Warranty and indemnity insurance has emerged as a common instrument to address deal risk in M&A transactions globally.
What is warranty and indemnity Insurance?
Warranty and indemnity Insurance covers losses arising from breach of a warranty (or in certain cases under an indemnity) given in connection with an M&A transaction thus facilitating transactions by transferring risk for breaches of warranty from the seller or the buyer to the insurer.
Why use warranty and indemnity Insurance?
Some of the key reasons for using warranty and indemnity Insurance in an M&A transaction include:
- Providing a ‘clean exit’ from the transaction – the policy can effectively allow a ‘clean exit’ for the seller (other than in specified circumstances such as fraud) with no residual risk.
- Bridging the gap between seller and buyer expectations – Sellers wish to minimise their risk by giving limited warranties whereas buyers wish to extend their scope. The use of warranty and indemnity Insurance can bridge these expectations, by paying the insurer to bear the risk.
- Providing security to the buyer (and financiers) for financial risks associated with the warranties and indemnities given by the seller – where there is uncertainty over the seller’s capacity to satisfy future claims (eg distressed assets being sold upon insolvency or foreign sellers) warranty and indemnity Insurance can give comfort that an insurer will pay any claims.
- Enhancing a bid proposal – in a competitive tender a buyer can enhance its proposal by using warranty and indemnity Insurance to provide a clean exit.
- Dealing with multiple sellers – it can be difficult for buyers to recover against multiple sellers and warranty and indemnity Insurance can provide an alternative for the buyer.
- Assisting to maintain an ongoing business relationship – where the seller will continue to have a role with the buyer, warranty and indemnity Insurance can assist as breach of warranty claims can be made against the insurer and not the seller.
The warranty and indemnity Insurance market
Over the past 5 – 10 years, warranty and indemnity Insurance has increased in popularity. The main drivers of the change have been increasingly flexible solutions from insurers, increased adaptability to deal requirements, more compatibility deal timelines, and the development of buyer-side policies providing greater certainty for buyers and sellers.
Tips & Traps
It is important for buyers and sellers and their advisers to understand that in order to offer warranty and indemnity Insurance, insurers will expect to see that adequate due diligence has been undertaken by buyers and that the warranties have been actually negotiated by the parties (rather than relying on insurers to underwrite a bad deal). Insurers will appoint their own legal advisers to review the due diligence process undertaken by the seller or buyers advisers.
Warranty and indemnity Insurance can be structured as either a buyer-side or seller-side policy (with numerous variations). Until a few years ago, insurers had a strong preference toward seller-side policies – to align the interests of the insurer and the insured. In a seller-side policy the buyer still claims against the seller and it is the seller that then calls on the warranty and indemnity Insurance to respond to the claim. However, in Australia this is changing with buyer-side policies becoming the dominant form of warranty and indemnity Insurance due to sellers’ desire for a clean exit. A buyer-side policy is appropriate in circumstances where the buyer does not have confidence in the financial capacity of the seller, where the seller wishes to make a ‘clean exit’ or where it is known or envisaged that the seller will not be in existence during the warranty claims period.
To an extent, over recent years consensus has developed on what will typically be excluded from a warranty and indemnity Insurance policy and these include:
- matters of which the insured had actual knowledge before the effective date of policy (e.g. matters which the buyer identified in its own due diligence or which are disclosed by the seller (note that separate, standalone cover may be available for known matters));
- fraud and deliberate non-disclosure by the insured;
- changes to transaction documents following review by the insurer and without the insurer’s permission;
- fines and penalties;
- purchase price adjustments. These are dealt with through the contract and completion accounts/leakage covenants;
- forecasts or forward-looking warranties;
- anti-bribery and corruption risks in high-risk jurisdictions;
- superannuation underfunding; and
- tax avoidance, including transfer pricing.
The policy will generally specify which warranties are insured so a breach of some warranties may not fall for cover.
There are a range of other key provisions and it important that the terms of cover are carefully reviewed to ensure the policy operates as expected.
Warranty and indemnity Insurance is not appropriate for all transactions. However, such insurance is an additional tool that can enhance a buyer’s or seller’s position in a negotiated M&A transaction. The flexibility of the product when correctly and strategically used can facilitate any M&A process.
This blog is a snapshot of a longer article recently published in the Australian Insurance Law Bulletin. See: Jyoti Singh and Ray Giblett, ‘Warranty and indemnity Insurance – Insuring a Smooth Transition’ (2016) 32(2-3) ILB 30 Insurance Law Bulletin 30. Contact us if you would like a copy.