With Thomson Reuters recording a 47% increase in the total value of worldwide M&A in its annual Mergers & Acquisitions Review for 2014[1] and The Financial Times reporting a 21% increase of M&A activity within the first three months of 2015[2], it is not surprising that there has been a rise in the use of transaction insurance policies.
Warranty and Indemnity insurance (“W&I”) is one such insurance policy that has gained significant traction. W&I provides financial cover for losses arising from a seller’s breach of warranties and, in certain jurisdictions, tax indemnities. Under English law, a warranty is a contractual promise which, if breached, gives rise to a claim for damages so as to put the innocent party in the position that it would have been in had the warranty been true. Claims for breaches of such reps and warranties are the most common to arise out of such transactions. W&I aims to provide tailored back-to-back cover for the seller’s liability under a sale and purchase agreement (“SPA”).
There are essentially two types of W&I: a buyer policy and a seller policy. A buyer W&I policy indemnifies the buyer for losses caused by breaches of warranties and claims arising under tax indemnities. This alleviates the need to pursue the seller and enables the buyer to claim directly from the insurer. A seller W&I policy, on the other hand, indemnifies sellers for losses resulting from claims made by the buyer for breaches of warranties and/or tax indemnities.
In each instance, a significant number of benefits arise. Buyers obtain commercial certainty when dealing with a distressed seller or one with a poor trading history, a situation in which the ability of the seller to reimburse the buyer for breaches of such warranties or tax indemnities may be minimal. This is further exacerbated if alternative solutions such as escrow funds or a letter of credit are unavailable. Additionally, if the seller is in a different jurisdiction to that of the buyer, the ability to claim through a W&I policy removes the added costs and potential jurisdictional issues that arise when dealing with international transactions and disputes. In both instances, the buyer would be able to reduce the risk of the M&A deal and preserve the value of the transaction.
Another situation is where the buyer depends on the future business relationship with the seller. Consequently, as the negotiation of a seller’s warranties is one of the most contentious parts of an M&A transaction, transferring liability to a third party insurer and removing the need to enter into such contentious negotiations substantially reduces the risks of damaging such crucial relationships. Consequently, tailored W&I policies allow buyers to be placed in a position where they can both reassure investors and devote core energies to creating value.
A seller W&I policy, on the other hand, may result in higher bids being received. The ability of a seller to offer a customary set of warranties and a higher warranty cap from the outset may raise the attractiveness of the purchase. A W&I policy may also, by reducing the risk and uncertainty of an M&A deal, allow for a larger group of bidders to be interested and therefore a more competitive bidding environment. This is particularly true for corporate or Private Equity investors that are likely to have internal investment guidelines to adhere to.
W&I policies are of particular use to the Private Equity industry where they may be unwilling or unable (depending on the contractual and strategic structure of the investment vehicle) to provide the warranties and indemnities needed for a sale. This is overcome with a buyer W&I policy as a buyer would pursue and claim from the third party insurer rather than the Private Equity seller.
There are some key factors to be borne in mind for the private equity sector. The use of such transactional policies, whilst providing a useful strategic and commercial tool for both buyers and sellers, does not cover every potential liability faced in an M&A transaction. For example, such policies tend to exclude liabilities arising from factors known or ought to have been known by the buyer, fines and penalties uninsurable by law and anything arising out of fraud or dishonesty. It is therefore only one avenue for risk reduction but may assist in avoiding the difficulties faced in 2014, when approximately 93 percent of M&A deals valued over US$100 million were litigated[3], do not transpire in 2015.
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