Breaking down the lingo.
Sellers in an M&A transaction are required to make certain statements (representations and warranties) about the company they are selling, to paint the legal picture. For example, the company is not party to any litigation, it has complied with all employment laws, it holds all required permits etc. If these statements are not true, the buyer can claim against the seller for any damages it incurs as a result of the inaccuracies.
Warranty & Indemnity (W&I) insurance (aka representations & warranties (R&W) insurance), is essentially an insurance to cover the cost (or part of the cost) of the buyer’s damages if it transpires that the seller’s representations and warranties are not accurate. The insurance policy can be taken out by the seller or the buyer.
Under a seller-side policy, the seller is the beneficiary and the buyer will make a claim against the seller, who in turn seeks recourse against the insurance company.
Under a buyer-side policy, the buyer is the beneficiary and will make a claim against the insurer directly.
What’s in it for the seller?
In order to secure the seller’s representations and warranties, and ensure that the seller has the ability to indemnify the buyer if these statements prove incorrect, part of the purchase price is typically placed in escrow or held back for a certain period. W&I insurance may remove the need for an escrow, giving the sellers a clean exit and immediate access to the whole purchase price. Sellers may prefer to pay the cost of the policy premium to the insurance company and walk away, rather than having a significant amount of their exit payment deferred and at risk of being returned to the buyer.
A “clean exit” is particularly important if the seller is a financial investor, such as a private equity fund nearing the end of its life-cycle, that wishes to disburse its proceeds and liquidate.
A W&I policy can also be an attractive tool to sellers in a distressed sale. Here buyers tread extra cautiously as the seller is in a financial crisis. A third party insurer may make the acquisition more attractive to potential buyers.
Finally, such insurance allows a seller to avoid exposure for its fellow sellers’ breaches, as purchasers will often ask that the sellers are jointly and severally liable for each other.
What’s in it for the buyer?
If a buyer is concerned about the credit worthiness of the seller and its ability to pay out damages, for example where the seller is a special purpose vehicle or fund that will cease to exist after the sale has closed, traditionally it may have asked for a parent company or other form of guarantee from the seller. However, such guarantee is not always an option. W&I insurance therefore offers an alternative security and source of comfort for the buyer.
As sellers would prefer such a policy to an escrow mechanism, W&I insurance can be used by buyers to make a more attractive bid when vying for a company being sold as part of a tender process or auction – in lieu of offering a higher purchase price.
In certain cases it may be difficult for the buyer to claim against the sellers; for example if the seller was active in the company and is being required to stay on as management or if there is a commercial relationship with the sellers going forward. Here it would be politically easier to seek recourse against an insurance company rather than the company’s CEO.
If the buyer is purchasing a company in a foreign jurisdiction or from foreign sellers, W&I insurance may also be attractive to the buyer as it may be easier to seek recourse against a local insurance company as opposed to claiming against the sellers and enforcing a judgment in a different country, which can be challenging and costly.
Finally, if there are numerous sellers who are not severally and jointly liable for each other, the buyer might prefer to seek recourse against one insurance company instead of 15 different sellers, which could otherwise be expensive and a logistical nightmare, particularly if there is no escrow or the damages exceed the monies then held in escrow.
What’s in it for both?
The seller’s indemnification obligations are typically capped and restricted in an M&A deal, limiting the buyer’s recourse. These restrictions are always a point of negotiation and W&I insurance can be taken out to bridge the gap, allowing a deal which might not otherwise have happened to close.
The fine print.
As with any insurance policy certain risks are excluded. Generally these include any facts identified by a buyer in its due diligence or otherwise disclosed by a seller, certain tax or environmental matters, forward-looking warranties, fines and penalties, fraud etc. In other words, the sellers are not always entirely off the hook and the buyer is not always entirely protected. However, some insurers will agree to underwrite a specific issue, for the right price.
Time is of the essence.
AW&I policy is usually bespoke. The insurer and its advisers will review the acquisition agreement and buyer’s due diligence report on the target and perform its own due diligence. It will then negotiate the scope, deductibles and caps of the policy. While this is supposed to be done in tandem with the negotiations of the acquisition it inevitably weighs on the schedule.
An insurance policy may expedite the sale process by offering a solution to disagreements regarding the seller’s indemnity obligations and cutting out negotiations pertaining to escrow mechanisms and agreements. However, insurance companies expect the buyer to have performed a comprehensive due diligence on the target and for the parties to have sincerely negotiated the allocation of risk in the transaction documents, and not merely shirked and rolled all responsibility on to the insurers. If the insurer feels that the sale agreement is not on market terms, it may refuse coverage.
Moreover, if the final insurance policy is too limited the buyer may seek special indemnities or other protections from the seller to fill in the gaps, and may require an escrow and escrow agreement. This again takes time and adds obstacles to an already stressful and time consuming process.
W&I Insurance popularity is growing. These policies certainly have their benefits but also their draw backs (as with most things in life), that need to be weighed against each other in light of the idiosyncrasies of any particular deal.