Warranty and Indemnity Insurance (“W&I Insurance”) – Key Advantages from a Buyer’s Perspective
Introduction
W&I Insurance is a product designed to cover losses arising from a breach of warranty, typically in a share or business purchase agreement. It has become standard practice across most markets for sellers to cap their liability at a nominal amount, positioning the product as an effective mechanism for enabling sellers to achieve a ‘clean exit’.
For buyers with limited experience of the product, the advantages may not be as immediately apparent as the clear advantage it offers sellers in achieving a clean exit. In addition, the presence of W&I insurance in competitive auction processes (where sellers typically hold a stronger bargaining position) can sometimes lead potential buyers to perceive the product as serving the seller’s interests alone.
Regardless of whether W&I Insurance is a sell side requirement, when negotiated effectively, the product offers a number of advantages to buyers compared to a traditional set of seller backed warranties, certain of which are highlighted below.
Security for breaches
On transactions without W&I Insurance, the seller’s financial standing and its ability to meet potential future claims is often a key focus for the buyer and its legal advisers. Where the seller is an individual or a corporate entity with limited assets, it is generally advisable for the buyer to seek appropriate comfort that sufficient resources will be available to satisfy any claims that may arise. Depending on the specific market, escrow arrangements, parent company or third-party guarantees are among the solutions traditionally sought by buyers to address this concern. On insured transactions, the buyer’s recourse will ultimately be against one or more insurers with a high credit rating from a recognized credit rating agency, effectively eliminating the need for the buyer to seek further security from the seller to cover standard warranty claims, regardless of the seller’s individual financial circumstances. Security may still, however, be required where specific risks are uncovered by the buyer that are excluded from the W&I Insurance policy.
Joint and several liability
On transactions involving multiple sellers who are not part of the same corporate group or connected by close familial ties, it is common for sellers to insist that warranties are given on a several (rather than joint and several) basis. This requires the buyer to pursue each seller individually in the event of a breach of warranty. Although the structure of certain insurance markets (particularly on larger transactions where a tower structure may be necessary to provide an appropriate level of cover) can result in multiple insurers being involved in defending a claim, this rarely presents an issue for buyers in practice. Moreover, the ability to bring a single claim under a W&I Insurance policy, as opposed to pursuing multiple sellers individually, represents a significant advantage for the buyer on any transaction involving more than one seller.
Ongoing relationship between Buyer and Seller
On transactions where the buyer and one or more sellers intend to maintain an ongoing relationship post-completion (such as in sales involving less than 100% of a company’s shares or assets, or where a seller retains a managerial role) a direct claim against the seller can cause significant disruption to the business. This risk is largely alleviated on insured transactions, where the seller’s liability is typically capped at a nominal amount and recourse is instead directed to the insurer. Furthermore, even if, as part of the negotiations, it is agreed that the seller will retain some liability, the buyer will be entitled to pursue its claim exclusively against the insurer if it so choses.
Coverage of seller fraud
It is a common misconception amongst buyers that fraud of any kind will be excluded from cover under a W&I Insurance policy. Fraud on the part of the insured party (which is the buyer on the vast majority of policies) will certainly be excluded. However, the reality for a standard buy-side policy is that a fraudulent breach of warranty by the seller will be covered. Whilst a fraudulent breach by the seller will lift the cap on the seller’s liability, granting the buyer a direct right of recourse against the seller, the buyer will nonetheless retain its right to claim under the W&I Insurance policy. In practice, given the high burden of proof and other challenges of a direct claim, a buyer will typically claim under the W&I Insurance policy in the event of a fraudulent breach by the seller (assuming that the claim is made in time, it is not excluded from the policy and the buyer is able to satisfy the other conditions under the policy). This does not mean that the seller will be off the hook for a fraudulent breach as the insurer will have the right to seek recovery from the seller directly under the subrogation rights in the policy, which typically only apply in the event of fraud on the part of the seller.
Collaborative process
The negotiation of the policy and the claims on insured transactions both tend to be more collaborative processes than uninsured transactions.
In relation to the negotiation of the policy, there are certain key risks that insurers will almost always exclude and should be anticipated by a well-advised buyer at the outset of any transaction. These will include matters such as known risks, pollution (in the absence of a “clean” phase 1 report), condition of assets (in the absence of technical due diligence), transfer pricing, secondary tax liabilities, losses resulting from fines or penalties, underfunding of defined benefit pension schemes, forward looking statements or matters included within a purchase price calculation (including leakage, completion accounts provisions and earn outs). Conversely, depending on the market, insurers may agree to cover certain matters as standard, based on prevailing industry practices, that a seller would be unlikely to accept on an uninsured transaction. For example, in France, it is common for insurers to cover a broad compliance with laws warranty without a knowledge qualifier, which would typically be resisted by a seller in an uninsured context.
Buyers can also expect a more collaborative approach to claims on an insured transaction with insurers keen to show their goodwill during the claims process. Insurers will typically seek to understand the nature of the facts or circumstances giving rise to the claim and settle where appropriate. This can be contrasted with sellers in an uninsured context whose starting point will usually be to resist the claim regardless of the circumstances.
Conclusion
Whilst W&I Insurance is not devoid of all limitations, the key drawbacks of the policy exclusions and impact of the underwriting process on the transaction timetable, can and should be anticipated by a well-advised buyer at the outset of any transaction. In return, the product offers significant advantages from a buyer’s perspective, particularly in terms of certainty and transparency, both regarding the level of coverage that may be provided and the claims process.