Corporate Insights

09 June 2011

M&A warranty and indemnity insurance: a buyer's perspective

By Geoff Hoffman and David Gerber.

Key Points:
Warranty and indemnity insurance is designed to make life easier for buyers (and sellers) in financial terms, but it isn't a one-size-fits-all product.

We have published a paper on M&A Warranty and indemnity insurance which you can download here.

This article is a summary of the main issues addressed in the paper.

Warranty and indemnity insurance has been sold in the Australian market for many years, but its function and effect on transactions are not universally well understood.

Importantly, taking out warranty and indemnity insurance doesn’t simply mean that the insurer steps into the shoes of the seller. There are a number of specific issues that a buyer must consider before deciding whether to acquire insurance and how to put it in place.

This article focuses on buyer's warranty insurance, which allows buyers to claim losses arising from a breach of contractual warranties by the seller. It enables the buyer to claim directly from the insurer, without having to pursue the seller.

What are the commercial benefits?

The commercial benefits of buyer’s warranty insurance for both buyers and sellers are compelling. First, it allows for a real pricing of the risk by an insurer (and not the buyer).

It also protects the buyer from the seller who gives a warranty but doesn't have enough cash to meet a warranty claim down the track, or where it is otherwise impractical to sue the seller.

Finally, for a private equity seller, it has clear economic advantages over a hold-back or escrow as a means of managing default risk.

How can warranty insurance be structured?

As with other types of insurance, the risks covered, amount and period of warranty insurance can vary to suit the buyer’s needs.

The amount of loss (or size of warranty claim) at which the insurance begins to respond (known as the “deductible” or “excess”) can be as low as the first dollar of loss or as high as the buyer wishes.

The deductible could be set at the maximum liability of the seller. For example, if the purchase price was $100m and the maximum liability of the seller was 20% of the purchase price, the deductible could be set at $20m. In other words, below $20m is seller’s risk (and uninsured) and above $20m is insured.

Likewise, the period of cover can be short or very long.

For example, the seller may be particularly resistant to giving warranties for a period beyond, say, 12 months after completion. Insurers on the other hand are generally more comfortable with insuring risks for an extended period. They will generally be prepared to offer cover for tax warranties up to seven years and other warranties for up to three years. The insurance can therefore be structured to cover losses arising after the seller’s liability period has expired.

How much contractual liability to leave with the seller?

If a buyer decides to take out warranty insurance, how much liability should remain with the seller? A seller would prefer none, but a buyer needs to consider the implications of letting the seller completely off the hook for warranty breaches.

A seller may insist on a regime where the buyer's only recourse is to make a claim on its warranty insurance. This means that the warranty insurance will help ensure that the price paid reflects what the seller has told the buyer about the asset – but does nothing to "keep the seller honest". Whether this is acceptable will depend on the buyer's assessment of the seller's due diligence process and warranty verification and disclosure regime.

The buyer should also assess what other incentives the seller may have to not breach its warranties – a perennial seller of assets in a market has a different set of incentives to that of a foreign seller (who may have no intention of conducting further business in the market).

Apart from the potential commercial benefits, insurance law provides a very good legal reason for the seller retaining some liability.

The concept is simple: for there to be effective liability insurance, there must be a liability. If the sale contract is expressed so that the seller simply has no liability (or, say, liability of only $1), and if the policy provides an indemnity for loss for which the buyer would have a claim against the seller under the sale contract, then in the event of breach of warranty the buyer wouldn’t have cover under the policy because there would be no liability on the part of the seller for insurer to indemnify.

Therefore, to be certain that the limitations or exclusions of liability in the sale contract do not undermine the insurance cover, the limitation of seller liability needs to be carefully drafted. Essentially, it needs to be clear that the seller has liability under the warranties – and that the limitation of liability does not have effect to the extent that the liability is recoverable by the buyer under the insurance policy. This is a subtle but ultimately a very important difference.

What liability does the seller still have?

In some transactions, the sale contract provides that the buyer’s only recourse against the seller for breach of warranty is for a relatively small amount, which can be as low as $1.

Of course, in Australia the ability of the seller to contractually limit or exclude liability is subject to the overriding liability for misleading and deceptive conduct under provisions such as section 18 of Schedule 2 of the Competition and Consumer Act 2010 (formerly section 52 of the Trade Practices Act), and minimising or avoiding this liability is difficult if not impossible.

The other potential avenue to seller liability – which insurers will insist is not excluded under the sale agreement – is fraud.

In either case, a buyer that recovers its loss under its warranty insurance policy cannot then claim against the seller (whether for misleading or deceptive conduct, or fraud) unless it reimburses the insurer for any amount recovered.

The insurer, on the other hand, would be able to exercise its rights of subrogation and enforce any rights that the buyer might otherwise have had against the seller. Although we are not aware of any insurer actually doing this, insurers will insist that this option is kept open.

What if I don't have insurance in place on signing?

A buyer may sometimes need to execute the sale agreement before its warranty insurance policy is finalised. How does this lag period impact on the buyer’s transaction risk profile?

The first important point is that warranty insurance only covers a buyer for circumstances that are not known to the buyer at the time the policy is taken out. It does not cover a loss that has become apparent before the policy is entered into.

Further, the terms of the policy itself (and the buyer's obligations under the laws governing insurance) require the buyer to disclose to the insurer every matter that the buyer knows or could reasonably be expected to know to be relevant to the insurer's decision to provide the insurance.

So, if the buyer executes the sale agreement and then becomes aware of a breach of warranty before the policy is put in place, the policy will not cover the loss arising from that breach. In other words, there is a risk that the buyer will be "contaminated" by additional knowledge which limits its protection under the warranty insurance, but will still be obliged to complete the transaction on the original terms.

How does insurance impact on the approach to due diligence?

If a buyer plans to obtain warranty insurance:

  • it must be able to establish to the insurer that it has undertaken a comprehensive due diligence process (and insurers will want to review this due diligence); and
  • it must understand that matters which are left "unresolved" in due diligence are likely to be specifically excluded from the policy cover and therefore become buyer risks (and not seller risks, as would be the case under a traditional warranty regime).

Conclusion

Warranty and indemnity insurance is designed to make life easier for buyers (and sellers) in financial terms.

Like any major commercial insurance, however, it is not a one-size-fits-all product. As the party left with the risk of an unenforceable warranty, it is in the buyer’s interests to ensure that the policy’s coverage is, as much as possible, co-extensive with that risk. Because of the many variables, the buyer must think about bespoke insurance and plan for it as an integral part of the sale process itself.

 

You can download the full paper here…

For further information, please contact Geoff Hoffman and David Gerber.

Disclaimer
Clayton Utz communications are intended to provide commentary and general information. They should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this bulletin. Persons listed may not be admitted in all states or territories.