Traditional security models against warranty claims under the Merger and Acquisition ("M&A") transactions are commonly recognised as escrow mechanism, purchase price retention, share pledge and bank or parent company guarantees. Due to the characteristic difficulties of such security models, the market has invented a more effective supplementary protection method in lieu of the customary ones. The underlying reason of market's intervention is derived from potential pitfalls of traditional techniques such as requirement of depositing material part of the transaction income to a temporary account in case of a potential future indemnification (lacking from any possible interest or investment opportunity for years as in escrow mechanism). On the other hand, issuance of bank/parent company guarantees may mostly cause a substantial burden of time, cost and effort.
Frankly, is the new system designed well enough to an extent that would eliminate all such irritations? This article aims to outline a comprehensive overview of "warranty insurance model" (also known as "Representation and Warranty Insurance" or "Warranty and Indemnity Insurance") under 10 basic questions as follows:
1. Why Should the Parties of a M&A Transaction Consider Having Warranty Insurance?
As known, in M&A transactions, parties' eventual priority is to clearly clarify and constantly allocate the risks to which they are exposed to. Therefore, parties (mainly the buy-side) impose the other party to declare and undertake some deal-specific warranties (subject to some monetary caps, exclusions and time limits) clearly providing the warrantee a right to reimburse to the warrantor on embodiment of any threatening risk. Anyhow, there is always an inherent risk of the parties not to comply with their contractual obligations and reject the reimbursement. There is no guarantee that the buyer will be able to collect its losses without any security even though it achieves to have the most extensive warranty coverage by word. At that point, prudent parties seek out an unlimited comfort for the accuracy of the information and promises conveyed by the sellers, i.e. a back-up security model.
Warranty insurance, as a new insurance product designed by the insurance market shall cover and indemnify the insured party for damages resulting from any breach of representation and warranties determined by the parties in an acquisition agreement. Apart from traditional security models, warranty insurance targets to cover the real value of warranties in terms of monetary unit and removes the risk of seller failing to compensate any warranty claim in the future. In other words, warranty insurance is adjusting the traditional securities by trying to close the gaps and deficits and acting as an additional source of recourse. According to a reputable global law firm's 2019 M&A evaluation report, there has been a significant increase in utilization of warranty insurance for the last three years.
2. Who Would Mostly Prefer to Enjoy the Privileges of Warranty Insurance Model?
As a security tool, warranty insurance splits the risk of warranty breaches and ensures the involvement of an independent third-party distinct from seller's own financial distress and/or solvency difficulties to the deal. Having said, the risk is transferred to a third-party insurer in a solid and stable financial status. Accordingly, the income generated from the sale of the stake is directly transferred to the seller without the need of being subject to any security measure. Therefore, financial investors choose the warranty insurance model frequently as their security model in cases where they act as sell-side in a transaction, so they can achieve the full income freely at the exact moment of the sale. As already mentioned, traditional security models like escrow instrument may require the seller to maintain substantial illiquid capital after the closing. Especially in cases where the seller is a financial investor, it may lead to some unfavourable consequences like being obliged to remain at the exited business, unable to use the income for other potential investments and incapable of returning the funds to internal investors. In other words, warranty insurance mechanism aligns with highly reluctant characteristic behaviour of financial investors to leave warranty liabilities behind while exit.
3. What is the Roadmap for having a Warranty Insurance Policy?
At first, the parties of a transaction approach to an insurance company or an insurance broker to submit an official application. When the submission is received, certain analysis should be proceeded to estimate the pricing parameters and required deposit premium to be deposited by the insured party. Prior to that evaluation, the insurance company may request some information from parties such as transaction value, financials of the parties, scope of the representation and warranties, access to virtual and/or physical data room, draft or final form of any acquisition agreement, due diligence report and/or disclosure letter.
Following the insurance company's internal due diligence, the parties including the seller, the buyer, insurance company and their legal & financial advisors shall negotiate the content of the insurance policy. Fundamentally, they debate on the red flag issues detected by the insurer during its own due diligence. The insurance company may reserve its right to reimburse to the insured party or refrain from providing recovery in case of any intentional misrepresentation.
4. What are the Substantial Pros and Cons of Warranty Insurances?
As pros, in M&A deals sellers always refrain from providing a wide range of specific warranties whereas buyers are keen to have comprehensive warranties quite the opposite. Therefore, a warranty insurance aims to establish a stabilization between the parties and let them negotiate in peace through striking the uncompromising "warranties topic" off their agenda. Moreover, warranty insurance simplifies the deal process by eliminating any potential issues on the warranties, which are typically among the most problematic components of deals and accordingly may speed up warranty section negotiations. Besides, the warranty insurance serves to longer liability periods and contains wider levels of liability while eliminating most of the concerns about the future solvency risk of the sellers. Finally, it is beyond any doubt that especially in buy-outs warranty insurance allows a clean exit for sellers from the business with fewer contingent liability and mitigate the risk of unforeseen defaults. In cases where the existing sellers remain in acquired business as a buyer's key employee or as a consultant after the change of ownership, warranty insurance will protect the healthy relationship and goodwill between parties by preventing the buyer to submit a claim directly against his existing co-worker.
As cons, warranty insurance policies usually contain some standard limitations and exceptions such as implementation of coverage cap allowing the policy to operate at a certain level of loss, elimination of purchase price adjustments, exclusion of some tax-related and environmental issues (mainly if the business is an environmentally sensitive business), carve out of certain type of losses including consequential punitive and exemplary damages and leave out the forward-looking warranties such as revenue projections.
No doubt, insurance companies may provide excess coverages for such exclusions in return for additional premiums. Besides, buyers may insist on establishment of a separate indemnity for losses not covered by the policy such as retention amount even though the seller remains liable for gaps in coverage. Briefly, in cases where the policy is taken out by the seller, buyers are obliged to inform the seller when they come across with a third-party claim since the initiation of whole insurance coverage process is binding on a chain of sustainable actions which leaves the enforceability of the insurance package to the sole discretion and initiative of the seller. This addiction may discomfort the buyers as they may feel that they do not have any actual control over the security and thus, this requirement may lead them to a fair uncertainty. Finally, the premiums of warranty insurance could be blended at high ratios especially in countries like Turkey where warranty insurance is less popular. Consequently, not many insurance companies are willing to underwrite a warranty insurance policy currently in Turkey.
5. Is There Any Coverage Cap of Warranty Insurances?
Based on the numbers of international insurance companies' advertisement brochures, warranty insurance package applies a coverage limit which is commonly corresponding to 8%-10% of purchase price depending on each deal's parameters. In addition to the monetary limit, there are also some widely accepted exceptions limiting the scope of the warranty insurance policies such as price adjustments, administrative and criminal fines and penalties, disclosed information, confirmed or known by the insured party prior to the execution of the policy through a disclosure letter or due diligence report, punitive and exemplary penalty payments, fraud by the seller etc. There may be some other tailored exclusions stemmed from findings of insurance company during its own due diligence, negotiation or drafting phases of the relevant warranty insurance policy.
6. What is "Retention" under Warranty Insurances?
The insurance sector defines "retention" as an uncovered portion of the loss to be borne by the insured party itself. Retention is also being referred as "deduction" or "excess". The insurance company shall not provide any recovery unless the retention is first applied to the relevant claim. The retention shall be borne by sellers unless parties have agreed to share such amount among themselves prior to the execution of the relevant insurance policy. The retention amount is assigned by different percentages to be calculated over the total value of the existing transaction depending also on the premium amounts agreed. A high retention rate logically would indicate that the premium of the relevant warranty insurance should have a lower rate. In cases where the warranty insurance policy lacks any retention, the policy-owner may even break the policy for advisors' fee to be engaged for the resolution of third-party claims.
7. What Should Be the Duration of the Policy?
The periods regulated under the acquisition agreement with regards to time limitations of warranties should be reflected to the insurance policy and insurance policy should mirror the survival periods in full. Moreover, buyers may prolong the period of coverage beyond what was contractually agreed. Such extension provides additional time to buyers for protection against any problems and/or misrepresentations that may appear relating to the acquired business and shares in due course.
8. Does the Insurer Conduct its Own Due Diligence Prior To Execution of an Insurance Policy?
Since the warranty risk shall be allocated to the insurer, it is common practice for insurers to engage legal, tax and financial advisors while estimating the risk exposure and drafting the content of the insurance policy in detail. Warranty insurance offers a wide coverage including the warranties set forth under the relevant acquisition agreement to the extent that it is deemed feasible for the insurer. However, as mentioned above some general and/or tailor-made exceptions are assigned to the warranty policies therefore there will be a slight difference between what could have been claimed against the actual seller and to the insurance company.
9. What is the Average Cost (Premium) of the Policy?
Many global insurance companies label that insurance premiums of warranty insurance are around from 1% up to 4% of the total insurance coverage. The price of the premium of a warranty insurance depends on a variety of factors including but not limited to complexity of the deal, the operations of the target, sectoral and industrial risks, smoothness of the transactions, the claims filed in the past and finally country-based regional potential security threats. Long story short, the cost of the relevant warranty insurance shall be determined in accordance with how transparent, risk-free and straightforward the transaction is for both of the parties. The warranty insurance requires upfront payment in full before the coverage is activated. It should be noted that, the warranty insurance does not cover breaches occurred prior to the closing unless otherwise agreed by the parties.
10. Which Party Should Take Out the Policy?
Warranty insurance can be concluded by each party of the transaction. In practice, the sell-side policy covers the seller for its own innocent misrepresentations whereas a buy-side policy covers the buyer against the seller's all misrepresentations even innocent ones. The advantage of a buy-side policy is that, in this scenario, buyer submits its breach of warranty claim directly against the insurance company since it is the prevailing beneficiary party on paper without having any necessity to chase the seller in case of any breach. Otherwise, buyers should expect sellers to take an action against relevant insurance company for recovery. In addition, the remedy periods of warranties determined under acquisition agreement may likely to be extended in a buy-side policy to satisfy the buyer's own needs and to procure a more efficient protection with great recourse opportunities.
It is worth underlining that there is no existing local insurer directly offering warranty insurance in Turkish insurance market. However, parties willing to benefit from warranty insurance privileges are reaching out to foreign insurance companies through local insurance brokers. Consequently, warranty insurance is now more accessible in Turkish M&A market.
There are multiple reasons that the warranty insurance is not effectively recognized in Turkey yet. The most prominent one is the lack of regulatory framework and high premium amounts. On the one side, Turkish legislation does not directly impose any obstacle to engage with a foreign insurance company as long as the parties settle on terms and conditions. On the other hand, Turkish legislation does not explicitly regulate any legal framework for the instrument itself. For instance, there has not been any ruled out "general conditions" published by authorities for warranty insurance model under Turkish practice. Since the general conditions of warranty insurance have not been officially published yet, insurance companies are only able to offer warranty insurance model under liability insurance package for now.
With regards to premium payments, it is commonly accepted that foreign insurance companies request higher premium amounts in Turkey due to (i) temporary economic slowdown, (ii) unpopularity of the warranty insurance instrument in Turkish market attracting less competitors into the game, and (iii) on-going regional security threats. The 2019 M&A UK Report of a reputable law firm implies the correlation between popularity level of warranty insurance and premium by saying for UK that warranty insurance continues to increase in popularity as it becomes cheaper.
In a nutshell, warranty insurance is a highly growing trend around the world and on the eve of invading Turkey's M&A market. It is beyond any doubt that it will increase its popularity and convert into one of the mainstream components of Turkish M&A deals with the reciprocal support of diminished premium amounts and component legal framework.
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.