Warranty and Indemnity Insurance
Those with experience of negotiating share or asset purchase agreements will know that the negotiation of "representations and warranties" and "specific indemnities" and of the related indemnification arrangements, is a time-consuming, yet often crucial part of those negotiations. One of the aids for reaching an agreement on these issues, is the use of "Warranty and Indemnity Insurance".
Although not commonly used in Belgian M&A practice, it is now being increasingly used in other European countries (such as the United Kingdom but also in the Netherlands).
1 Some general M&A concepts
The main M&A concepts to be taken into account in the framework of Warranty and Indemnity Insurance are:
Representations and warranties can be described as (general) statements made by the seller with respect to (i) the state of affairs of the target company (e.g. relating to compliance with legislation, ownership of assets,...) and (ii) the capacity of the seller to enter into the sale and purchase agreement. If one or more of these representations and warranties proves to be incorrect, the seller will have to indemnify the purchaser (or the target company) for its losses.
The seller's duty of indemnification will, in most M&A transactions, be subject to a number of limitations and exceptions. The most frequent of these are:
- limitation in time: a claim for a breach of representation will typically have to be made within a certain period of time ;
- limitation in amounts: often (i) a minimum threshold of losses ("de minimis" / "basket") will be agreed, below which, seller's obligation to indemnify is not triggered and (ii) seller's maximum liability will be capped at a certain level (often a percentage of the purchase price) ("cap") ;
- disclosures: a sale and purchase agreement typically contains a number of exceptions to the representations and warranties ("disclosures"). They can be listed in a Disclosure Letter (listing the exceptions to the different warranties) but sellers will often try to obtain a general disclosure of all information provided to the purchaser in the framework of its due diligence ("data room disclosure").
Specific Indemnities usually refers to the seller's duty to indemnify with respect to specific risks, discovered by the purchaser during its audit (due diligence) of the target company. The limitations, mentioned above, do not normally mitigate the seller's liability related to specific indemnities.
Often the purchaser will try to guarantee its rights under the representations and warranties and/or the specific indemnities. Several options are available, such as a bank guarantee or an escrow arrangement (whereby part of the purchase price is paid on a blocked bank account to serve as a guarantee for the seller's indemnification obligations).
Negotiating all these issues can be a complex and tricky exercise. Warranty and Indemnity Insurance may be a useful tool in this respect, as it enables the purchaser to obtain (additional) protection from an insurance company (rather than from the seller) while avoiding additional guarantee mechanisms (such as an escrow), which may be hard to accept for the seller. A (significant) part of the risk relating to the representations and warranties, and sometimes certain specific indemnities, can thus be shifted to the insurer.
2 Warranty and Indemnity Insurance : main features
Warranty and Indemnity Insurance may be described as coverage against losses that could arise from breaches of the representations and warranties, and sometimes certain specific indemnities, contained in a sale and purchase agreement.
In general, two types of Warranty and Indemnity Insurance exist:
- Seller-side policy: insures the seller for the loss resulting from claims brought against it by the purchaser as a result of a breach of the representations and warranties (or certain specific indemnities). The coverage under this type of policy often mirrors the coverage, including the limitations, referred to above, agreed in the sale and purchase agreement, with a possible extension to the sellers' defence costs.
- Buyer-side policy: covers the purchaser (or the target company) for the loss resulting from breaches of the representations and warranties and/or specific indemnities.
Buyer-side policies are most often used in M&A transactions, as they offer advantages to both the seller and the purchaser. For the seller, the use of such a policy enables it to significantly reduce its own contingent liabilities towards the purchaser. In addition, the seller may avoid the burden of having to consent to a guarantee (such as an escrow agreement), which would otherwise limit its ability to freely use the proceeds of the sale. The purchaser, on the other hand, may obtain, through the insurance, an increased entitlement to compensation (e.g. in terms of amount or duration) than it would have been able to negotiate with the seller. In addition, in some cases, the insurance policy may also address the purchaser's concern about the solvability of the seller.
Although this type of policy is typically "tailor made", some general insurance features will apply to Warranty and Indemnity Insurances, such as:
- The insured will have to pay a premium. Although this will vary on a case by case basis, (depending, amongst other things, on the risks to be covered, the (tipping) retention, the remaining liability for the seller under the sale and purchase agreement, ...), the premiums for this type of insurance usually vary between 1% and 2.5% of the limit of the amount insured.
- The insurance policies will also provide for a "retention", (or "deductible", or "excess"), being the amount of losses to be borne by the insured before the insurance policy can be called on. Again, the amount of the deductible will depend on specific variables, but will often be around 1% of the total value of the transaction. A "tipping retention", similar to an aggregate de minimis, might also be envisaged.
- The insurance policy will typically contain a number of exclusions (matters which are not covered by the insurance). This will depend on the negotiation of the insurance policy but "typical exclusions" include: all disclosed matters, knowledge of the insured, fraud on the part of the insured, criminal fines, forward looking warranties and transfer pricing warranties. The exclusion of all disclosed matters may, of course, significantly reduce the scope of the coverage if a data room disclosure has been agreed in the sale and purchase agreement. However, in these cases, requesting coverage for certain specific indemnities (even if disclosed in the data room) appears to remain negotiable for insurers.
- Procedure: The insurance policy will provide for a specific claim procedure which the insured will have to comply with in order to make a valid claim under the policy.
3 Warranty and Indemnity Insurance as an M&A structuring / negotiating tool
As shown by its increasing use in European M&A practice, Warranty and Indemnity Insurance can be an interesting tool in structuring and negotiating M&A transactions.
For sellers, Warranty and Indemnity Insurance allows them to (significantly) reduce their contingent liabilities under a sale and purchase agreement. An effective insurance policy may even allow a "clean exit" for a seller. This can be particularly interesting for private equity funds or closed-end real estate investment funds (who wish to distribute the proceeds of a sale without having to retain part of the purchase price against potential claims by the purchaser) or sellers who require (the entire amount of) the proceeds to pay back existing debts.
Purchasers may also benefit from Warranty and Indemnity Insurance, as it may enable them to increase the level and duration of the compensation terms as compared to those under a straight sale and purchase agreement. In certain cases, it may also protect them against potential sellers' solvability issues. Furthermore, in private auction processes, the use of Warranty and Indemnity Insurance may distinguish a bid from competing bids, as an effective insurance policy will enable the bidder to seek less indemnification from the seller under the sale and purchase agreement.
The effectiveness of Warranty and Indemnity Insurance will, to a large extent, be determined by the terms and conditions of the insurance policy itself, and more specifically by the scope of its cover. In order for it to represent real added value, the main risks will need to be covered by the policy and should not fall within the excluded risks.
The use of a Warranty and Indemnity Insurance will have an impact on the negotiation process itself.
The insurance company will want to make its own risk assessment (by reading due diligence reports, requesting advice from its own advisers on certain topics,...), which may have a (limited) impact on timing. When considering the use of Warranty and Indemnity Insurance, the party/parties involved should, therefore, contact the insurance company early on in the process and provide them with a realistic set of representations and warranties / specific indemnities for which they request coverage.
The use of a Warranty and Indemnity Insurance implies a number of additional commercial and technical questions which will have to be dealt with during the negotiating and drafting stages of the sale and purchase agreement. For example, the (possible) impact of the insurance premium and of the retention amount on the price, the applicable law (the same law should apply to the insurance policy and the sale and purchase agreement), the legal subrogation right of the insurer (which may be waived but this will of course increase the premium), the choice of the insured party (being the purchaser and/or the target company), the benefit for the insurer of some clauses regarding the determination of the loss, the tax treatment of an insurance payment received by the purchaser and/or the target company and the related possible impact on tax gross-up clauses, the conduct of claims, the transfer of the arbitration clause,...
The use of Warranty and Indemnity Insurance in Belgian M&A practice is still exceptional. However, the focus on risk management and the growing use of Warranty and Indemnity Insurance in other European countries, may cause it to be used more frequently in Belgium than has been the case up till now.
Whether a Warranty and Indemnity Insurance is appropriate for a given transaction will depend upon the terms of that transaction, taking into account its context (private auction process or not), the (financial) situation of the parties, the scope of insurance that can be obtained (in the light of the risks discovered during due diligence),...
Warranty and Indemnity Insurance will not, therefore, replace negotiations between seller and purchaser about representations and warranties, specific indemnities and indemnification, but may, in certain cases, offer an effective tool in finding a solution acceptable to all parties involved.