When a business is sold a seller is usually required to give various warranties to the buyer. Warranties are statements of fact about the target business which protect a buyer in two primary ways: (i) they help to flush out information which is inconsistent with the warranties that the seller is asked to give, and (ii) they give the buyer a contractual right to bring a claim against the seller in the event that they suffer losses in circumstances covered by a warranty.
A seller will therefore remain at risk for the duration of the warranty period – which is typically up to 2 years from the date on which the business is sold for non-tax warranties, and up to 7 years for tax warranties. In the worst-case scenario, a successful warranty claim could result in a seller being obliged to pay back some or all of his sale proceeds. Indemnities can be even more severe; they provide the buyer with a pound-for-pound remedy in the event that losses arise from a pre-identified set of circumstances.
Warranty and indemnity claims are quite rare for a seller who has been well advised and done a thorough job of due diligence and making disclosures, but the opportunity to insure against this worst-case scenario can be attractive. Warranty and indemnity (W&I) insurance is an increasingly popular, affordable and flexible solution – in 2017 it is estimated that over 3,000 deals used W&I insurance. In larger deals it has become market practice to explore at the outset whether W&I cover is appropriate, rather than bringing it in later on when a deal roadblock arises.
In this article we will look at some of the key features of W&I insurance and address some frequently asked questions.
The benefits of W&I insurance to a seller include:
Equally important, however, are the benefits that W&I insurance can give to a buyer where:
There are also various scenarios in which a W&I policy can be used to reach agreement on a commercial point where negotiations have broken down.
It is possible for either the buyer or the seller to be insured, but the significant majority of W&I policies are taken out by the buyer, for the following reasons:
The question of who pays for the policy will normally be subject to negotiation and depend upon the commercial strength of each party to the transaction.
The overall cost of taking out W&I insurance will include the following elements:
It should be noted that the figures indicated above will vary on a transaction-by-transaction basis so as to reflect the risk being assumed by the insurer.
As with any product, the cheapest policy will not necessarily be the best option. Buyers and sellers should look for the best, most appropriate coverage, and should consider in detail the flexibility of the provider and the overall cost of the policy (including the amount of retention that is required).
Traditionally the costs of W&I premiums have meant that the transaction value / policy limit at which they start to become economically viable was quite high. However, as W&I policies become more popular, premium costs have started to reduce.
The insurer’s lawyers will need time to review key transaction documents such as the sale and purchase agreement and disclosure letter, as well as due diligence reports which have been prepared for the buyer. Most of the work is carried out in the later stages of the transaction, but generally it will take a couple of weeks for the policy to be agreed.
The policy will normally take effect from completion of the business sale, although it may also be possible to enter into a policy after a transaction has completed.
If the sellers know that the business being sold is very clean and the risk of a warranty claim is therefore very low, the cost of a W&I policy may not seem worth it (although applying the same logic the W&I premium is likely to be much lower to reflect the risk profile). The same principle will apply to lower-value transactions.
A buyer should also be aware that there will be certain costs/losses which are not insured, including:
It is also important to note that W&I insurance should not be considered a panacea for all risks as there will always be certain matters that cannot be insured against – for example, matters known by the insured party and breaches relating to tax and pensions are typically not covered by the insurance. Insurance will usually not cover claims arising from fraud and dishonesty.
As with most commercial policies, most risks can be insured against, but this is likely to impact upon the cost of the premium. Alternatively, separate policies for known risk areas (such as environmental liability relating to a property) may be available from specialist insurers.
Where there are ‘gaps’ between the warranties given by the seller and the coverage provided by the W&I policy the buyer should carefully review the risks associated with a claim arising which will not be covered by the policies.
This should be discussed with potential insurers, but in principle most insurers are happy for the insured party to assign the benefit of the W&I policy to another company within the same group.
This is important because if the underlying business is transferred to a group company then it will be the group company that is at risk of suffering loss for breach of a warranty – and will therefore need to be the beneficiary of the W&I policy.
Please do speak to us if you would like more information about W&I insurance. We will be happy to discuss whether W&I insurance might be suitable for you and introduce you to specialist insurance brokers to advise you on the next steps.
If you are in the process of negotiating a deal and think W&I insurance should be used, we would always recommend that you include as much detail as possible in heads of terms, including excesses and total cover, who will be paying for the premium and how this will be reflected in the context of the overall agreement that has been reached.
This article is for general information only and does not, and is not intended to, amount to legal advice and should not be relied upon as such. If you have any questions relating to your particular circumstances, you should seek independent legal advice.