ABOUT THIS SERIES
- This is the fourth edition of McCullough Robertson's six part Commercial Law Masterclass series.
ABOUT THIS ARTICLE
- Allocating risk between parties in M&A transactions can be a long and drawn-out endeavour. In this article, we discuss how sellers can reduce their exposure through warranty and indemnity insurance and highlight that it's not always the cure all some parties hope it to be.
- We'll wrap up the series with a Masterclass in Brisbane in early 2019 where you can ask our expert panel any questions.
COMING UP NEXT
- Our next article in this series will focus on managing FIRB, a guide for buyers and sellers.
W&I Insurance – reducing exposure in M&A transactions
Due to the inherent divergence of interests of buyers and sellers in M&A transactions, the process of allocating risk between the parties to a sale and purchase agreement (SPA) can be a long and drawn-out endeavour. Sellers seek to secure a clean exit and buyers wish to hold sellers accountable for their pre-contractual representations in respect of the sale assets or sale shares. Warranty and Indemnity (W&I) Insurance can help buyers and sellers bridge the divide by passing the risk of warranty claims to a third party (the insurer). Importantly though, there are often gaps in coverage, so it is important that the parties are aware from the outset that W&I Insurance is not a fool proof solution in all circumstances.
In this edition of the Commercial Masterclass, we discuss what W&I Insurance is, how it works and what you should consider when deciding whether to take out a policy for your next M&A transaction.
What is W&I Insurance?
W&I Insurance provides cover for loss arising as a result of a breach of a warranty or indemnity given under the SPA. It transfers risk away from the seller, while providing security to buyers who can turn to W&I Insurance for compensation in connection with losses suffered as a result of a breach of warranty.
Typically, W&I Insurance is taken out by the buyer under the SPA, but can be taken out by either the seller or the buyer. W&I Insurance can be structured as either:
- a buy-side policy, in which the insured party is the buyer, who claims for loss arising from a breach of warranty directly against the insurance policy, and not against the seller; or
- a sell-side policy, in which the insured party is the seller, who claims against their insurance policy in the event that a successful claim is made against the seller by the buyer.
Alternatively, the parties may choose a 'seller-initiated buy-side' policy, which is a hybrid between the two policies outlined above. It involves the seller arranging W&I Insurance prior to or at the time of signing the SPA and then handing the process and the premium over to the buyer once the transaction has sufficiently progressed. Under this arrangement, the buyer receives the same recourse under their W&I Insurance policy as the buy-side policy and must make their claims directly under the insurance policy.
A W&I Insurance policy can be obtained at any time during the negotiation stage, as well as leading up to or after the completion of a SPA, but parties should keep in mind that it can take up to one month to implement. Once obtained, the W&I Insurance policy typically operates from the signing of the SPA (or at later date if the policy is obtained post-signing) and usually survives the periods of the warranties and indemnities contained within it.
In Australia, the premium for W&I Insurance is typically around 1% to 1.5% of the policy limit (which is usually the consideration agreed upon in the SPA). As premiums vary across jurisdictions, consideration should be given to the jurisdiction in which the W&I Insurance is purchased. For example, in other jurisdictions such as the United Kingdom and Europe, the premium is typically 1% to 3% of the cover purchased.
How would W&I Insurance benefit me?
As mentioned above, W&I Insurance serves many benefits for sellers and buyers alike. W&I Insurance enables sellers to:
- circumvent the need for an escrow or holdback arrangement under the SPA, which in turn enables sellers to distribute sale proceeds to investors or use the proceeds to pay off existing debt;
- exit from the transaction and the sale assets cleanly, by reducing the risk of contingent liabilities arising from future claims made by the buyer;
- progress pre-signing negotiations more effectively by transferring risk away from the parties and towards the insurer, thereby reducing the potential intractability of negotiations around risk allocation;
- protect other sellers (particularly those who were not actively involved in the management of the target assets) from accidental breaches of the SPA or failures to disclose information; and
- offer an attractive and comprehensive warranty package to buyers without increasing their liability for claims under the SPA.
W&I Insurance is useful for buyers, as it:
- may allow for a higher liability cap and limitation periods beyond what a seller may be willing to offer. This in turn provides buyers with extended time to detect problems that may exist within the assets acquired;
- offers buyers greater certainty that any claims will be paid, particularly where the seller is in financial difficulty or leaving the jurisdiction after the completion of the transaction;
- enables buyers to provide a more attractive bid in a competitive tender process, by accepting terms in the SPA that limit liability of the sellers (the buyer's contractual recourse is instead bolstered by the W&I Insurance policy); and
- promotes the protection of the commercial relationship between the buyer and the seller, who may continue to be commercial business partners after the completion of the SPA.
Things to keep in mind
Despite its many benefits, there are a number of things that parties should keep in mind when looking to take out W&I Insurance. Importantly, both buyers and sellers should give careful consideration to the extent of the coverage and the limits of their proposed W&I Insurance policy. Sellers in particular should know exactly what their policy does and does not cover, what claims are excluded from the policy and whether the seller will be responsible for certain amounts of the liability before the W&I Insurance responds.
Some examples of typical policy exclusions include:
- environmental risks (particularly contamination and pollution);
- fraudulent activity, bribery and corruption committed by the party giving the warranties and representations (the fraudulent party will be directly liable in this instance, such that the innocent party will be required to sue them personally and not claim from the insurer);
- certain tax risks, such as transfer pricing, secondary tax liabilities and loss of deferred tax assets;
- fines and penalties;
- liabilities relating to cyber or information-technology issues;
- adjustments to the purchase price;
- risks known by the parties (parties should carefully review any definition of 'knowledge' in their SPA, as it will indicate what level of knowledge would make a risk a 'known risk' for the insurer's purpose); and
- instances where the circumstances of the transaction drastically change and are not covered by what the insurer contemplated at the time of ascertaining the terms upon which it insures the party.
A (generally) short and straightforward road
In our experience, the process of obtaining W&I Insurance policy is usually straightforward. The proposed insured party first seeks confidential high-level guidance on the structure and pricing range of the W&I Insurance policy required under the SPA. The broker will generally want to review a draft of the SPA and other basic information relating to the transaction. This information will enable the broker to then make a formal submission to potential insurers, who provide confidentiality undertakings in respect of the transaction information received from the broker. Once they have reviewed this transaction information, the insurers provide an indication as to the terms upon which they are prepared to offer insurance to the buyer, including the premium costs and excess.
Upon receiving offers from insurers, the proposed insured party selects their preferred insurer, who conducts underwriting due diligence. This requires a fulsome buyer or vendor due diligence report. Once this process is complete, the underwriter offers a formal quotation based on its standard policy form, which should be negotiated to ensure that it aligns with the final version of the SPA. The limit of liability under the policy should also be negotiated between the insured and the insurer. From the insurer's perspective, the limit they are willing to offer is driven by the value and complexity of the transaction, as well as the quality of the transaction process and the advisers involved.
Finally, the insurer will require the insured party to provide a no claims declaration, prior to issuing confirmation of cover and a final insurance policy. A copy of the signed transaction documents should be sent to the insurer and the premium is settled after the cover is confirmed.
Parties should carefully examine and negotiate the terms of any proposed W&I Insurance policy, to ensure that it corresponds as closely as possible with the liability regime and representations and warranties contained in the SPA. Sellers in particular should aim to obtain an insurance policy with minimal divergence from the SPA, such that what can be claimed against the seller pursuant to the SPA is the same as what the seller can claim against the W&I policy. If there are any divergences between the SPA and the W&I Insurance policy, the insured party should carefully assess whether these limits are acceptable in light of their needs under the SPA.
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.