Interests of each of the parties to an M&A transaction are diametrically opposed. Buyers, for example, will be reluctant to enter into deals if the warranties provided by the seller in a sale & purchase agreement ("SPA") are too limited, or if they have concerns about the possibility of enforcing the warranties. Sellers, on the other hand, will be worried about their liability for a breach of warranty and will therefore try to restrict the scope of their warranties to the bare minimum. Striking a balance can be difficult, which means that adequate cover for such risks are often deal breakers.
Traditionally, the parties either go about the usual end results- dispute resolution mechanism for breach of warranties and indemnities that cover specific transactional risks, seller providing for money in escrow or bearing the risk out of its own pocket. With time, the mechanism of warranty and indemnity insurance ("W&I Insurance") has been developed to mitigate these risks in SPAs. W&I Insurance policies can result in the seller having immediate access to the sale proceeds, a ring-fencing against identified transaction issues, a reduced period of risk and, in many cases, no requirement to leave funds in escrow. For the buyers as well, it provides a sense of security when investing in a new jurisdiction, a relief against aspects where a seller is not ready to indemnify, amongst other benefits.
With increasing number of M&A deals happening in India and the development of a number of private equity investors, there has been a constant development in the sophistication that such transactions now face. There has been an acknowledgement of high degree of risks involved in such buyouts and post recession, a realization that these risks need to be adequately safeguarded. This article deals with the resultant evolution of W&I Insurance in India and further scope for its growth.
W&I Insurance policies: the concept
W&I Insurance is the generic name for insurance which provides cover for losses arising from a breach of warranty, or in certain cases, under an indemnity. The first W&I Insurance contracts were signed in the UK and US during the 1970s. W&I Insurance policies have undergone several changes over the years. Broader terms are now offered, and the amount of cover purchased is rising.
W&I Insurance aims to offer as close as possible "back-to-back" cover with the warranty language in the SPA as well as liability under any indemnity for claims arising out of matters which have not been fairly disclosed or known to the insured.
The various notable risks that a transaction normally faces for which either party seeks indemnification from the other include losses incurred as a result of uncertainty in tax related aspects, environmental losses and other breach of warranties, amongst other transaction specific risks. For each of these areas, the concerned party may opt for an insurance coverage.
A seller policy indemnifies sellers for losses resulting from claims made by the buyer for breaches of the warranties and indemnities given in the SPA. The policy also indemnifies the warrantors for the defence and investigation costs incurred which can be highly significant.
Buyers' insurance developed as a result of sellers either being unable or unwilling to provide the necessary level of warranty cover to the buyer. The buyer may be concerned about the seller's financial standing post-completion and whether it will have the resources one to two years after closing. Alternatively, the seller may seek to cap its exposure at a very low quantum so that it can make a clean "exit" with limited or no residual risk. In the light of market uncertainties, there has been resistance on part of sellers to provide indemnities and therefore, this cover is being taken by buyers increasingly.
When is W&I Insurance useful?
W&I Insurance is most useful where there is a commercial gap between the warranty cover being offered on the sale of a company and the amount of warranty cover desired by the buyer. This typically arises in the following scenarios:
- one or more of the sellers is a venture capital or private equity fund, who as a matter of policy do not give warranties;
- the seller is not willing to give full warranty cover, either because of lack of knowledge or unwillingness to take on risk, for example, where seller is a trustee;
- the seller is returning the consideration to lenders or shareholders;
- there is an issue visible through the due diligence which, if crystallized, may be of a large magnitude, such as breach of environmental laws; and
- investment by a buyer is in an unfamiliar jurisdiction or in a diverse range of business where recovery may be difficult.
Specific aspects in SPAs for which indemnities are usually provided are taxation and environmental claims. These covers are against identified issues on a transaction. There are other general covers for representations and warranties which generally provide covers for unknown liabilities in a transaction and help partiers manage the risks on a transaction in a better fashion.
In the last three or four years, many insurers have joined the W&I Insurance market. Also, an increasing number of enquiries are coming from countries that are relatively new to W&I Insurance, according to some underwriters. These include India, Hong Kong, Latin America, Dubai, Eastern Europe and Australia. As a result of the financial crisis provoking more warranty breaches, some insurers have received more W&I claim notices during 2008 and 2009 to date.
Scope in India
In India, in addition to the financial crisis, uncertainties in law has played a great role in convincing parties to M&A deals to seek W&I insurance. However, as a result of the market being very cost sensitive, these policies still remain a hard-sell. The premium for the W&I Insurance is at around 2-3.5% while for specific tax issues it is 5-8% and the entities providing with such covers are also handful like Aon and March, to name a few.1
As a result of rulings in the E*Trade2 and Vodafone3 cases, parties to an M&A transaction are increasingly inclined to take tax insurance. This is because of the widespread uncertainty regarding the tax protections under treaties between India and other countries and resultant divergent judicial pronouncements.
With increased cross border private equity transactions, the warranties provided for in an SPA need to be increasingly insured in addition to only tax related coverage. This is more pertinent in the light of the following issues: (i) a number of Indian companies are involved in cross-border transactions and are not entirely aware of the risks associated with a new jurisdiction; (ii) enforcement through courts in India is a long-drawn process; (iii) strict laws such as concept of absolute liability and judicial activism may result in massive penalties; and (iv) prevalent uncertainties in laws.
A large market for W&I policies is untapped as a result of non-awareness of the benefits of such insurance. Considering the potential of India as an upcoming market and the rise of tax insurance as a result of uncertainties in law, the Indian market still has a tremendous scope for W&I Insurance with regard to other forms of such insurance.
Partner, General Corporate and M&A, J. Sagar Associates, Gurgaon.
Associate, General Corporate and M&A, J. Sagar Associates, Gurgaon.
1. http://www.vccircle.com/500/news/marsh-india-pushes-insurance-covers-for-pe-deals, visited on 20 March 2011.
2. E*Trade Mauritius Ltd, a subsidiary of E*Trade Financial Corp., sold its stake in listed Indian firm IL&FS Investsmart Ltd to HSBC Violet Investment (Mauritius) Ltd in 2008. The tax department then raised a demand of Rs.24.5 crore on HSBC. After two years of litigation, the Authority for Advance Rulings last year ruled in favour of E*Trade and said that the firm was not liable to pay capital gains tax in India as per the Double Tax Avoidance Agreement between the two countries.
3. In May 2007, Vodafone International bought 66.98% stake in Hutchison Essar for US$11.2 billion. Hutchison controlled its Indian telecom subsidiary through a Cayman Islands firm called CGP Investments (Holdings) Ltd. CGP's shares were sold to Vodafone, which consequently became majority owner of the Indian telecom firm. Tax authorities said that Vodafone should have deducted tax at source before paying Hutchison and raised a tax liability of Rs.11,217.95 crore on Vodafone International Holdings BV, treating it as an assessee in default for its failure to deduct tax at source/withhold tax before making the payment. In November 2010, the Supreme Court directed Vodafone, which is contesting the tax demand, to deposit Rs.2,500 crore, along with a bank guarantee of Rs.8,500 crore, within eight weeks for adjudication of the suit.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.