Throughout the past decade there has been an upward trend in the use of warranty and indemnity insurance (“W&I insurance”) in M&A transactions both across the UK and globally. Whilst W&I insurance was historically more popular with private equity houses, it is now used in both large and small transactions.
What Are Warranties and Indemnities?
All share purchase agreements (“SPAs”) will contain warranties and indemnities covering a range of aspects of the target’s business. They also feature in asset purchase transactions.
Warranties are assurances given by the sellers to the buyers in a transaction which, if later found to be untrue or inaccurate, can give rise to a claim in damages against the sellers, subject to any limitations. Warranties are given in a wide variety of circumstances, but commonly cover the following areas of the target:
- Accounts and accounting standards;
- Corporate records and commercial contracts;
- Real estate;
- Employees;
- Tax; and
- Compliance with laws (in particular data protection, health and safety and anti-bribery), litigation and disputes.
Indemnities are promises by the sellers to reimburse the buyers of the cost of a certain risk if it crystalises. One example is where the sellers have disclosed a risk of litigation, the buyers will inevitably ask to be indemnified against the cost of defending that litigation and any damages which may follow. Indemnities more commonly relate to specific risks which have been identified during the due diligence process.
Sellers will want to give as few warranties and indemnities as possible to limit their exposure. Conversely, buyers will ask for as many as possible to maximise their opportunities to recover their losses if something goes wrong in the transaction. Ultimately, a compromise must be reached between the parties, often influenced by any differences in bargaining power.
Sellers have a number of options available to negate the effect of any warranties or indemnities given: (1) disclosing any exceptions in advance; (2) limiting their liability in the SPA; or (3) arranging W&I insurance to cover a breach.
Forms of Warranty and Indemnity Insurance
Two forms of W&I insurance exist: buyer-side and seller-side.
Buy-Side Policies
Buy-side policies are attractive to buyers because they offer them a direct claim with their insurer, avoiding the possibility of ending up in a longer dispute resolution process with the sellers. Additionally, buy-side policies provide buyers with protection against fraud by the sellers.
The key benefits to buy-side policies are that they alleviate buyer’s concerns surrounding the sellers’ ability to pay any claims arising post-completion. Also, in some transactions, preserving the commercial relationship between the parties is important such as where the management are remaining within the target for a period following completion. Buy-side W&I insurance can help preserve this commercial relationship if a claim arises since the claim will not require the buyer to sue the sellers.
Sell-Side Policies
Policies can also be taken on the sell-side and cover claims brought against the sellers. The policy will include obligations for the sellers to cooperate with the underwriter in responding to any claims. As this policy is taken out by the sellers, it does not cover fraud on their part.
Sell-side policies provide sellers with a cleaner exit from the target since the sellers will not have to be as concerned about looming claims. Sellers will ordinarily benefit from a quicker release of funds because the buyer will be assured by the existence of the policy. However, they are less flexible than buy-side policies and tend to lend themselves better to an investment into a business by multiple investors rather than a sale.
Common Exclusions
Different policies and underwriters will vary their exclusions but there are a range of issues which are excluded in most policies:
- In buy-side policies, fraud on the part of the buyer(s);
- In sell-side policies, fraud on the part of the seller(s);
- Post-completion adjustments to the purchase price, which are ordinarily made by reference to a completion mechanism in the SPA and disputes arising out of this are ordinarily referred to a 3rd party expert to resolve;
- Fines which are uninsurable by law;
- Known issues or issues which fall outside the areas covered by the due diligence process;
- Issues disclosed in the disclosure letter; and
- Other specific exclusions which vary depending on the nature and sector of the business.
Premium and Level of Cover
W&I insurance takes the form of a one-off premium and in the UK is subject to a 12% insurance premium tax. There is no renewal cost and the premium is highly dependent on the risk factors and sums involved. Some of the factors which underwriters consider when determining the premium are:
- How broad the warranties/indemnities are;
- The sector and industry the target is operating within;
- The quality of advisors involved in the transaction, including the scope and quality of due diligence; and
- Trends in the relevant sector and industry, based on the underwriter’s claims data.
The level of cover varies depending on the size of the deal; however on larger transactions the policy limit will usually be around 30% of the target’s enterprise value. On smaller transactions the policy limit is often higher than this, with potential to cover the whole purchase price. The level of cover can be impacted by the parties’ negotiations around who is paying. Even on a buy-side policy, it is usual for a buyer to insist on the sellers paying half, if not all, of the policy cost.
How to Obtain Warranty and Indemnity Insurance
It is best practice to involve underwriters at an early stage. Providers are usually from specialist M&A departments of insurance brokers. Brokers will be able to work with parties’ advisors to assist in how to structure the deal, the scope of due diligence and identify potential issues or specific policy exclusions at an early stage.
Policies would normally be entered into on or immediately prior to completion, but post-completion policies do exist, save that they will exclude any claims which arose between the period of completion and the policy being taken out.
Warranty and Indemnity Insurance as a Useful Tool in Managing Post-Completion Risk
The use of W&I insurance can be attractive to sellers and buyers who seek the certainty of funds being available to cover any breaches. Whilst in the short-term the use of insurance creates increased costs to the parties, it allows them to leave the sale with greater certainty, should anything go wrong. The growing trend in the use of W&I insurance is not showing signs of slowing and is likely to continue being a useful tool in managing post-completion risk for both buyers and sellers in the years to come.
