Warranty & Indemnity Insurances
How To Cover
Distressed M&A Transactions
Against the backdrop of the Corona crisis, Distressed M&A is expected to play an incremental role over the next months. Dr. Stefan Steinkühler specializes in German insurance law and explains how the associated risks can be mitigated by way of special insurance policies and how executives can protect themselves against personal liability.
Dr. Steinkühler, which risks typically play a role in M&A transactions?
Steinkühler: In a typical asset or share deal, guarantees (warranties) are usually granted by the seller and management in terms of the company or asset (e.g. correctness of the balance sheet, number of employees, patent & trademark rights). Accordingly, warranty violations may result from incorrect financial information, undisclosed legal proceedings, infringements of intellectual property, tax claims, etc.
Transactions often comprise of contractual promises of the seller to compensate the buyer in case of unforeseen liability situations
(e.g. sudden termination of an important business relationship).
The transfer of such promises falls under the term “indemnity”. In relation to private equity transactions, buyer insurance policies are mainly concluded in order to minimize the seller’s warranty liability under the purchase agreement (share purchase agreement, SPA) and also to avoid a purchase price withholding for the protection of warranty violations in an escrow account (“clean exit”).
And what about distressed transactions?
Steinkühler: The slump in the M&A market caused by the Covid-19 virus leads to a noticeable decline in “normal” corporate transactions. Instead, the need for a risk transfer increases with so-called distressed transactions. It is likely that special situations and insolvencies increase significantly in the first quarter of 2021 and, accordingly, there will be a “bargain hunt”. Distressed funds have had sufficient liquidity for years. When it comes to seller’s liability in case of a struggling company, the risk of default for the buyer is naturally higher. The seller can basically offer a way out with warranty insurance and increase the attractiveness of the target for potential buyers.
Are there any risk-related particularities of Distressed M&A?
Steinkühler: We need to differentiate between the corporate crisis before and after insolvency.
While the implementation of a transaction prior to insolvency supposedly has the decisive advantage that buyer and seller themselves can still control the M&A process and the insolvency administrator does not have a say, this phasis often implies greater uncertainties from the M&A insurers’ perspective than during insolvency. Unlike an asset deal before insolvency, employee and tax liabilities are not being transferred to the buyer. While this is mandatory under German law for tax liabilities due to Section 75(2) of the AO, this also applies to employee liabilities which had been established before the opening of insolvency proceedings. The buyer can acquire the operations debt-free. Pre-existing liabilities remain with and are settled by the insolvency administrator. For the potential buyer, cherry picking becomes more calculable. Nevertheless, an asset deal can also be insured prior to insolvency. If there is an assessment report or a fairness opinion, even contestation risks can be insured.
How can these risks be mitigated?
Steinkühler: By way of an M&A warranty insurance, also known as Warranty & Indemnity (W&I) or Representations & Warranties (R&W) Insurance, damages in conjunction with a violation of a warranty or indemnification obligation issued by the Seller in the SPA can be covered.
Who can or should take out such insurance?
Steinkühler: The warranty insurance can be taken out by both the seller (Seller Police) and the buyer (Buyer Police). For some time now, the so-called Seller-Buyer-Flip as a mixed form has been seen in the markets. The seller initiates the W&I insurance, but the buyer ultimately becomes policyholder. In case of the Seller Policy, the buyer asserts its claims against the Seller; the latter forwards it to the insurance company.
In practice, this is a liability insurance. In case of a Buyer Policy, the buyer asserts the claim directly against the insurance. In practice, this is a (self-) damage insurance. Contrary to Section 103 of the German Insurance Contract Law (VVG), the fact that it is not a liability policy also provides insurance cover in the event of malice and intent on the part of the seller. Due to the direct claim against the insurer and also the protection in case of malice or intent, this approach can avoid litigation between seller and buyer. Under German insurance law, the insurance cover in accordance with Section 81 VVG is only at risk if the buyer himself has caused the insured event at least through gross negligence.
What should the parties be aware of in general terms from an insurance law’s perspective?
Steinkühler: It is advisable to address the recourse waiver pursuant to Section 86 VVG in case of Buyer Policies. Otherwise, the insurer could generally assign compensation claims of the policyholder (buyer) against a third party (seller). Limitations on recourse to intent or fraudulent deception of the seller is appropriate for the interests of the parties. From an insurance lawyer’s perspective, however, the question is always whether English or German terms and conditions with corresponding jurisdiction agreements are being used. Unfortunately, the latter is rarely the case and leads to less legal clarity due to the lack of corresponding insurance offers (only a few German-speaking terms and conditions are known). Thus, in case of a German transaction with an English insurance contract, the question arises whether a foreign, usually English court or arbitral tribunal, answers the questions of interpretation in case of a clause in the same way as the contracting parties involved. In practice, it is countered that the parties involved are used to dealing with English texts. But have they ever fought a corresponding cover dispute with an insurer over the interpretation of an English insurance clause?
What should be considered specifically for Distressed M&A with regard to transaction insurance?
Steinkühler: Although the buyer can check contracts for legal and other risks in the course of the due diligence, the buyer always needs at least the guarantee that all (essential) contracts have been disclosed. In case of distressed transactions resulting from insolvency, however, the problem arises that the insolvency administrator will not, in principle, provide any guarantees in relation to the sale, except possibly the guarantee of ownership of the assets sold. Due to the guarantee liability, the insolvency administrator would create mass liabilities for which he would be personally liable. The former management is no longer allowed or willing to give any guarantees. By issuing guarantees, the management would create an independent new basis of liability towards itself and is therefore generally unwilling to provide guarantees without any consideration. In addition, the relevant directors are often no longer with the company.
What can be done as a buyer or investor in this situation?
Steinkühler: In the event that no guarantees can be agreed, W&I insurers are now still able to offer an insurance solution by insuring the guarantees “synthetically” separately from the SPA. The warranty catalogue can be provided by an (experienced) W&I insurer or the purchaser. Both parties negotiate the guarantees without involving the seller side, which are then taken as an appendix to the policy. If, exceptionally, the assurances stem from the managing directors of the target company as “Management Warranty Deed”, their independent liability under civil law may be limited to EUR 1, but only limited to intent liability in accordance with general legal principles.
What exactly does such W&I insurance cover and for what period?
Steinkühler: Predominantly unknown risks covered by warranty promises are insurable. In addition to the risks already mentioned, which can generally be covered by M&A insurance, there are also special characteristics (sub-forms) for known risks:
- Tax Indemnity Insurance
Cover against known but not yet quantifiable tax effects
- Litigation Buy-out Insurance
Cover against pending or imminent litigation.
- Environmental Insurance
Cover against known but not yet quantifiable environmental risks (contaminated sites)
- Special Situation Insurance
Cover against known risks already identified in advance (e.g. political risks, IP risks)
The different warranty periods in the purchase contract are taken into account in the insurance contract. Depending on the type of warranty, the possible periods are usually between 3 and 5 years; in case of tax warranties, 7 to 10 years are also possible. The warranty periods can also be extended by way of W&I insurance. In addition, with regard to thresholds/baskets, small limit (de minimis) and maximum liability (cap), it may sometimes be in the buyer’s interest to enter into agreements in the insurance contract which are broader than the SPA.
What risks are not covered by W&I insurance?
Steinkühler: W&I insurance covers only unknown risks according to Section 2 (2) VVG. Hence, known and disclosed risks (due diligence/data room) usually cannot be covered. This does not apply if risks are known as such but still unclear as to the date of occurrence or the final amount. As a rule of thumb, therefore, the following risks are excluded:
- Forward-looking guarantees (e.g. budget/turnover figures, etc.)
- Purchase price adjustments and leakage
- Insufficient pension provisions
- Guarantees in the event of other insurance cover (e.g. product liability, environment, guarantees, etc.)
- Fines, fines or penalties
- Secondary Tax and Transfer Pricing (currently the insurance market opens up in this regard)
- Indirect tax liability
- Industry-specific risks, such as asbestos risks or the nature of building material in real estate transactions
In the past, it was often said that transaction insurance slows down the process. Is that still the case?
Steinkühler: The first contact is usually made via a specialized insurance broker who can give a first rough assessment at short notice.
Based on further documents (draft of the purchase agreement, due diligence reports, financial statements, information memorandum) the broker obtains indications from suitable insurers (so-called non-binding indications / NBIs).
The selected insurer then goes into the “deep examination” (underwriting); to this end, the insurer regularly also uses external assistance from lawyers. Only after the decision for a W&I insurance and typically also for a certain provider, the insurer is given access to the due diligence reports and the insurance policy is negotiated. Even at this point, a front-up fee for underwriting can be due, which is intended to cover the insurer’s expenses for the extensive risk assessment. Occasionally, the insurer does not charge any fees. Most insurance policies are available within 10 to 14 business days. The underwriting process has significantly streamlined over the last couple of years and has also become faster overall. W&I insurance can also be taken out after closing.
What about the costs of W&I insurance: are they not extremely expensive?
Steinkühler: The insurance premium for M&A insurance is a one-off premium for the entire policy term (up to 10 years). The premium is payable from the beginning of the policy, usually from the date of signing (date of signing of the purchase agreement). Over the last few years, insurance premiums for M&A insurance have been steadily declining. At present, the following rough calculation basis applies to the premium:
0.8% – 1.4% of coverage for “classic” corporate transactions
0.5% – 1.0% of the coverage for real estate transactions
As a rule of thumb, the coverage amount ranges from 10% to 50% of the transaction volume in case of a Buyer Policy. Talking about a Seller Policy, a cover amount of up to the seller’s maximum liability according to the purchase agreement makes sense.
Are there any other costs incurred for W&I insurance? And what about the deductible?
Steinkühler: An underwriting fee is often also due as soon as the insurer, through his lawyers, reviews the documents in the data room. It is possible to offset the insurance premium when the insurance contract is concluded. The deductible is usually between 0.25% and 1.0% of the transaction volume. In case of real estate transactions, a deductible can often be avoided completely. In terms of distressed transactions, the risk of default of insurers is naturally higher. Accordingly, the premium is estimated at 2% – 4% of the coverage amount. The deductible is also higher: about 1% of the enterprise value.
Does the W&I insurance also cover personal liability risks of the managing directors involved or what should they do to protect themselves?
Steinkühler: M&A insurances cover liability risks under warranties or exemptions, but not all liability risks for directors that occur in relation to the transaction. In this respect, D&O insurance should cover the entrepreneurial decision regarding the deal (the “IF”). But the “HOW” is also likely to fall within the scope of coverage of a D&O insurance. On the buyer’s side, in particular, liability issues could arise in terms of a proper due diligence regarding the target company, the participation of the shareholders or the supervisory board, the contractual concept, audits in relation to the post-merger phase or notification obligations. On the seller’s side, it is regularly of interest whether the sale was completed with the “best” bidder or whether guarantees were given incorrectly.
What do you recommend to managing directors and boards of target companies from an insurance law perspective when it comes to Distressed M&A?
Steinkühler: If financial sponsors acquire a company, they regularly try to get the management provide guarantees (Warranty Letter, Warranty Deed, Directors’ Certificate). The submission of management guarantees creates a contractual obligation between the management and the recipient of the guarantee declaration. As a rule, the guarantees are given in a separate document. Typical terms and conditions of D&O insurances provide cover only for liability based on law whereas management declarations are typically not covered. The parties should also make sure that they are on the same page as far as the insurance cover of such declarations is concerned in general.