Why does a GC need to know about warranty and indemnity insurance?

I am writing this from my home office, the world having been turned somewhat upside down in the last few weeks. I was expecting to be writing about warranty and indemnity (W&I) insurance trends and claims in 2020, but the form book has been very much disrupted, at least in the short term. I have therefore reframed my commentary with this in mind.

W&I insurance has been a prominent feature of M&A activity for the best part of a decade now, making an appearance more often than not in disposals and acquisitions. It is a great deal enabler and has gradually moved from a product used by private equity funds for domestic real estate deals to one used by corporates for global cross-border acquisitions, and is now regularly used in almost all sectors.

Effectively the W&I insurer steps into the shoes of the seller for the purposes of any claim for damages for breach of warranty, thereby allowing the seller a clean exit with limited or nil recourse absent fraud. This is particularly attractive to private equity funds and acquisitions involving management buy outs. It also allows a claim to be advanced against a well-funded insurer instead of a seller whose assets may be hard to access.

Without a doubt the use of W&I insurance changes the deal dynamic. Not all deals in all jurisdictions will be attractive to W&I insurers and the W&I insurer will have a limited appetite for certain risks which will likely be excluded – these may include matters such as known matters, pension underfunding, secondary tax liabilities and cyber/data issues. It will be a matter for negotiation as to whether the buyer has no recourse for these risks or can procure some protection from the seller or through bespoke insurance cover. The cover will also be subject to terms and conditions, which vary between insurers and should be closely negotiated in the same way as any other critical contract. After all, the buyer may be relying on the W&I policy document alone to recover the full claim value for any breach of warranty (potentially many millions of pounds) and it is the policy which sets out the terms for recovery. Informal or high-level buyer due diligence upon which a buyer might ‘take a view’ will likely lead to the imposition by the W&I insurer of additional deal specific exclusions, so the level of investment in diligence directly impacts the cover.

The choice of insurer (and broker) is also a very important one, and for some an insurer’s claims performance, as well as its wording and risk appetite all play a role in selection. This has proved an attractive market with regular new participants. Selection based on price alone can prove to be a false economy.

The deal volume has increased significantly over the last few years and claims are starting to track this. Anecdotally many brokers and insurers report about a 20% rate of claims. Historically accounts and tax have been among the more frequent subjects of claims. My advice to an insured/buyer is to expect that an insurer will look to test any claim in the same way as the seller or warrantor would in relation to breach, causation and quantum. Indeed, the insurer will know far less about the deal than the seller, which can mean there is a need for some extra leg-work in progressing the claim.

There is complex case law in relation to all of these issues and an insured buyer that is not fully across all these legal issues will not gain proper value for its premium. Common matters which arise and are challenged include whether a matter was ‘disclosed’, the correct basis of valuation and whether events after the breach are to be taken into account. Having the right team of lawyers, accountants and brokers is key to maximising value.

Insureds not infrequently discount value in their W&I policy by not fully complying with the relevant terms and conditions, such as in relation to notification. At best non-compliance gives insurers some grey areas to found a price chip. At worst, cover could be lost. Some policies cover tax risks for seven years so the original deal team with institutional knowledge may well have moved on at the time of any claim leaving a less than perfect document trail.

It can therefore be seen that the value which an insured ultimately receives from a W&I insurance policy depends on a number of steps and decisions over potentially many years by many individuals – picking the right insurer, the right wording, setting the deal and diligence up to maximise cover, keeping the policy alive and complying with it and pressing the claim diligently and with knowledge of all the legal and valuation issues. That is why in my view W&I insurance is a general counsel issue.

Coming full circle, what impact will the inevitable financial fall-out of COVID-19 have? First and foremost, there may well be an uptick in claims activity. Liquidity is going to be sparse (and key) and those that have recently made acquisitions will likely be looking closely to see if there are hidden assets in terms of viable claims. Post completion quibbles that might have been overlooked may well assume greater significance in straightened times. Second, insurers will be feeling the liquidity pressure as well; their investment income if nothing -else will likely be impacted. That may affect both claims response and their appetite for new deals. Third, there will likely be increased distressed sales. On the one hand, such sales may not be a perfect fit for W&I insurance, as the diligence may be less than perfect and the ‘known’ issues fairly extensive. On the other, if insurers are able to be flexible and demonstrate a broad appetite, the product may be able to provide sufficient (if not complete) comfort to enable an otherwise difficult deal to progress. The W&I market was barely known at the time of the 2008 financial crisis. A combination of the global events of 2020 and its performance in the face of the steady increase in claims will enable all to see if it now comes of age. GCs should be watching carefully.