Australia: Warranty & indemnity (W&I) insurance: what it is and why you should consider it in your next M&A deal

What you need to know

• Warranty & indemnity (W&I) insurance has become a key ingredient in M&A transactions but it may be a foreign concept to some, particularly those who are not experienced buyers or sellers of businesses.
• Even those who have come across W&I insurance before may not fully understand the rationale and mechanics behind it.
• It's important for all parties to an M&A transaction to be aware of why W&I insurance is taken out, how it works, how due diligence can impact policy coverage, and how this type of insurance is dealt with in sale agreements.

Why W&I insurance is taken out

Consider the position of the buyer of a business, entering into a sale agreement with the seller. The seller will make various representations about the business that will be underpinned with warranties and indemnities, all for the purpose of giving the buyer comfort about what they are purchasing.

Those warranties and indemnities may look great on paper, but what happens if there is a breach? What recourse will the buyer have if, weeks or months after the deal has closed and the parties have parted ways, a breach is uncovered?

If the buyer's only option is to bring a claim against the seller, it may be in a difficult spot if the seller does not have deep enough pockets to compensate the buyer. This complication will often arise where the seller has chosen to offload the business due to financial difficulty or, more commonly, where the seller is a private equity fund and has already distributed the sale proceeds.

This is where W&I insurance can come into play.

How it works

Under a typical W&I insurance policy, the insured party is covered for warranty and/or indemnity claims. It may be taken out in one of three ways:

• By the buyer: It is most common for the buyer to be the insured party in a W&I insurance policy. If a breach were to occur, the buyer would make a claim under the policy for the amount to which it is contractually entitled under the sale agreement (subject to any policy exclusions) and that amount would be paid by the insurer directly to the buyer. The seller is rarely involved in this process.
• By the seller: It is less common for the seller to take out W&I insurance although it does happen occasionally, where the seller seeks coverage for potential claims that the buyer might bring against it for a breach of the seller's own warranties or indemnities. If such a claim were to be brought, the insurer would pay the relevant amount to the seller who would then be liable to the buyer for the warranty or indemnity claim. It is not uncommon for a buyer to be unaware of the existence of the W&I insurance policy in this scenario. The disadvantage of this approach is that there is no insurance coverage for a seller where there has been seller fraud.
• As a 'flipping' policy: In some cases a seller might obtain a quote for W&I insurance relating to an upcoming transaction, particularly if the seller intends to run a competitive bid process where offers are made by multiple potential buyers. Upon selecting the successful bidder, the policy which was initially quoted for the seller would be 'flipped' and taken on by the buyer as a condition of the sale proceeding.

Regardless of whether the insured is the buyer or seller, it is common for the seller to cover (or contribute to part of) the cost of the W&I insurance policy (that is, the premium). The premium is typically about 1.3% of the total cover limit – it's important to note that the cost of the premium is determined by a number of factors. Even if the buyer is the insured party, this still benefits the seller immensely, providing it with a 'clean exit' after the sale. Where the buyer is the insured, the cost of the policy is typically covered by a reduction in the purchase price.

Benefits of obtaining W&I insurance

W&I insurance carries several benefits for different parties with an interest in the sale of a business, the most common of which are set out below.

• For the buyer: Where the buyer is protected by a W&I insurance policy, it can obtain a higher degree of certainty that a legitimate loss arising from a breach of warranty or indemnity will be recoverable, regardless of the seller's financial position at the time the claim is made.
• For the seller: The existence of a W&I insurance policy allows the seller to take the proceeds of the sale without further exposure to warranty or indemnity claims following completion of the sale.
• For both buyers and sellers: Where a seller remains involved in the company post-sale, such as by staying on as a shareholder, employee or in management, a W&I insurance policy can protect the parties' ongoing relationship.
• For other stakeholders: Where the seller is a private equity fund, the internal rate of return to its investors will be increased by the funds being distributed on completion.

Importance of due diligence

Coverage under a W&I insurance policy is negotiated between the insurer and the insured party which, as noted above, is most often the buyer. During that negotiation process, some warranties and indemnities may be excluded from cover.

First, when providing a quote for the policy, an insurer may indicate that particular warranties or indemnities are excluded. It is generally accepted practice that W&I insurance policies will not insure known issues or known risks.

Second, the insurer will want to ascertain the level of the insured's knowledge of the target's operations and risks, during what is known as the underwriting process. Since an insurer's interests tend to be aligned more with those of the seller, in an effort to reduce its obligation to make payment under the policy, the insurer will usually require that the insured undertakes comprehensive due diligence to increase its knowledge of the target business or company. Insured parties who conduct limited due diligence of a target, have a higher materiality threshold, or conduct an 'exceptions only' due diligence investigation, are more likely to experience greater scrutiny during the underwriting process.

As a result of the insurer's scrutiny of due diligence undertaken on the target, a W&I insurance policy may contain exclusions based on:

• an insurer's finding that the due diligence has not been comprehensive
• the insured being aware of any fact, matter or circumstance that was disclosed during the insured's due diligence investigations – on this issue, it's common for a sale agreement to define what constitutes disclosure to include information that is actually disclosed (for example in a data room) or deemed to be disclosed (information publicly available)
• the insurer's finding that although a comprehensive due diligence process has been undertaken, issues raised have not been resolved.

Impact on sale agreements

Where the buyer is the insured under a W&I policy, the sale agreement will typically specify that completion of the transaction is conditional upon the buyer entering into the policy with the insurer. Where such a condition exists, the buyer usually agrees to provide the seller with a copy of the policy.

W&I insurance policies can come into effect at one of two times:

• On completion of the transaction, where the policy generally only covers completion warranties and indemnities. This then raises questions about what happens if a breach occurs after the transaction documents have been signed but before the deal has completed. A prudent buyer would not to agree to sole recourse language (that is, where the sale agreement specifically refers to claims being made only against a W&I insurance policy and not against seller, despite a breach of a seller's warranty or indemnity) unless the seller agrees to stand behind the warranty in the period between signing and completion. A buyer may seek additional protection by negotiating the right to terminate the sale agreement for a breach of warranty or indemnity prior to completion.
• On signing of transaction documents, where the policy generally covers signing and completion warranties and indemnities. In some circumstances the insured may want the W&I policy to cover breaches in the earlier period between signing and completion. Insurers may agree to provide such policy cover, but apply a mark-up to the policy premium and limit the cover to a set period of time, for example for 30 days during the period between signing and completion.

The financial limitations and time limitations relating to warranty claims in the sale agreement will usually mirror the W&I insurance policy. If the buyer secures a W&I insurance policy for amounts and timeframes in excess of those set out in the sale agreement, and similarly where the seller is the insured under the W&I policy, this can have little to no impact on the sale agreement. On the other hand, in the unusual event that the seller agrees to provide cover for amounts and timeframes greater than those set out in the buyer's W&I insurance policy, a prudent buyer would require the removal of sole recourse obligation for these claims.

Key takeaways

It is important for both buyers and sellers involved in M&A transactions to understand the general role that W&I insurance can play and how they may stand to benefit from securing a policy. But because the specifics of a W&I insurance policy will always depend on the circumstances in which it is taken out, and the nature and results of due diligence conducted, seeking advice on W&I insurance in a particular transaction is always a good idea.

This article is intended to provide commentary and general information. It should not be relied upon as legal advice. Formal legal advice should be sought in particular transactions or on matters of interest arising from this article. Authors listed may not be admitted in all states and territories