Data & Intelligence
Mind the Gap – Stand Clear of the Risk: Warranty and Indemnity Insurance
What is W&I insurance?
W&I insurance provides insurance against both unforeseen losses (e.g. warranties and indemnities (typically tax)) and in some circumstances, identified risks contained in the share purchase agreement (SPA) relating to the private equity transaction. The insured risks will be limited in time and amount. It can be purchased either by the seller or the buyer and each policy is tailored to the particular private equity transaction. Certain risks will not be covered by W&I insurance. These include most identified risks (but see below) and commonly, warranties or indemnities relating to: transfer pricing and secondary tax liabilities, fraudulent conduct of the insured, price adjustments, forward looking warranties, anti-bribery and corruption, criminal fines and penalties and deficiency in contribution pension schemes.
Where the seller purchases W&I insurance, the insurance contract is between the seller and the insurer. Consequently the buyer has to make a claim against the seller for breach of contract under the SPA (e.g. a breach of a warranty or an indemnity) and the seller then has to make a claim under the insurance contract if the risk is insured under the W&I insurance policy.
Where the buyer purchases W&I insurance, the insurance contract is between the buyer and the insurer, rather than between the seller and the insurer. Consequently, the buyer does not make a claim against the seller for breach of contract under the SPA but instead makes a direct claim under the W&I insurance contract against the insurer. A claim can be made by the buyer under a buyer’s side W&I insurance policy and it will not be voided even if the seller has committed a fraud or been negligent. Where the insurer pays out under the buyer side W&I insurance, the principle of subrogation applies and the insurer is entitled to step into the buyer’s shoes and exercise any rights against the seller that the buyer has under the SPA.
For these reasons, buyer side W&I insurance is more popular than seller side W&I insurance particularly as the buyer is not required to make a claim against the seller under the SPA and can claim direct against the insurer. The SPA itself will look very similar to an SPA drafted where there is no insurance in place. The main difference is that it will provide, in the absence of fraud, for the liability of the seller to the buyer for the insured risks to be a nominal amount (e.g. GBP1.00). When acting for the seller, where buyer’s side insurance is taken out, it is important to include in the SPA a provision that the buyer will first claim against any insurance policy for a breach of the SPA before claiming against the seller.
The insurer will typically (but not always) require someone to have “skin in the game”. This usually takes the form of an excess under the W&I insurance policy. It is up to the seller and buyer to decide who should bear this excess. By way of example, in a recent private equity transaction we acted for the seller with a transaction value of GBP320,000,000, where the excess was GBP1,000,000 (which excess was borne by the seller). We are currently acting for the seller on a private equity transaction with a transaction value of GBP155,000,000 where the excess is being born entirely by the buyer.
If W&I insurance is being considered and to avoid a delay to the private equity transaction, the prospective insurer should be brought on board at an early stage in the transaction to enable it and its legal advisers to have an opportunity of reviewing the due diligence materials contained in the data room, the due diligence report, the SPA and the disclosure letter prepared in connection with the warranties. The insurers will want to have the opportunity of providing input into the wording of the insured risks (the warranties and indemnities) and in some cases may require the deletion of certain indemnities and warranties (please see above for examples of excluded risks).
The insurer will require the insured to certify in writing at the date when the warranties and indemnities are given, that it does not have actual knowledge of any breach of them.
It is possible, depending on the nature of the identifiable risk, for it to be covered by insurance. This insurance can be taken out by the seller or the buyer. For example, the seller may be required under the SPA to provide an indemnity to cover a risk that has been identified in due diligence. In view of the fact that the identified risk is a known liability, insurers are generally less willing to provide insurance against it and where they are so inclined, the cost of insurance is greater than W&I insurance for unforeseen risks.
Why use W&I insurance
In private equity transaction, a seller may not be willing or able to give warranties and indemnities (other than fundamental warranties e.g. title to the shares free from encumbrances and capacity to sell). For example, a private equity seller will be unwilling to provide warranties and indemnities because the day to day management and control of the target company will have been vested in the executive managers and any warranties and indemnities contained in the SPA will prevent it from achieving a clean break and stopping the IRR clock running on proceeds that would otherwise be distributed back to the limited partners in the private equity fund. If the executive managers of the target company are prepared to give warranties and indemnities, the level of cover is unlikely to provide the buyer with sufficient financial covenant. Furthermore, it is extremely unlikely that the executive managers will provide any cover at all where they receive minimal or no proceeds from the sale (e.g. where the target company is sold at a loss).
Emerging markets – is W&I insurance available?
A W&I insurer will carefully assess the risk before offering up W&I insurance. This assessment will include the legal, regulatory, anti-bribery and corruption and political regimes of the jurisdiction in question. Where the risk is perceived to be high, the cost of insurance will increase and the policy exclusions will be greater (for example tax and environmental risks may be excluded in their entirety). Insurers will also place weight on whether the operations of a company are carried out in a particular jurisdiction as opposed to where the company is domiciled. For instance, W&I insurance is more likely to be offered in places such as Mexico and China if the company being insured has its main business operations in these locations. Insurers have demonstrated a willingness to offer W&I insurance in the emerging African markets of: Namibia, Zambia, Zimbabwe and Botswana. However, it is considered more difficult to place W&I insurance in the African countries of Malawi, Tanzania and Rwanda.
W&I insurance provides the seller with a clean break (subject to the potential excess on the policy) and the buyer with warranty and indemnity cover for a stated amount and period of time backed up by a stronger financial covenant (the insurer) than would otherwise be available. It also provides a solution for those who have been passive shareholders or carried out an executive function and do not receive any material financial benefit from the sale. For these reasons it is likely that the growing trend to take out W&I insurance will continue and become more commonplace in the emerging markets.
About the Authors
David Baylis is a Partner at Norton Rose Fulbright LLP
Ffion Flockhart is a Partner at Norton Rose Fulbright LLP
Freya Byrne is an Associate at Norton Rose Fulbright LLP
Renuka Ramnath | Founder, Managing Director & Chief Executive Officer, Multiples Alternate Asset Management Private Limited
Brian Lim | Partner and Head of Asia and Emerging Markets, Pantheon Ventures
David Rubenstein | Co-Founder and Co-Executive Chairman, The Carlyle Group
Dr. Andrew Kuper | Founder and CEO, LeapFrog Investments
Torbjorn Caesar | Senior Partner, Actis
Drew Guff | Managing Director & Founding Partner, Siguler Guff & Company