Outlook for warranty & indemnity insurance in Spain
September 2019 | EXPERT BRIEFING | MERGERS & ACQUISITIONS
Although warranty & indemnity insurance policies (W&I) arrived in the Spanish M&A market more than 10 years ago, only recently have they gained traction as a valuable and increasingly popular tool, particularly in certain sectors, such as real estate, and with certain players, particularly private equity (PE) houses.
Broadly speaking, W&I, in the context of an M&A deal, covers potential damages derived from a seller’s misrepresentations, i.e., a seller’s representations and warranties (R&W) being untrue and, in certain cases, specific indemnities, i.e., liability retained by the seller in relation to known contingencies.
In Spain, W&I are governed by general regulations on insurance. By and large, Spanish regulations have no particularities affecting W&I, so Spanish law-governed W&I, and W&I subject to other than Spanish law in respect of a Spanish law-governed transaction, are substantially similar to those subject to English law.
We can distinguish between two types of W&I depending on who the insured party is: buy-side and sell-side policies. In sell-side policies, the seller is the insured party and the insurance works as a back-to-back arrangement, where a claim is brought by the purchaser against the seller under the relevant transaction agreement. The seller can, in turn, claim for coverage under the W&I. In buy-side policies, the purchaser is the one insured and, where a damage resulting from a misrepresentation (or specific indemnity) exists, the purchaser is the one to claim against the insurer under the W&I.
As sell-side policies do not cover scenarios where there is fraud of the seller, e.g., the seller knew an R&W to be untrue, buy-side policies are the norm. This, however, is irrespective of who bears the cost of the insurance premium, which is generally negotiated as part of the deal terms.
Why are W&I becoming popular in Spain?
The following reasons are among those which explain why buy-side W&I are becoming more popular in the Spanish M&A market.
First, they are a very useful tool to bridge the gap between the seller liability regime required by the purchaser and what the seller is ready, or allowed, to provide. W&I transfer totally or partially the risk deriving from R&W and, in certain cases, specific indemnities from the seller to the insurer in exchange for a premium. However, W&I do not eliminate altogether the need for parties to agree on the allocation of certain post-closing liability risks, as retentions or franchises and exceptions and limitations – generally applied to all deals and specific to the relevant deal – do apply.
Second, W&I eliminate or reduce the need for price escrows, bank guarantees and the like as collateral to secure the seller’s post-closing liability obligations.
Third, W&I allow the seller to obtain a clean exit, i.e., with no or little post-closing liability risk, which is especially useful for private equity sellers.
Finally, in competitive auction processes, W&I allow bidders to put together a more attractive bid, and sellers to put together a more attractive offer, as regards the seller liability regime.
In this regard, following a global trend, the so-called ‘staple W&I’ is becoming more common in Spain. In a ‘staple W&I’, the seller, as part of the auction process, offers bidders W&I coverage sponsored and coordinated by the seller, tailor-made to the relevant deal and deal documentation. This allows the seller to limit post-closing liability while offering a comprehensive R&W coverage (provided by the W&I), retain control over the insurance process, coverage and pricing and allows for a quicker auction process with reduced negotiation on seller liability.
Despite the benefits, there have been at least two factors which explain why W&I have taken so long to gain traction in the Spanish market.
First, the lack of knowledge and experience of Spanish M&A participants, particularly those less sophisticated – e.g., sellers of family-owned businesses and industrial and corporate players – has historically been a deterrent. Sellers have worried, and still do, that W&I will not totally isolate them from R&W-related risk, whereas buyers have worried that W&I will not adequately cover them when required, due to the complex limitations and exclusions regime or the potential opposition of the insurer to a claim under the W&I.
As W&I become more common in the Spanish market, these fears, while not eliminated altogether, are certainly subsiding. To this end, the role of insurance brokers and legal advisers has been, and still is, key.
Second, the integration of the insurer in M&A transactions complicates the deal and slows down a typically time-pressured M&A process, as: (i) the insurer needs to review and comment on due diligence materials and transaction documents; and (ii) W&I documentation must be negotiated and agreed upon in parallel with transaction documentation.
While these downsides remain in most cases, they are lessening as insurers and insurance brokers become more experienced. Working alongside legal advisers, insurers and insurance brokers are now able to integrate more seamlessly into the M&A process and commit to challenging timelines.
What seek W&I cover?
Each W&I is bespoke, designed and tailored to specific M&A transactions. It is typically structured to provide back-to-back coverage for the R&W agreed by the parties ‒ negotiated at arm’s length ‒ in the deal.
As a general rule, W&I only provide coverage with regard to matters or assets that have been subject to comprehensive due diligence, which insurers are typically entitled to rely upon.
While business or general warranties – e.g., related to the truthfulness of financial accounts, licences and no ongoing litigation – are normally covered by standard W&I, fundamental warranties (e.g., share title and authority) are often excluded and, when included, tend to entail a higher insurance premium.
Furthermore, there are certain exclusions generally applicable to W&I, including the following: (i) contingencies unknown by the purchaser (although known contingencies covered by specific indemnities can in certain cases be covered by W&I); (ii) forward-looking R&W; (iii) adjustment price mechanisms; (iv) financial prospects; (v) tax deferred assets and transfer pricing risks; (vi) indirect or consequential damages; and (vii) bribery, corruption and anti-money laundering (AML)-related risks.
As to the policy period, it is normally designed to tie in with the period of potential liability negotiated in the M&A deal. Moreover, the maximum liability amount under the W&I typically varies between 10 to 50 percent of the target’s enterprise value.
In turn, W&I typically include a retention or franchise of between 0.1 percent and 1 percent of the enterprise value of the target. With regard to a franchise – which entails risk retained by the purchaser or seller, whatever the case may be – insurers are becoming more willing to accept lower amounts, as competition between insurance companies increases and the classic conception that parties need to have ‘skin in the game’ to avoid agency problems gradually fades away.
Public statistics on insurance claims under W&I provide a valuable view as to how W&I work when a claim is brought. For example, while the number of claims made under W&I has substantially risen over the last few years in Spain, insurance claims remain the exception – claims are brought under only one of every seven W&I.
In addition, claims relating to financial statements, tax matters, compliance with laws, material contracts and employment are the most common. Furthermore, more than half of all claim notices are received within the first year and only a very small number of all insurance claims are challenged by insurers.
Eduardo Bagaría is a partner and Josep Moreno is an associate lawyer at Uría Menéndez. Mr Bagaria can be contacted on +34 (600) 914 456 or by email: email@example.com. Mr Moreno can be contacted on +34 (628) 650 480 or by email: firstname.lastname@example.org.
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Eduardo Bagaría and Josep Moreno