When businesses are sold, sellers usually give warranties to buyers, which are statements of facts about the target business. They typically touch on all key aspects of the target's business (including, for example, its accounting records, employees and litigation history) and protect buyers by:
- drawing out information inconsistent with the warranties; and
- giving buyers a contractual right to bring a claim against sellers if they suffer losses in circumstances covered by a warranty.
Warranty and indemnity claims are rare for well-advised sellers who carry out due diligence thoroughly and make full and frank disclosure of the target’s key characteristics and issues. Generally speaking, if a seller has fairly disclosed all relevant matters to the buyer, the buyer will be prevented from bringing a claim for breach. However, as warranties given in a sale and purchase agreement (SPA) are one of the most contentious aspects of a transaction, there is a risk that under negotiation and time pressure, or simply due to a lack of investigation, factual matters may go undisclosed, which could lead to a breach of warranty claim. Indemnities can be even more severe, giving a buyer a pound-for-pound remedy if losses arise from a pre-identified set of circumstances. Insuring against these worst-case scenarios is therefore now unsurprisingly common.
- Whilst either the buyer or seller can technically be insured, most W&I policies are taken out by buyers.
- Premiums are usually between 0.9 per cent - 1.5 per cent of the policy limit, plus insurance premium tax. The premium rates depend on factors such as the jurisdiction of the target, the governing law of the acquisition agreement, the industry sector, the financial stability and identity of the parties and the scope of the warranties. The premium is a one-off payment made at the start of the policy.
- The party who pays for the policy will be negotiated, as will the limit of the policy coverage.
- An insurer must have a good appreciation of the transaction and negotiations undertaken in respect of the warranties, and confidence in the disclosures made. The insurer's lawyers will also need to review key transaction documents such as the SPA, disclosure letter and due diligence reports before the policy can be agreed. They will usually want to see that both seller and buyer have endeavoured to undertake the disclosure exercise diligently. As a result, obtaining cover usually takes a few weeks.
- The policy will generally reflect the duration of the warranties given in the SPA, although if a seller successfully limits the duration of the warranties, a policy can be extended beyond the SPA time limits, normally up to a maximum of seven years' post-completion for tax warranties and two years' post-completion for general warranties.
In M&A transactions, a buyer will aim for the warranties to be as broad as possible whilst the seller will seek to limit them. If the parties' expectations as to the scope of the seller's liability are too far apart, W&I insurance can effectively bridge this gap.
For the seller
- Clean exit - W&I insurance reduces the need for buyers to ask for part of the sale proceeds to be subject to escrow or holdback arrangements, allowing sellers to access the full consideration and make a clean exit without the risk that they will later become liable for a warranty claim. This is particularly important for private equity sellers (who may be unable to take on liability under their fund terms and/or need to make immediate distributions of sale proceeds) but also commercially attractive for retiree sellers and those wishing to roll funds into future investments.
- Increases attractiveness of target - W&I insurance can be particularly attractive if the target and/or seller are in financial distress. Such insurance can increase the target’s attractiveness to potential buyers.
- Caps liability - W&I policies allow sellers to cap their liability under an SPA to a far greater extent than would be acceptable to a buyer if a W&I policy was not in place.
For the buyer
- Maintains relationships - A buyer may hesitate to bring a warranty claim against sellers who continue to be employed by the business after completion. But a W&I policy allows claims to be made without damaging a buyer's relationship with valuable retained valuable staff, as a claim is instead brought under the policy.
- Foreign jurisdictions - W&I insurance cover is advisable to buyers who do business in foreign jurisdictions, as the enforcement of warranty claims against sellers may be difficult and combined with additional risks.
- Protection - Claiming under a W&I policy removes the risk of a seller not being able to pay out should a warranty claim arise.
- Lower offer - A seller might be willing to entertain a lower offer if they know that the sale proceeds will be immediately available to them, rather than having the uncertainty of seeing a warranty period through or having money held back in an escrow account.
- Cost of insurance - W&I insurance can sometimes be costly for a buyer.
- Not a complete solution - Certain losses will not be recoverable under a W&I policy, including the cost of investigating and bringing a warranty claim, claims with a value below the de minimis threshold in the policy, claims which the insurer disputes and claims where loss cannot be shown to have resulted from a breach of warranty. Known facts are also generally excluded from W&I insurance coverage, although recently, insurers have been increasingly willing, for the right price, to underwrite these. Common exclusions include tax liabilities, consequential losses, fraud and forward-looking warranties.
- Does not replace due diligence - Insurers expect a thorough due diligence exercise to have been conducted by a buyer and will expect a seller to have undertaken a thorough disclosure process, as is standard practice for M&A transactions.
- Retention - Typically, the insurer requests a policy retention meaning the sellers will bear the first portion of any warranty claim by way of an excess. The amount of the excess will be negotiated between the buyer and seller and depend on several factors such as the magnitude of risk. Whilst policies which allow for zero recourse against sellers are becoming more common, they may be more expensive and aren’t always available.
Taking out W&I insurance as part of an M&A transaction is now commonplace and at least considered in the majority of larger deals. Obtaining a policy is an increasingly straightforward process and whilst not a panacea, it can certainly be a useful solution to many issues, giving comfort to seller and buyer alike.
If you require further information about anything covered in this briefing, please contact Beth Balkham, or your usual contact at the firm on +44 (0)20 3375 7000.
This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.
© Farrer & Co LLP, October 2020