In the current economic environment, market deterioration has set up attractive buying opportunities, particularly as companies are forced to sell off assets to satisfy debtors and support balance sheets against further market unrest. However, buyers and sellers of distressed assets or troubled companies face unique risks. Whilst bargain basement prices might incentivise buyers to close a deal, if the fundamentals of the deal are flawed, the buyer will have to line up with all the seller's other unsecured creditors in order to seek financial recourse.

Risk allocation is always difficult to address in transactional deals. Sellers usually want to exit the target as cleanly as possibly, while buyers want to ensure that there is some financial and commercial certainty around the asset or the target company, usually through the provision of warranties and other protective mechanisms in the deal terms. This is particularly so, as the due diligence process may not bring all the risk factors to light.

Inaccuracies in representations and warranties made by the seller or the target company in connection with a merger or acquisition can result in costly liabilities. Buyers can be left without the ability to recover losses arising from these inaccuracies from the seller. Sellers can be forced to hand back a portion of the purchase price.

One option for the buyer is to utilise M&A transactional insurances to manage the credit risk of a distressed seller. M&A transactional insurance may provide a means of getting the deal done without either party having to assume an unwanted liability for future risks.

The most well known of these is Warranty & Indemnity (W&I) Insurance. This insurance can both protect a seller's position and give confidence to the buyer. Seen as a method of breaking through a stalemate in warranty negotiations, this form of insurance is today being structured into deal negotiations as part of the wider transaction strategy. Warranties Insurance helps protect buyers and sellers from financial losses resulting from inaccuracies in representations and warranties made in connection with acquisitions and other business transactions.

If the financial crisis deepens, more sellers will be forced to sell their assets while giving warranty protection to reassure buyers. But with more risk-adverse buyers and debt providers, some sellers might be unable to provide all the warranties and indemnities required. This is where recourse to W&I insurance can be helpful.

Similar insurance products are tax indemnity insurance and litigation buyout insurance, each of which are designed to close out known, but contingent, risks. Liability insurance (also known as loss mitigation) provides the buyer with a cap on liabilities that the buyer knowingly assumes under the deal.

Not every acquisition from a distressed (or near distressed) seller is the same, and these insurances will not suit every acquisition. Disposals executed on a take-it-or-leave-it basis are usually conducted on a no diligence, no warranties and no recourse basis in exchange for heavy discounts on the purchase price. However, many prospective buyers are finding this approach disagreeable and are heavily focused on the disclosure process and the risk allocation profile of the transaction. It is these types of deals, where due diligence appropriate to the deal has been undertaken, to which transactional insurance is best suited.

Transactional insurances allow the buyer to seek a way out directly against the insurer, rather than having to pursue the failing or failed seller. Under W&I Insurance, the purchaser may recoup losses suffered in the event of a breach of warranty or certain indemnities given by the seller in the sale agreement. Insurers seek to provide back-to-back cover with the warranty regime negotiated between the seller and buyer in the sale agreement and more recently have offered extended coverage for claims under certain indemnities for the target company's contingent liabilities.

The buyer should work with its legal and insurance advisers early in the deal structuring or negotiation to determine whether the risk will be insurable and to develop coverage that fits the risk allocation sought by the buyer.

In the current credit-constrained environment, acquisitions will inevitably require a higher equity contribution than previously. Transactional insurance is one tool that may help facilitate better protection of the capital committed. However, with decreasing prices, more products and increasingly risk-averse participants, we may see a time when such coverage could become a standard element in the majority of transactions, rather than a specialist tool for difficult or distressed environments.

Swaab was recently named a 2009 Winner in the ALB Employer of Choice awards, and was winner 'Best Law Firm in Australia (Revenue < $20m)' and 'Attribute Award for Exceptional Service (Australia Wide)' in the 2008 BRW- Client Choice Awards.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.