Partner Piece – Simons Muirhead & Burton LLP
January 21, 2020
Warranty and Indemnity Insurance – Minimising Risk
By Joseph Davis of Simons Muirhead & Burton LLP
Beyond the purchase price, perhaps the most important negotiation regarding the sale of a business relates to the warranties and indemnities given by the seller. Warranties and indemnities represent the greatest ongoing liability of a seller to a buyer, and therefore ways to minimise this risk are very attractive to sellers. Warranty and indemnity (“W&I”) insurance is an increasingly popular means by which sellers may seek to reduce this risk, as well as providing additional comfort to the buyer.
What are warranties and indemnities?
When buying a business, a purchaser will require the seller to give warranties in relation to the target business within the sale and purchase agreement (“SPA”). Warranties are a set of contractual promises made by a seller about the state of the business being sold, which will be relied upon by the buyer. These warranties can be qualified by disclosures where the seller can explain that a warranty is untrue and, subject to the disclosure complying with the terms of the SPA, the seller will then not have any liability in respect of that matter.
A buyer requires the seller to provide warranties for two principal reasons: (1) to elicit information through the disclosure process; and (2) to provide a remedy for the buyer if it suffers loss in relation to an undisclosed warranty breach.
An indemnity is a promise from the seller to reimburse the buyer on a pound for pound basis in relation to a specific head of loss. When claiming under an indemnity the buyer is not under a duty to mitigate its loss, as it is regarding warranty claims, and indemnity claims can be framed as debt claims whereas warranty claims are for breach of contract.
What are the benefits of warranty and indemnity insurance?
One of the key benefits of W&I insurance for a seller is that it allows them to walk away with the proceeds of the sale without having to consider the risk that they may become liable for a claim in the future. The seller is therefore able to immediately spend or invest the purchase price with the certainty that they will not have to use their sale proceeds to cover a warranty or indemnity claim. One of the key benefits of W&I insurance for the buyer is that it covers the sellers’ fraud and increases the amount of contractual protection made available to them under the SPA through a broader suite of warranties , higher liability caps and lower de minimis claim thresholds.
Buyers will also want certainty, in this case the certainty that the seller will have sufficient funds to pay for any claims the buyer may have. A common solution to this problem is the use of an escrow account, meaning that the seller will not receive the sale proceeds until a later date (often several years depending on the limitation periods negotiated under the SPA). The use of W&I insurance eliminates the need for an escrow account, and therefore allows the seller to receive the proceeds of the sale immediately, whilst giving the buyer comfort that it will be able to recover any loss it suffers. W&I insurance can also reduce the risk of purchasing from a private equity seller who would not otherwise give warranties, or from a seller who would be difficult to make a claim against (e.g. a corporate seller which will cease to exist after the transaction).
Warranty claims can also harm the ongoing relationship between the buyer and seller of a business. This is of particular importance in circumstances where a selling shareholder continues to work for the business. Ordinarily a buyer may be reticent to bring a warranty claim against such a person and harm their ongoing relationship with the seller, but the use of a W&I insurance policy eliminates this issue as the insurer rather than the seller will be liable for the claim.
What are the disadvantages of warranty and indemnity insurance?
As a counterbalance against the benefits of W&I insurance there are a number of drawbacks to consider when deciding on the appropriateness of taking out a policy. The most significant of these is the cost – the price of the premium itself is discussed below, however the use of a W&I policy will also cause increased legal costs and may add time to a deal. There is an extra level of administration required to satisfy the requirements of the insurer, which means that deal timelines may be extended, and lawyers will have to expend additional time and costs for the buyer and seller. Whilst the risk of warranty and indemnity claims is an important factor for a seller to consider and seek to mitigate, provided a proper disclosure exercise is undertaken, such claims are rare. This remoteness of this risk should be considered when weighing up the cost of W&I insurance against the risk of warranty or indemnity claims arising.
Additionally, the use of a W&I policy means the seller will not have ‘skin in the game’. As the seller will not be financially harmed by warranty or indemnity claims that are covered by a W&I policy, the seller may be less motivated to make proper disclosure of potential warranty breaches. Especially in circumstances where a seller is remaining in the business after the sale, their lack of motivation to prevent a claim arising may be a significant drawback to a buyer.
‘Buy Side’ or ‘Sell Side’ policy?
Either the buyer or seller may be the insured party under a W&I policy, although it is more common for the buyer to take out the policy and be the insured party, known as a ‘buy side’ policy. Even where the buyer is the insured party the seller will often pay the premium. Lockton Companies LLP (“Lockton”) are a broker of W&I and other M&A related insurance products, and of the 224 transactions they closed last year, 97% were buy side policies.
If the seller is the insured party, a ‘sell side’ policy, then the buyer must make a claim against the seller who can in turn then make a claim under the W&I policy – this negates the benefits of the seller not having to maintain sufficient funds to cover a claim and the protection of the relationship between buyer and seller. The type of policy taken out will have to be agreed between the parties, and the form of policy as well as who pays the premium will depend on the relative bargaining positions of the buyer and the seller.
Is it expensive?
The cost of a W&I insurance policy, as with all insurances, depends on the risk profile of the potential heads of loss – in this case the warranties and indemnities – being insured. The premium is a one-off payment made up front when the policy is taken out, and it is dictated by a variety of factors. Key factors that determine the price include the excess payable on claims, the proportion of the purchase price the policy will cover and the perceived likeliness of any claims arising. Whilst no two deals will be the same, a rough marker is that the premium for W&I policies in UK transactions are usually around 1% of the amount covered (however, it can be as low as 0.65% of the insured cap depending on the nature of the target company), although prices may continue to come down as the market becomes more competitive.
What is, and isn’t, covered?
. Claims within the buyer’s knowledge at the time of the acquisition and certain tax and pensions related claims are likely to be excluded. Ultimately the level of cover will depend on what the party paying for the policy is willing to pay, as cover for warranties or indemnities that are considered to carry a greater risk of being subject to claims will mean a higher premium.
What does the process entail?
The insurer will need to review the key transaction documents and the due diligence process throughout the course of the transaction in order to ascertain the risk level of the insured party. It is a condition of W&I policies that a proper due diligence exercise has been carried out by the buyer, and a full disclosure process carried out by the seller, as otherwise the buyer would not be motivated to spend time and money doing so, safe in the knowledge that any loss it suffers as a result would be covered by the insurance policy. The insurer will therefore closely monitor the due diligence and disclosure processes and will require ongoing discussions with the buyer to provide sufficient comfort.
W&I insurers and brokers employ experienced corporate lawyers to oversee this process – they tend to be highly responsive and understand the market and the deal process. It is key to get them involved as early in the deal as possible, in order that they do not have to spend time getting up to speed with a deal, therefore the appropriateness of using W&I insurance should be considered at the outset of a transaction.
Summary
W&I insurance policies are an increasingly popular way for buyers and sellers to minimise the risks associated with corporate acquisitions. The particular circumstances of each deal will determine the appropriateness of a W&I policy, but the use of one can be a clean way to overcome issues that may otherwise derail a deal – such as the need for an escrow account, the breadth of warranty cover and the limitations on claims. However, W&I policies are not a silver bullet and are not a substitute for full due diligence and disclosure processes. W&I policies are bespoke products which are only appropriate in specific circumstances, and buyers or sellers considering the use of such a policy should take professional advice and consider all the circumstances of the deal. Ultimately the appropriateness of using a W&I policy will come down to balancing the risk of a warranty or indemnity claim arising against the cost of the insurance, both in terms of time, the insurance premium and additional legal fees.
Lockton explain that “W&I insurance has gone from a rarity on deals to commonplace or even the standard market position. Our team looks at nearly 1000 transactions a year globally. It’s now estimated that around 5000 policies are placed annually. Recent statistics suggest that over 50% of corporate real estate transactions in Europe now use W&I Insurance, and 25-30% of private equity transactions; a large driver for this has been the adoption of a £1 cap on sellers’ liability under the SPA, leaving buyers with little choice but to take out W&I insurance in the absence of any contractual protection under the SPA”.
Joseph Davis (Solicitor) Simons Muirhead & Burton LLP 87-91 Newman Street, London W1T 3EY Email: joseph.davis@smab.co.uk Tel: +44 (0)20 3206 2731 Mob: +44 (0)7811 971400
