The In-House Lawyer

Irrespective of the scope and quality of the usual due diligence in an acquisition transaction, the primary financial protection for the buyer of a company on either a share or asset deal is the scope and quality of the warranties and indemnities given on its purchase, which themselves depend on the security of the warrantors. If a buyer has any concern as to that security, and a suitable holdback or escrow of part of the purchase price is not available, one solution is to underwrite the financial risk under the warranties and indemnities by obtaining warranty and indemnity insurance. This generically splits into either a warrantor/seller policy or a buyer policy, but can also be a combination of the two, usually with the buyer policy sitting in excess of the seller policy.

Policies

The seller policy is a third-party liability policy covering the liability of the warrantors to the buyer for breaches of warranty or bona fide indemnity claims (eg under a tax indemnity on a share sale). The buyer policy is a first-party policy covering the buyer for any loss suffered in buying a company that through the warrantors’ breach of warranty or failure to meet indemnity claims is worth less than anticipated. Claims under this policy can extend beyond the contractual limitation in the sale and purchase agreement. Either way, through warranty and indemnity insurance the seller/warrantor should be able to achieve a clean break with minimal risk and immediate access to the sale proceeds, which can be important for those leaving the business or simply wanting to ringfence their and their families’ assets. A clean break is often very attractive and especially important to venture capitalists who wish to realise and reinvest their profits elsewhere without any unqualified tail of liability. Alternatively the buyer may wish to retain the goodwill of the seller for that and other post-completion trading relationships.

How much?

The cost of the insurance will depend on many factors but is roughly 1-2% of the insured limit (and 2-3% in the US). Insurers can be wary of sectors that are heavily regulated or where valuations include a large amount of goodwill, but each proposal is approached individually and the seller’s individual risk factors (which include the warranty limitations and deal dynamics) tend to be more important to underwriters. The ‘insured’ will also have to agree to pay the insurer’s due diligence fees, but in the UK these are usually set off against the premium if the insurance goes ahead. If the transaction is relatively small then the insurers may effect all their due diligence in-house and charge no fee at all. In the US the insurers generally require the due diligence fees in addition to the premium.

The process can generally be broken down into an initial submission by a broker to the lead insurer, an information request and preliminary evaluation resulting in a non-binding indication, and a detailed review. The process usually involves a discussion between the insurer and the proposed insured about the transaction generally, usually involving the insured’s legal advisers (particularly if specific issues have been identified); an explanation to the insurer of the disclosure process, and, if a buyer policy, access to the due diligence reports; and copies of the sale and purchase agreement (SPA) and disclosure letter (and any tax deed), as well as the various iterations as negotiated.

A final policy will be issued and executed at completion provided that:

1. the SPA has not been amended without consent;
2. copies of final documents are provided;
3. there is a signed and dated no claim declaration (in a seller policy); and
4. the premium is paid within 10-30 days of the commencement date of the policy.

Which is better: a Warrantor or Buyer policy?

Until a few years ago insurers preferred the warrantor to be the insured, because:

• Insurers want their insured warrantors to retain sufficient financial interest in the warranties and indemnities to ensure that they give them after proper consideration and investigation, with appropriate disclosure, and to suffer if they did not. What's good for the warrantors is therefore good for insurers.
• Insurers prefer the claim to be made by a third party (buyer) against their insured (warrantor) because they believe that there is more likelihood of a successful defence. Primarily this is because a first-party claim simply requires loss or damage, and insurers pay out with minimal argument. There is usually very little defence to a claim. A third party, on the other hand, has to prove both his legal entitlement under the warranties and the quantum of loss. Insurers can defend such a claim, even if only to reach a better settlement, and have greater control over a claim.
• Warrantors had to state formally to the insurers that every material issue had been duly investigated and disclosed during the deal process, as well as complying with their duty of utmost good faith. This created an evidential and disclosure obligation towards the insurers that for the seller could be more onerous than the requirement to give true and accurate warranties to the buyer. The value of the coverage was often considerably diminished as a result.

Advantages of a buyer policy

• No need for seller’s warranties (so that all owners can exit without contingent liability or leaving funds in escrow);
• a buyer always has an insurable interest, so that claims could not be rejected for lack thereof;
• insurers waive subrogation rights against management/warrantors (unless fraud is involved);
• buyer does not have to establish breach of warranty or that legal liability attaches to warrantors;
• a buyer need not certify to the insurers that every relevant item has been disclosed, because this information is almost entirely within the purview of the seller, and while the duty of utmost good faith will always apply, its effect is also similarly diminished.

Disadvantages of a buyer policy

• There may be less effective due diligence, in the sense that a seller may be less inclined to reveal existing problems if it knows that warranty claims are to be met through insurance;
• claims handling/proof of loss may be more difficult;
• liability-free managers/warrantors have less incentive to co-operate in resolving a claim; and
• the first-party nature of the insurance means that insurers may sometimes only cover catastrophes rather than mundane disputes, and so may require a larger retention.

Product

The absence of an extensive or highly diversified warranty and indemnity insurance market means that for the most part the insurance products on offer are fairly similar, and offered by a limited number of specialist insurers. In essence, each product will probably contain many of the following.

An insuring clause

A seller’s policy will consist of an indemnity to the insured sellers/warrantors for any loss arising from a breach of an insured warranty or claim under an indemnity that results in a claim during the period of insurance, together with the costs and expenses in defending any claim (excluding the usual overheads of the insured). A buyer’s policy will cover the reduction in value of the company purchased.

A limit of cover

This will be specified in monetary units and will usually be a maximum aggregate limit that will apply whether there is one large claim or several small ones. The limit will apply both to the indemnity for breach of warranty and (in a warrantors' policy) to any defence costs incurred.

Period and extent of cover

This should match the warranty and indemnity periods in the SPA. In a buyer policy these can be extended.

Most insurers’ standard policy wordings include coverage for the general tax indemnity in a tax deed, for unknown and undisclosed matters. A tax indemnity for a known contingent risk would typically be underwritten separately under a bespoke tax insurance policy.

Exclusions

It used to be the case that insurers carefully and specifically defined many potential aspects of a deal as areas that they were not prepared to cover. The exclusions most usually identified by insurers included:

• any claim arising out of fraud, dishonest, criminal or malicious acts, fraudulent misrepresentation or deliberate concealment by an insured;
• the impact of any legislation not in force at the date of the underlying agreement that takes effect retrospectively, or increase in the rates of taxation in force at the date of the underlying agreement;
• any scheme for the reduction of tax involving steps that have no commercial purpose other than the avoidance or deferment of taxation, which might result in a higher tax burden;
• future warranties, ie those representing that a state of affairs or facts will or will not exist after the date of the completion of the underlying agreements;
• the failure of a warrantor to discharge any liability prior to completion;
• the inability to collect debts after the date of completion;
• claims from an insured pursuing or defending a claim by another insured;
• claims where the warrantors and buyer were associates immediately prior to the date of the underlying agreement unless full details have been disclosed to and agreed by insurers prior to the insurance;
• claims arising from inadequacy of pension funding;
• claims arising from inadequacy of any insurance cover, so that insurers do not effectively provide the cover that should have been obtained by the seller;
• claims arising from inadequacy in any goods or services sold;
• changes to underlying agreements without insurers’ agreement;
• penalties;
• pollution;
• from any material amendment, addition to, or variation of, the underlying agreement not approved by the insurers; and
• loss caused by radioactive contamination and explosive nuclear assemblies.

Today many of these exclusions have been removed. There is still a general exclusion for matters of which the insured was aware and of specific items, such as future warranties, changes to underlying agreements without insurers’ authorisation, fines only if uninsurable as a matter of law, inadequacy of pension funding if involving a defined-benefits scheme, pollution depending on the target, and the inadequacy of insurance exclusion has been removed but can reappear in another guise. Insurance for fraud is included as standard in a buyer policy but cannot appear in a seller policy as a matter of public policy – you can’t insure against your own fraud. Of course the cover will be limited both in terms of a ceiling of liability and in some deals a de minimis threshold for claims.

Policies usually contain restrictions against assignment, originally to avoid a warrantor policy becoming a buyer policy. Usually insurers will only allow assignment intra-group or to one’s own financiers, and exclude the operation of the Contract (Rights of Third Parties) Act 1999, so that no third party can claim directly against them.

Extensions

Cover is usually given to the estate, heirs, legal representatives, trustees in bankruptcy and liquidators (provisional or otherwise) when an insured becomes deceased, incompetent, insolvent, bankrupt or in some form of liquidation.

Insurers may agree not to avoid the policy or deny coverage following any non-disclosure or misrepresentation in breach of the insured’s duty of utmost good faith, (except as regards the particular insured in breach of this duty where there are several insured parties). The insureds’ rights are usually specifically expressed as several rather than joint so that the knowledge of one person will not be imputed to others; thus no fraud or dishonesty on the part of one insured will be imputed to any other, and facts or knowledge known by one insured will not be imputed to others. If the seller company is giving the warranties then the personnel with the appropriate knowledge should be specified. The issues arising from the strictures against financial assistance in the case of public limited companies should be borne in mind if the company intends to pay for a policy covering its management warrantors, and restructured as appropriate.

Notification and Claims Handling

The insured must invariably give written notice to insurers of claims or circumstances likely to give rise to a claim as soon as reasonably practical. All warranty and indemnity insurance is written on a claims made basis, so that claims must be made against the insured within the policy period and in some policies actually reported to insurers (or within a short specified period thereafter). As to claims against warrantor policies and third-party demands on buyer policies, the standard insurance conditions apply so that all appropriate letters before action, writs, etc, should be passed to insurers without delay to enable them to make the appropriate investigations and take any action that they see fit. Generally speaking, an insurer will not be obliged to defend a claim but will be entitled to participate fully in its defence and any settlement, and the insured will not be entitled to make any admission, settlement, compromise, release, waiver or offer of payment without the prior written consent of insurers.

Insurers are invariably entitled to defend claims and to prosecute actions for recovery in the name of the insured (but under a buyer policy only against the seller if the seller has been dishonest) and to have full discretion in the conduct thereof. It is an implied term that insurers will indemnify the insured for any costs and expenses incurred in its name, but it may be as well to clarify this with express wording in the policy itself, particularly in the event that a claim is defended by an insurer unsuccessfully so that the other party is also entitled to its costs, which are technically due from the insured. It is also important to avoid any clash between the claims management process in the SPA and that under the policy; these should be carefully synchronised.

Similarly, it is as well to specify that if an insured gives written notice after becoming aware of any circumstances that might reasonably be expected to give rise to a claim, then any claim subsequently made against the insured, whether within the policy period or not, should be covered.

The insurer will also require the insured to produce all relevant information and to co-operate with the insurers in investigating and defending any claim, which invariably gives rise to considerable disruption to management, none of which is paid for by insurers.

Can the Warrantor avoid all liability by having insurance?

Is insurance the universal panacea?

A warrantor will sometimes only give the warranties as long as its potential liability is fully insured, usually under a seller policy, and so the SPA will specify that any claim is limited to the extent to which the insurance pays out, so that it will not itself ever have to pay any sum to the buyer. Everyone wins; the warrantor achieves certainty at no cost (assuming that the buyer pays the insurance premium) and the buyer is covered so that it does not end up with a company worth less than it anticipated. There is, however, a problem.

An insurer will only pay out under a policy if the contract contains an insurable interest and there is liability or loss capable of indemnity (and insurable interest and indemnity are almost two sides of the same coin). If an SPA provides warranties and specifies that the total sum payable is limited to the insurance, and that no payment will be made in the event that the insurance does not respond, then arguably there is no real loss and therefore no insurable interest capable of being insured or loss capable of being indemnified. The insured is only liable if the policy responds but the policy can only respond if the insured is liable. The insured will never have to pay out. Any lack of insurable interest became less of a problem when the Gambling Act 2005 disposed of the need for an insurable interest in many types of insurance, but the insured must still prove its loss under the indemnity principle.

• Various solutions to this technical problem have been tried over the years, with varying degrees of success. One of the most bizarre involved the insured insuring itself against a lack of insurable interest. None of these ‘solutions’ appears to have become the subject of dispute, perhaps because an insurer who took the point would be immediately ostracised by the broking community for this and probably all their other business, as well as potentially removing this type of clause from SPAs.
• In reality the problem faced previously by the lack of insurable interest (and any lack of indemnity) and the softening of market rates has resulted today in insurers simply insuring the buyer, using a low excess, and letting the seller and buyer decide who is to bear that excess. Insurers used to require considerable due diligence and often insisted upon additional limitations in the cover, but the disappearance of their preference for seller policies now means that both types of policy are treated largely the same. The reduction in exclusions, and the fact that the disparity in rates between buyer and seller policies has virtually disappeared, should make this type of insurance very attractive to the sellers of a business. The historic difference in rates between the two types of policy meant that seller policies were often taken out to maximise the sale proceeds, but a buyer policy represents such good value (at least in relative terms) that its inclusion ought to be carefully considered as part of the deal process and cost.

further comment

The ways in which a financier could optimise their security in any insurance in this and other areas will be considered in a future article.

By Jeremy Hill, partner, and Christopher Henley, international counsel, Debevoise & Plimpton LLP.

E-mail: jhill@debevoise.com;

chenley@debevoise.com.