a seller in a competitive auction process, both in terms of value and ease of negotiation.
Obtain a higher price: By limiting the potential risk to the buyer, the offer of insurance can help a seller negotiate a higher price.
Allows Private Equity funds to distribute: PE funds typically have a defined investment window, during which they must invest, exit those investments and distribute the proceeds back to investors. As a result, funds often strongly resist giving commercial warranty protection as they are limited in their ability to give effective security and are often unable to keep funds in escrow for long periods. W&I insurance resolves this issue, explaining why it is prevalent in PE transactions.
Buyer financial security: W&I insurance can give the buyer significant financial comfort in the absence of a ring fenced retention amount. This is because sellers almost always plan to put the proceeds of the sale to use elsewhere, whether it be to pay down debt, shore up working capital or invest in new ventures, often making it difficult for buyers to recover if a warranty or indemnity claim arises. W&I insurance also shields buyers from the costs associated with recovering funds, particularly where there are multiple sellers, the seller is distressed in some way or it has exited the jurisdiction.
Preservation of relationships: In many cases, a seller will continue to be involved in the operation of the business, either as a continuing investor or through a revised management structure. In these cases, bringing a warranty claim against a business partner or employee can have a material effect on that relationship moving forward. By removing the seller from the claim process, W&I insurance helps preserve these relationships.
Prices the risk: Agreeing the terms of the warranties in a transaction is about apportioning risk between the buyer and the seller – the seller remains liable for certain pre-completion risks, and the buyer takes on others as a part of operating the business. In a perfect world, the risks the seller remains liable for would simply be priced into the consideration but their uncertainty makes them difficult to value. W&I insurance effectively does this for the parties by charging a premium to accept the risk on the seller’s behalf.
Promotes economic certainty: Whilst W&I insurance does not reduce the vigour with which warranty negotiation and disclosure should occur, it does take some of the emotion out of the fight, as all parties are better assured of a finally agreed position. For the seller, as insurers have only a certain amount of flexibility when negotiating the scope of cover, an insurer’s refusal to cover a number of liabilities as drafted can pressure the buyer into accepting the seller’s proposed position.
No escrow: For a seller, the cost of money in escrow is broadly equivalent to its cost of capital (and arguably higher for PE funds). This cost is often higher than the proposed insurance premium under a W&I insurance policy, making this good value from a financial perspective.
So is W&I insurance a silver bullet?
Insurance does not replace the need for the buyer to conduct due diligence, nor for the seller to negotiate warranties and indemnities proposed by the buyer, and nor should it. As mentioned above, a key purpose of warranties and indemnities is to draw out disclosures to allow the buyer to better understand the risks associated with the business and then price those risks into the consideration.
From a seller’s perspective, a failure to properly negotiate or disclose against warranties potentially opens them up to reputational damage. If the seller is a PE fund, this could limit their ability to obtain future insurance. There may also be extra-contractual liability for the seller, such as for fraud, a statutory liability, or a claim for misleading or deceptive conduct.
A common approach to keep sellers honest is for them to remain liable for the deductible amount under the insurance. This focuses sellers’ minds on the benefit of participating in a thorough disclosure process as they effectively have something to lose. It also helps reduce the insurance premium.
What to look out for when considering W&I insurance
There are several factors to keep in mind when considering W&I insurance:
Limitations in coverage: There are some liabilities that W&I insurance will not cover and the parties will need to decide who bears that risk. If the seller becomes liable, the issue of security potentially arises again and the benefit of a clean exit for the seller is lost. To best combat this risk, the insurance broker should be invited into the process early, so the parties can quickly understand the limitations and decide whether insurance will be beneficial.
Disclosure must be full and complete: Significant time is often spent agreeing the limitations on warranties clearly defining what “disclosed” means in a sale agreement; for example whether the results of certain searches are deemed to be disclosed against the warranties (regardless of whether they have been undertaken) or whether an understanding of the risk must be clear from the disclosed information before disclosure is accepted as a defence. Insurance puts in place an added layer to this requirement. On taking out the insurance, the insured must provide a no claims declaration confirming they are not aware of any matter which may give rise to a claim under the policy. In giving this, the insured must be mindful of their obligations under section 21 of the Insurance Contracts Act 1984 (Cth) – namely to disclose all matters they know to be relevant, or a reasonable person would expect to know to be relevant, to the decision of the insurer whether to accept the risk and, if so, on what terms.
Repetition of warranties – Repetition of warranties is where the warranties are given by the seller on signing of the sale agreement and then repeated on closing of the deal. This is always an area of conflict between the parties, as the seller does not wish to commit to warranties given in the future without some ability to disclose against them and the buyer wants to be able to claim for all pre-completion liabilities. Insurers add to this complexity by not typically covering liabilities that the buyer has become aware of during this period. Care therefore needs to be taken to ensure that a mechanism is in place to appropriately deal with this issue, such as a price reduction mechanism or a right of termination. Some insurers will now cover breaches during this period, but for an increased premium.
Look forward warranties and price adjustments – W&I insurance will not cover forward looking statements, nor will it provide any protection in relation to contractual price adjustments such as earn-outs.
Level of coverage – In many cases W&I insurance can cover liability up to the purchase price, however often the insured will agree to a lower level of protection to help reduce the premium. The remaining risk then usually sits with the buyer.
Insurers will generally move fairly quickly, but it is always advisable to get them involved early in the transaction so that gaps in coverage can be minimised and expectations managed. Trying to wrap an insurance product around an existing deal is rarely an attractive proposition and can result in significant delays or gaps in coverage.
The parties should be aware that their diligence will be heavily scrutinised by the insurer and the insurer will need access to certain disclosed information and advisor due diligence reports, although it will usually accept receipt on a no reliance basis. Where internal due diligence reports are relied on, the insurer will want to be satisfied with the quality and depth of these reports and the qualifications of those preparing them. An email from a technical director that everything looks to be in order will not be sufficient. Where the insurer does not achieve a level of comfort from these reports, they will most likely want to interview key people involved in the due diligence process. If a data room has been set up, insurers will prefer to see this as deemed disclosure against the warranties. If it is not, expect a more vigorous assessment of the due diligence process.
Where unresolved risk remains, or the insurer is not satisfied with the level of due diligence, it may exclude or qualify coverage, only partially cover certain warranties or indemnities, or increase the premium or adjust the retention amount.
In summary, W&I insurance is a great tool in M&A deals and adds a viable and welcome option for buyers and sellers grappling with the near impossible task of pricing risk on a standalone transaction. And while it is not a one size fits all product, it is certainly something worth considering at the planning stage of any M&A deal.