M&A Plus Insurance – Please mind the gap: managing the timing considerations of warranty and indemnity insurance
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In this edition of M&A Plus, we take a close look at M&A plus warranty and indemnity insurance.
In Australia, warranty and indemnity (W&I) insurance has become increasingly popular in the context of private M&A transactions. Typically, the buyer takes out a W&I Insurance policy (W&I Policy) to protect against financial loss arising from a breach of seller’s warranty or under an indemnity. For further information, see our previous article ‘W&I insurance: a practical guide to the Australian M&A market’.
Importantly, the decision to obtain W&I insurance may alter the negotiation positions taken by, and ultimately, the content of the sale agreement reached between, the seller and the buyer. In a W&I insured deal, the seller may be more willing to accept a broader warranty set than it would under a non-insured deal, if those warranties (after thorough due diligence) are underwritten by the insurer.
Timing of cover
Commonly, the W&I Policy is negotiated before the sale agreement is signed. That way, if the insurer declines to cover a particular warranty, the buyer and the seller still have an opportunity to deal with the issue another way, or alternatively, contractually allocate the risk between themselves.
If the parties agree to put the W&I Policy in place after the sale agreement has been signed, the seller should insist on a condition precedent requiring the buyer to obtain adequate W&I cover (to the satisfaction of the seller) within a specified timeframe prior to completion. The buyer’s failure to do so would then entitle the seller to terminate the sale agreement. In the absence of a condition precedent and right of termination, the seller may find itself in a precarious position. Having agreed to a broad warranty set on the basis that those warranties would be insured, the seller will still be bound by those warranties, and liable to the buyer if insurance is not obtained.
Mind the gap
Often, a sale agreement will not sign and complete contemporaneously - there may be a gap of several days, weeks or even months, between signing and completion. During this time, the parties are generally required to satisfy (or waive) certain conditions precedent and comply with various pre-completion obligations.
If W&I insurance is taken out at the time of signing the sale agreement, but there is a gap (particularly, a lengthy gap) between signing and completion, the parties should be mindful of potential liability traps that may arise.
The level of coverage under W&I insurance varies from policy to policy. While specific terms may be negotiated between the insurer and the insured, a number of ‘standard’ exclusions tend to apply, including in relation to information which has been disclosed (or is known), transfer pricing, fraud, forward-looking information, and criminal liability.
A lesser-known standard exclusion relates to breaches of insured warranties and claims under insured indemnities, which occur in respect of the period between signing and completion. Despite this being a customary exclusion, the insurer may sometimes provide coverage for warranty breaches and indemnity claims arising in respect of the period from signing to completion under 'new breach cover'.
The availability and suitability of new breach cover depends on a number of factors, including:
- willingness of the insurer: this is usually guided by:
- the insurer’s risk appetite;
- the sufficiency of due diligence that has been undertaken; and
- the nature and features of the transaction. For example, insurers generally do not offer new breach cover for:
- distressed deals;
- cross-jurisdictional deals; and
- deals where a breach may constitute a material adverse change under the sale agreement;
- pricing: new breach cover is usually priced at an additional 10 to 15% of the premium per month of cover. This is quite a hefty increase, which, from a commercial perspective, may be off-putting to the insured party; and
- timing: new breach cover is generally offered in 30-day increments, with an option to extend (usually up to 60 or 90 days) at the insurer’s discretion. If the sale agreement provides for a lengthier period between signing and completion, the underwriter may agree to provide new breach cover for only part of that period. Alternatively, the insurer may be willing to cover the whole period, but usually, subject to the insured complying with additional periodic disclosure obligations.
A general principle of W&I insurance is that the insurer will only cover unknown risks. If there are risks known to the insured (whether identified during due diligence or otherwise), these risks will be excluded from cover. In line with this position, the insurer will require the insured to periodically deliver a written ‘no claims declaration’ (NCD) confirming that its nominated deal team members are not aware of any matters that would result in a claim being made under the W&I Policy.
The first NCD is required at signing, with a final NCD to be given on completion. Additional NCDs may be required in the interim (usually, at the end of each 30-day period) if new breach cover has been taken out.
In the absence of new breach cover, a breach that occurs between signing and completion must be disclosed in the completion NCD and will be excluded from cover.
Interaction between policy coverage and the sale agreement
The parties should give careful thought to the operation of the W&I Policy and its interaction with the contractual rights and obligations of the parties under the sale agreement. In particular, it can be problematic for the buyer where the sale agreement provides:
- no recourse against the seller outside of the W&I Policy; and
- no right of termination in respect of matters arising between signing and completion.
If standard W&I insurance cover is taken out, the parties should consider how to deal with any potential or contingent breaches which become apparent between signing and completion. If the buyer is unable to terminate for a potential warranty breach, then the seller should not be under a positive obligation to disclose potential breaches prior to completion. Otherwise, the buyer’s deal team members will have knowledge of the potential breach, which may then be excluded from cover. In this scenario, the buyer will have no right to terminate, no right to claim against the W&I Policy and no right to claim against the seller.
Where new breach cover is taken out, the W&I Policy will usually exclude any material adverse change that occurs between signing and completion. If the buyer has no right to terminate for a material adverse change, the buyer will be forced to wear the loss, having once again, no right to terminate, no right to claim against the W&I Policy and no right to claim against the seller.
In recent years, W&I insurance has become more widespread in the Australia market. Under the right circumstances, W&I insurance can help facilitate smoother M&A transactions. However, it may also lull the parties into a false sense of security, unless due care is taken to align the W&I Policy with the sale agreement. Similarly, parties should be aware that W&I insurance is not aimed at replacing, but rather complementing other insurance solutions, such as directors and officers liability insurance, professional indemnity insurance, and cyber insurance.
Whether you are on the buy-side or the sell-side on an M&A transaction, be mindful of the period between signing and completion. Take care to select an appropriate W&I Policy and obtain advice to carefully negotiate the sale agreement to close out any unintended liability traps.
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