Breaking the deadlock
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How can W&I insurance make transactions easier and more secure?
In acquisitions, the most heavily-negotiated aspects often concern warranties, indemnities and the caps on liability. The buyer might be concerned about the level of liabilities that it may be taking on, or the seller may be keen to reinvest the proceeds of the sale soon after the transaction completes. Either way there is a dilemma: the sellers want to walk away knowing that they will only be liable for a limited amount over a specified period in the event of a successful claim, while the buyers will want to ensure that there is a sufficient pot available in order to meet such claims when they arise. Warranty and indemnity (W&I) insurance can ease the friction in this area and maintain momentum in negotiations.
What is being insured?
Warranties are assurances and guarantees from the seller regarding the target company. The buyer’s solicitors will draft warranties in a way that clearly emphasises important information concerning the liabilities of the target company. Should any of the warranties be proved untrue post-completion, the buyer will have the right to sue under contract; which will lead to the normal remedy of damages being paid (ie, with the onus on the buyer to prove the breach and quantifiable loss which has been mitigated against). The sellers will know that they will be liable if any of their assurances are not true.
Indemnities are not within the court’s discretion in the same way as warranties; an indemnity is a guaranteed remedy offering pound-for-pound reimbursement to compensate for any wrong committed. No proof of loss needs to be provided by the buyer in advance of recouping money under an indemnity claim. The sellers will often try to resist indemnities, given that an indemnity is a very simple mechanism of post-completion price-adjustment in favour of the buyer and its ramifications can be far-reaching.
Warranties and indemnities can both constitute financial black clouds over the proceeds of sale after completion. The consequences of this financial exposure for the sellers can mean that they will try to reduce the timeframe within which they can be held liable and also seek to minimise the cap on the amount of claims (both individual claims and the aggregate amount). Each of these tactics may prejudice the buyer and therefore be a source of tension.
Thankfully, this is not the case of an unstoppable force meeting an immovable object. A solution that has proved increasingly popular over recent years in helping to navigate these negotiations is the use of W&I insurance, whereby a third party insures against the risk of a payment under a breach of warranty or an indemnity clause becoming due.
Factors that encourage parties to consider this mechanism include the increasingly litigious nature of mergers and acquisitions (with W&I insurance offering a measurable, predetermined and finite level of financial outlay as opposed to the vagaries of court decisions) and the reduced premiums charged by insurance companies, as the level of competition between insurers has lowered the prices.
Often, lawyers will draft a provision in the sale and purchase stating that the buyer will first try to recover under the insurance policy. However, the buyer will want to sue the seller should the W&I insurance policy be void for any reason, so this option should not be discounted altogether.
For sellers, the use of W&I insurance can avoid lengthy time limitations and ensure that, as much as possible, they can make a clean exit upon completion with no financial exposure. The buyer has a guaranteed level of warranty and gains great comfort from having an additional party with deep pockets responsible for discharging payment obligations.
While obtaining W&I insurance is not straightforward and will never be a substitute for thorough due diligence, it is an effective mechanism for transferring risk, reducing the need for escrow accounts and, importantly in this market, facilitating deals and encouraging investment.
Teresa McCarthy is a solicitor in the corporate team at CMS Cameron McKenna.