Warranty & Indemnity (W&I) insurance has helped lawyers execute M&A transactions faster and more effectively. This article explains what warranties and indemnities are, why buyers and sellers are interested in insuring against them, and how this streamlines the M&A process.
When a buyer agrees to purchase a company or asset from a seller, the two parties enter into a Sale and Purchase Agreement (SPA). The SPA is the fundamental document that governs the terms of any commercial transaction. It will set out who is selling, who is buying, what exactly is being sold, how much is being paid for it and what else needs to happen for the sale to complete.
When buying a company, it tends to be very difficult for a buyer to gain a complete picture of the risks associated with what exactly they are buying and will therefore ask the seller to make certain assurances as to the condition of the company. These are warranties and are a key point of negotiation in SPAs. For instance, a seller might warrant that the company has no pending litigation, that the company’s financial statements are correct, or that the business is not in breach of any laws or regulations. Warranties are statements of fact that reassure buyers of what they are buying. In the event that a warranty is breached, the buyer can take legal action against the seller. The buyer will need to prove that breach of warranty led to material damage, and can accordingly seek compensation from the seller.
Indemnities are a stronger form of protection for buyers, and are also negotiated in the SPA. They tend to relate to specific risks identified by the buyer or seller in the due diligence and disclosure processes, and reflect the seller’s commitment to reimburse the buyer if a certain event happens. For instance, the seller might agree to indemnifying the buyer against any tax liabilities that arise prior to completion, or against any ongoing litigation.
Negotiating warranties and indemnities can be a particularly long drawn out part of the M&A process: buyers want strong protections, and sellers often want a clean break from the company they are selling.
Enter: W&I Insurance. To avoid extensive negotiations, buyers can instead take out W&I insurance, where the insurer will step into the seller’s shoes, and pay out the buyer in the event of a breach. Either the buyer or seller can take out the insurance, and it is often something the seller will arrange as soon as they look into selling the company if they want to ensure a clean, fast break.
For lawyers, this takes out one of the most arduous aspects of the M&A process. In drafting agreements, lawyers’ essential role is to allocate risk, and W&I insurance negates the need, as the insurer will assume the risk of a breach of any warranties and indemnities. Transactions can be executed faster, and at less risk to both parties, streamlining the M&A process.
W&I insurance is particularly attractive to sellers looking for a clean break. That is, those who want to extinguish all their obligations relating to a company upon its sale. This is commonly the case for financial clients, such as PE houses, who will want to be able to focus all their resources and attention on existing portfolio companies and forthcoming acquisitions, rather than dealing with lingering disputes relating to a warrant they made on a previous exit. W&I insurance therefore allows such clients to achieve this clean break without compromising buyers’ protections.
Whilst it is a useful tool, many buyers and sellers may still not opt for taking out W&I insurance. Given warranties and indemnities are commonly very difficult to enforce, given the need to demonstrate material adverse change on the buyer’s part resulting from a breach, it is common that concerns that may ordinarily be mitigated against by warranties and indemnities, will be reflected in a haircut on the amount the buyer pays the seller. That is, if there is a known incoming tax bill, the buyer might instead simply request a discount on the purchase price, so they don’t need to rely on enforcing warranties or indemnities and can guarantee compensation. Sellers are likely to be satisfied with this approach given it still ensures their clean break. W&I insurance will be most common in complex transactions with a number of known concerns that neither party is willing to accept liability for.
