Warranty and indemnity (W&I) insurance has become a ubiquitous part of negotiated M&A in the Australian market through the innovation of insurers, however it is no longer exclusively restricted to private treaty transactions.
W&I insurance, which allows parties in an M&A transaction to reduce the seller's liability for warranties given under a sale agreement, has ‘tip toed’ into listed company M&A. Over the last 10 years, there has been a slow trickle of listed company ‘scheme of arrangement’ transactions where acquirers have been able to obtain cover. However, continuing the spirit of innovation, insurers have increasingly branched out to provide cover for acquirers beyond schemes of arrangement.
Historically, the warranties given in public M&A transactions have been quite limited. In large measure this reflects the complexity in disparate shareholders making representations about the target. In practice, this means that no individual seller gives the acquirer representations beyond title and authority, placing the acquirer in a difficult situation and prompting them to ask: if my due diligence is limited, how can I make myself whole for losses arising from matters beyond title?
In general terms, acquirers of listed entities have taken the view that their due diligence processes (in non-hostile transactions) and the rules regarding periodic and continuous disclosure have made ASX listed company acquisitions inherently less risky than their private counterparts. But the acquirer is still left vulnerable to unknowns, for example undisclosed regulatory investigations.
This gap has caused acquirers to build into their M&A transactions solutions to provide extra comfort. These ‘baked-in’ solutions have included:
- added due diligence
- earn outs and other structural solutions
An obvious alternative is W&I insurance, as these policies are designed to move the risk arising from loss from an acquirer’s balance sheet on to the insurer. But does W&I insurance for ASX listed entities work effectively to give this comfort?
Insurance cover for M&A transactions involving listed entities will be sole recourse, in that the acquirer will only have recourse to the insurer, other than in the case of fraud. The majority of private deals are, of course, also sole recourse. However, unlike private deals, there is no room on public transactions for any significant exclusions to the W&I insurance policy to result in the sellers taking on that risk and providing security for any claim.
Putting to one side transaction-specific exclusions resulting from underwriter due diligence, when you take the standard exclusions from a private W&I policy - for example, contamination, disclosed matters and uninsurable fines and penalties - and add any additional exclusions for a public transaction, does W&I insurance on ASX listed deals give acquirers bang for their buck?
Insurers are keen to be flexible and work with acquirers to remove exclusions through the underwriting process, however the following exclusions are likely to apply to all public M&A transactions:
1. Compliance with the Listing Rules – a loss arising from a company’s failure to comply with its legal and disclosure obligations under the Listing Rules is likely to be an exclusion and, in particular, breaches of Listing Rule 3.1 (continuous disclosure) will not be covered. Instead, for matters of compliance, an acquirer will need to rely on its own due diligence. However, where the acquirer has done more fulsome due diligence, in our view there is scope for the exclusion to be narrowed, giving the acquirer cover for compliance which it would not otherwise have.
2. Fraud – this will always be an exclusion. An insurer cannot subrogate against the shareholders. This is not the same position as in a private deal when the insurer covers fraud or deceit of the sellers and its officers but includes a right to subrogate against the sellers. Instead, for matters of fraud, the acquirer will need to claim against the company pursuant to the terms of the transaction documents.
3. Shareholder class actions – group litigation by aggrieved shareholders or shareholder activism will be an exclusion to the policy. While third party actions will be covered, for matters involving class action by shareholders, the acquirer will need to resolve these and wear the cost.
The process and pricing for W&I insurance on public deals is otherwise largely the same as private deals and the process will not hold up a deal. Specifically, the warranties and indemnities given by the target will need to be negotiated between the company and the acquirer, and the transaction documents will also need to include customary limitations and qualifications to the warranties.
In summary, even with the above exclusions, if an acquirer is willing to undertake a little more due diligence and negotiation, it is still left with a meaningful set of warranties otherwise absent on a public transaction. In our view, having this option must be a good thing, and may well evolve to a more uniform approach where a sensible set of warranties is accepted as a standard approach and provided with a stapled W&I policy.