Pitfalls in the use of warranty & indemnity insurance
June 2019 | SPECIAL REPORT: MERGERS & ACQUISITIONS
Financier Worldwide Magazine
June 2019 Issue
In recent years, the use of warranty and indemnity (W&I) insurance in M&A transactions has exploded. This is due to the ability of the insurance industry to offer more suitable solutions for problems that arise during an M&A deal. It can be expected that the use of insurance solutions in M&A transactions will increase as insurers strive to create even better products for the market. Once faced with the proposal to use W&I insurance in a transaction, two questions arise almost immediately: how does W&I insurance function and how does it affect my position as a seller or buyer in a transaction?
Mechanics of W&I insurance
There is no such thing as W&I insurance. But there is a wide variety of products by insurers suitable for covering risks in M&A transactions. Therefore, insurance solutions may look very different, depending on the jurisdiction the respective M&A transaction plays in, the structure of the deal, the sector of the enterprise sold or the structure of the purchase agreement. The following observations are made from a German law perspective.
Buy-side insurance. The insurance product most commonly used is buy-side insurance. In most cases, the purchaser in an acquisition concludes this insurance simultaneously with the signing of a purchase agreement. The insurance covers damages suffered by the purchaser caused by a breach of warranties under a purchase agreement. In many cases, claims toward the seller under indemnities in the purchase agreement are also covered. In order to put this into effect, the insurance mirrors the purchase agreement and creates a second layer of contractual arrangement between the purchaser and the insurance next to the purchase agreement. If warranties are breached or an indemnity is triggered and coverage is granted, the insurance pays directly to the buyer. The insurance thereby releases the buyer from the uncertainties of claiming damages from the seller and enforcing such claims.
Furthermore, buyers profit from the high solvency of the insurance. The conclusion of the insurance has significant advantages for the seller as well. Therefore, sellers are often willing to pay such insurance via direct payment to the purchaser or via a reduction of the purchase price. The seller is exempt from negotiations on the provision of securities for a possible breach of guarantees, such as escrow amounts, purchase price retention, comfort letters or guarantees by parent companies. These are topics which often jeopardise a transaction. In addition, the seller is released from the liability under the purchase agreement, as far as the insurance holds the purchaser harmless.
Sell-side insurance. Of lesser importance is sell-side insurance, which is best described as a liability insurance in case of an enterprise sale. The insurance keeps the seller harmless from claims by the purchaser resulting from the purchase agreement. This insurance might be meaningful, if private individuals, such as start-up entrepreneurs, sell their enterprise. The insurance helps to avoid contingent liabilities on the private estate of the seller resulting from the purchase agreement. An advantage of the sell-side insurance is that the purchaser is not necessarily involved. The seller might not even inform the purchaser that it arranged for insurance cover for the transaction. Once an insurance solution comes into play, the purchaser could ask for additional wide-ranging guarantees arguing that the liability risks are covered by the insurance.
Risk-specific insurance. Besides these two standard types of insurance, there is a variety of insurance covering specific risks in an M&A deal. In real estate transactions, indemnities in respect of unknown contaminations in the soil are a common battlefield when negotiating the purchase agreement. Indemnities or guarantees concerning such contaminations are typically not included in W&I insurance. Environmental insurance provides cover in such situations. Tax insurance provides cover for legal risks concerning tax treatment of specific circumstances in a transaction. Finally, litigation buyout insurance covers risks resulting from pending or threatened litigation involving the target company.
Independence and dependency between the insurance and the purchase agreement
In the past, the overall rationale of W&I insurance was that the insurance covers the deal as negotiated between parties. Insurance required that the deal is negotiated at arm’s length, as if there was no W&I insurance. This seems to have changed. Lately, insurers are providing so-called ‘synthetic enhancements’ and thereby have abandoned this rationale. For instance, insurance does not provide for deductibles under the insurance, even if a purchase agreement provides for a liability threshold. Policy periods extend beyond the limitation periods of guarantees as provided under the purchase agreement or policies extend coverage beyond the liability cap under the purchase agreement. Lately, insurance even accepts that the parties agree to extremely short limitation periods or very low liability caps in the purchase agreement, providing coverage under standard terms. In this light, it is no longer a viable argument in negotiations that terms must be aligned with the insurance coverage or must provide for a market standard in order to receive insurance coverage.
Points to consider in the use of buy-side insurance
As buy-side insurance is the most commonly used, the effects on the position of a seller or buyer will be discussed in some detail below.
Points to consider during drafting and negotiating the purchase agreement
From a purchaser’s point of view, the negotiation of a purchase agreement is facilitated once W&I insurance is concluded. Hurdles arise, however, when there is significant time between signing and closing. A purchaser will always require coverage when signing. Upon conclusion, the insurer will require a declaration by the purchaser that they are not aware of any guarantee breaches or other insured events. In cases in which the seller delivers warranties in the purchase agreement that must be accurate at the time of signing and at the time of closing, the insurance will often require a second no claims declaration. As a basis of such no claims declaration, the insurance may also require a statement by the seller that no guarantees are breaches as of closing or a respective disclosure of breached guarantees. In the purchase agreement, the seller should reflect this as a closing action. Further, the insurance might require that withdrawal rights in case of a breach of guarantee between signing and closing are executed once existing.
It is a misunderstanding that buy-side insurance is solely in the buyer’s interest. Buy-side insurance has significant advantages for a seller. The seller should therefore include a covenant in the purchase agreement stipulating that W&I insurance will be obtained by the purchaser. It may also be advisable to attach the insurance policy to the agreement as an annex. Thereby, the seller will also have a chance to review the insurance agreement and the cover granted before signing. Finally, for the seller, it is important that insurance effectively limits liability under the purchase agreement. The purchase agreement should set out that the seller is not liable for a warranty breach to the extent that the insurance provides cover. It is up to negotiation between the seller and the purchaser if such exclusion of liability is triggered as soon as the purchaser has a claim under the insurance agreement, or as soon as the insurance has actually covered the purchaser’s loss.
Points to consider when reviewing and negotiating the insurance agreement
Once W&I insurance comes into play, of equal importance to the negotiation and drafting of the purchase agreement is reviewing and negotiating the insurance agreement. Insurers often use standard documents and tables, which leave little room for negotiation. Nevertheless, the insured should ask for clear and distinct wording despite the rather short and formalised insurance agreements.
Typical points of discussion are exclusions. These are cases or breaches carved-out from the insurance cover. As a general principle, insurance covers damages resulting from unforeseen and unexpected events. Therefore, a standard exclusion of coverage is that risks known to the purchaser or dealt with in due diligence reports are not covered by the insurance. Other exclusions depend on the industry sector of the transaction. Finally, there may be specific exclusions in respect of issues identified by the insurance provider in its due diligence. The applicability of these exclusions should be clearly defined. As far as indemnities are concerned, another standard should apply, as risk reflected in an indemnity is often identified in the due diligence and therefore known to the purchaser.
For a purchaser, it is very important that claims made by a seller are not assigned to the insurance, once the insurance has covered a specific loss. A seller should take care that such an assignment is clearly excluded from the insurance agreement, as well as in the purchase agreement.
The rise of W&I insurance is a deal facilitator in many aspects and provides for suitable solutions in many cases. However, it does not necessarily facilitate the work of M&A lawyers and advisers, as an additional player now enters the M&A scene, with its own distinct role. For a purchaser, in many cases W&I insurance becomes more important than a purchase agreement. Therefore, additional efforts should be placed on the review and negotiation of W&I insurance agreements in a deal setting. Insurers should be aware that they may want to provide standard products with standard agreements. However, they are entering a scenario where parties are used to negotiating tailor-made terms and conditions.
Dr Christoph Allmendinger is a senior associate at SZA Schilling, Zutt & Anschütz Rechtsanwaltsgesellschaft mbH. He can be contacted on +49 69 9769601 351 or by email: firstname.lastname@example.org.
© Financier Worldwide
Dr Christoph Allmendinger
SZA Schilling, Zutt & Anschütz Rechtsanwaltsgesellschaft mbH