M+A: Warranty & indemnity insurance

In circumstances where the seller wants to ensure a clean break after the completion of a transaction and the value of the transaction justifies the expense, it is worth considering negotiating on the basis that the buyer will rely upon warranty and indemnity insurance as its sole means of redress should the seller breach a material warranty and/or events occur that enliven an indemnity right in favour of the buyer.  One area where this approach is particularly worthwhile is where key representatives of the seller will continue to be actively associated with the business and the buyer post completion and it is therefore undesirable for the buyer to sue the seller.

A sales transaction that is structured around warranty and indemnity insurance typically develops as follows:

The buyer will contact a broker with details of the transaction and supply them with a copy of the draft share sale agreement (SSA) asking for initial quotes for warranty and indemnity insurance.  The buyer would typically seek responses to the following:

  • Level of cover: A request will be made for various levels of cover. This can be for an amount up to the purchase price, but the level will depend on caps on liability under the SSA. For example, if the parties agree that the seller’s liability shall not exceed 50% of the sale price then insurance would be sought at this level;
  • Level of excess: This is the component of the loss for which the seller is personally liable.  Some insurers will make the excess available on what is termed a tipping basis. This would be expressed as an offer of a retention amount of say $400,000 tipping to $200,000. This means that the insurer will have no liability until the claim or aggregate of claims is equal to $400,001 but then it will payout on the amount in excess of $200,000;
  • Total costs covered: Whether it is inclusive of all taxes and fees including legal fees;
  • Carve outs: Whether all warranties and indemnities will be covered or whether only certain warranties and indemnities will be covered. For example, if a tax problem is identified in due diligence the insurer may choose to expressly deny indemnification for any loss connected with that problem; and
  • Buyer named as policy holder:  The trend in Australia is that only the buyer is named as the insured party under the policy. This has arisen because of the onerous disclosure obligations that are imposed on persons wishing to obtain insurance from an insurer. It is simpler for a buyer to comply with this disclosure obligation than it is for the seller.  The seller’s comfort lies in the drafting of the SSA to the effect that the policy is the buyer’s sole recourse for claims up to the policy limit subject to standard carve outs for fraud.

The combination of these factors determines the price of the insurance.  Considering the cost of the policy and the degree of due diligence required to satisfy the insurer,  we are of the opinion that this type of insurance is generally only suitable for transactions with a sale price of $30m or more, but each situation needs to be looked at on its merits.

Once the buyer has selected the insurer, the insurer will commence their own due diligence process which will include accessing the due diligence data room, reviewing the buyer’s due diligence reports and reviewing the SSA.  This process will typically take several weeks.

Concurrent with the insurer’s review, the SSA will be negotiated between the parties and will include provisions to the effect that:

  1. The buyer warrants that it has warranty and indemnity insurance in place at signing to provide cover in respect of losses it incurs for breach of warranty claims and tax indemnity claims up to the amount of the policy limit.
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