28 March 2022
De-risking your deal: warranty and indemnity insurance
Warranties and indemnities are some of the most heavily negotiated provisions in a sale and purchase agreement, with buyers pushing for maximum protection, and sellers trying to limit their exposure. In this starter guide on warranty and indemnity ("W&I") insurance, Isobel Symonds explains how W&I insurance can provide a solution for both parties.
In an M&A transaction, the sale and purchase agreement (“SPA”) will include a wide range of warranties. Warranties are contractual promises made by the seller to the buyer at the point of completion regarding all aspects of the target business. As part of the disclosure process, the seller is invited to disclose to the buyer any facts that are inconsistent with the warranties. If, post-completion, a warranty given by the seller proves to be untrue and a disclosure has not been made to that effect, the buyer is entitled to make a claim for damages against the seller, to put them in the position they would have been in had the warranty been true.
The buyer may also request an indemnity from the seller in the SPA. Indemnities are another type of contractual promise. In this case, the seller promises to the buyer that it will reimburse the buyer on a pound for pound basis if the potential liability they have discovered during their due diligence exercise, and which is identified in the indemnity, should arise.
The role of warranty and indemnity insurance
Warranties and indemnities are consequently some of the most heavily negotiated provisions of the SPA, with buyers pushing for maximum protection, and sellers trying to limit their exposure. Warranty and indemnity (“W&I”) insurance provides a solution for both parties. In the event of facts coming to light or events coming to pass post-completion that would give the buyer a right under the SPA to bring a claim for breach of warranty or an indemnity claim, the insured party – usually the buyer – will make a claim under their W&I insurance policy to recover their losses from the insurer, rather than the seller.
W&I insurance has a particular role to play where there are a large number of sellers but only a minority of them are providing warranties over and above fundamental warranties relating to, for example, title to shares and ability to enter into the transaction, which all sellers are usually required to give. In those circumstances, W&I insurance effectively plugs the gap between the level of liability the warrantors are willing to accept, and the level of coverage the buyer will be seeking.
Broadly-speaking, buyers like the certainty of W&I insurance, knowing that if the need arises, they have recourse to their insurer. This is seen as preferable to having to bring a costly legal claim in the Courts against a seller or multiple sellers who may, by the relevant time, have already spent the proceeds of sale or be in a different jurisdiction.
From a seller-perspective, W&I insurance means a clean break, without the worry that the buyer may bring a claim against them during the warranty period. It also means receipt of all the sale proceeds immediately on completion; with W&I insurance in place, there is no need for the buyer to insist that a portion of the consideration is held back (typically, in a third party escrow account) for part or all of the warranty period, to give them certainty of recourse against the seller.
These advantages are particularly compelling for retiree sellers or sellers looking to invest the consideration into new business ventures. For this reason, buyers may be able to negotiate a lower sale price, or edge out competitors in a competitive bid process, by offering to take out W&I insurance.
Most W&I insurance policies have an excess, which the buyer will either need to pay themselves or claim from the seller, depending on what is agreed in the SPA.
The policy will also include a number of exclusions. Most W&I insurers will not cover issues which are known to the parties, in respect of which any risk can be negotiated and allocated between them before completion. Typically, fundamental warranties relating to, for example, title to shares and ability to enter into the transaction, are also excluded.
The cost of taking out W&I insurance can also be substantial, depending on the level of risk a particular deal presents. On top of the insurance premium, there are usually broker fees to be paid. In addition, many W&I insurers will insist on the policyholder (i.e. the buyer) taking out separate expensive specialist policies to cover high-risk areas, for example, tax, litigation, health and safety and environmental issues. In view of the mutual benefits of taking out W&I insurance as outlined above, it is common for the parties to split the cost of the premium between them.
The use of W&I insurance can also delay the timetable to completion and increase the professional costs of both parties, in particular those of the policyholder. The policyholder must consult with the insurer at every step of the transaction, in particular during their due diligence exercise (if, as is usual, the policyholder is the buyer) and negotiation of the wording of the warranties and disclosures. The insurer’s lawyers need to be satisfied that these processes have been undertaken thoroughly and diligently, and may have their own comments on the drafting. Insurers may seek to water down the warranties to reduce the risk of the buyer having a claim for breach of warranty which would require them to make a pay-out. All this extra process necessarily involves more work for the parties’ advisors.
While there are downsides to using W&I insurance, the advantages for both buyers and sellers are sufficiently persuasive to have driven a significant rise in demand in the last few years. W&I insurance is not suitable for every M&A transaction, but it is certainly something buyers and sellers should consider at the outset.
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This publication is not intended to provide a comprehensive statement of the law and does not constitute legal advice and should not be considered as such. It is intended to highlight some issues current at the date of its preparation. Specific advice should always be taken in order to take account of individual circumstances and no person reading this article is regarded as a client of this firm in respect of any of its contents.
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