02 March 2017

Bullseye: Managing your warranty & indemnity insurance process

Warranty and indemnity insurance (W&I Insurance) has grown to become an important feature of the Australian private M&A landscape. While the genesis for the growth of the W&I insurance market in Australia in the early 2000s originated with financial sponsors, in more recent times we have also seen increasingly strong take-up by trade players.

W&I Insurance can have significant benefits, not just by reducing seller risks and enabling sellers to have a much cleaner exit, but also by narrowing the range of commercial issues in contention and thereby potentially expediting transactions. That said, the comfort that the uninitiated take from the fact of W&I insurance can be disproportionate to the covered risks if the process is not carefully managed. It is important that the parties to an M&A transaction understand the scope and aim of the policy, as well as its limitations.

In this article we highlight some of the issues buyers taking out W&I Insurance should bear in mind to make sure they don’t end up with a policy that is more limited than expected.

Although “sell-side” W&I Insurance remains a feature of the Australian market, it has become a small part of the overall market. This article therefore focuses on “buy-side” policies and the issues arising from them, although many of the issues identified will have equal application regardless of policy type.

1. Non-recourse means no recourse to the sellers – not no recourse to the underwriter

Where buy-side W&I Insurance is obtained, the sellers will almost always give their warranties on the basis that they are not personally liable for warranty claims, other than in the case of certain specific and limited exceptions (refer below). Obviously however, this bar to claims against the sellers should not prevent claims being made under the W&I Insurance policy (Policy) itself.

It is fundamental that a specific provision in the Policy addresses this issue. This is because of the nature of insurance contracts and the fact that they usually only respond to actual loss suffered by an insured. In the absence of a specific provision which allows the buyer to claim under the Policy, the buyer could not claim under the purchase agreement and it would therefore have no actual loss which it could claim under the Policy.

A recent case in the Australian Federal Court highlighted the negating effect that seller limitations in a purchase agreement can have on the recoverability of loss under a Policy. In that case the underwriter of a Policy was able to deny cover because a qualitative limitation in the purchase agreement had been triggered (relating to the original buyer and its related bodies corporate ceasing to control the target group). To avoid instances like this, care should be taken to expressly write back into the Policy the ability to claim despite a qualitative limitation in the purchase agreement, where considered appropriate.

Check: The Policy must expressly dis-apply the purchase agreement’s bar to claims against the sellers (i.e. as if it were not in the purchase agreement at all) so that the Policy responds as if the buyer was entitled to make the claim against the sellers and the sellers were liable to pay that claim. Make sure that you have carefully considered the limits to claims in the purchase agreement and are comfortable that there will be no recourse to the underwriter in those circumstances or have a specific write-back in the Policy.

2. Make sure you have the right exceptions

In addition to fraud, most purchase agreements and Policies contain specified limited exceptions to the general principle of no seller recourse. These will usually be for key warranties such as title and authority and tax claims.

The basis for these exceptions is that they relate to fundamental matters which underpin the buyer’s valuation and, bearing in mind that the Policy will have an overall Policy limit as well as a retention and other limitations and exclusions, the buyer expects the sellers to stand behind these warranties regardless of the Policy limitations. Also, if there is a material known issue which the underwriter will not insure (e.g. a tax liability associated with a pre-completion tax restructure) a specific exception to the principle of non-recourse to the sellers may also sought.

A key consideration with exceptions like these is whether the buyer may only claim against the sellers after the Policy limit has been exhausted or whether the buyer has the option of either claiming under the Policy or pursuing the sellers personally. If the buyer claims under the Policy for excepted matters (e.g. title and authority), then this will erode the available Policy coverage for other valid claims (e.g. under the general business warranties).  The buyer may rightfully feel aggrieved if the Policy cover is eroded for fundamental matters that the sellers should easily be able to manage.

Check: Does the purchase agreement have the right exceptions for fundamental matters and known and uninsurable risks? Does the purchase agreement give the buyer the flexibility to choose whether it wishes to claim against the Policy or against the sellers for fundamental exempted matters?

3. Don’t bear the burden of 2 deductibles

The Policy should provide that loss which erodes the “per claim” threshold and “aggregate claims” (deductible) threshold under the purchase agreement also erodes the de minimis and retention under the Policy, dollar-for-dollar – to make clear that these limits are not separate.

It should also be explicit in the Policy that the buyer does not have to actually recover eligible loss from the sellers in order for the Policy’s retention to be eroded. Without this provision, and in the context of the purchase agreement’s non-recourse regime, the buyer would never be able to recover under the W&I Insurance because it would never actually be paid anything by the sellers and the retention would never be exceeded.

If the Policy provides a lower de minimis and retention under the Policy than the “per claim” threshold and “aggregate claims” threshold under the purchase agreement, then the Policy should respond on the basis that the purchase agreement thresholds are to be dis-applied when determining whether the Policy responds.

Check: Make sure the Policy’s retention is eroded even if the buyer can’t actually recover from the sellers because of the non-recourse regime in the purchase agreement. Also, if the Policy provides a different de minimis and retention under the Policy from that which exists in the purchase agreement, make sure the Policy expressly dis-applies the purchase agreement thresholds.

4. Limit the underwriter’s rights to cancel or avoid cover

The Insurance Contracts Act includes a statutory duty of disclosure for insureds which allows underwriters to deny or reduce their liability for claims if an insured fails to disclose certain matters to the underwriter before Policy inception.

It should be discussed whether an underwriter’s right to deny or reduce liability under a Policy should be expressly limited so it only applies in the case of fraudulent (that is, intentional) non-disclosure or misrepresentation. Additionally, it is in the buyer’s interest for the Policy to expressly define whose knowledge within the buyer’s team will be relevant (recognising that buyers often have advisers whose knowledge could otherwise be attributed to the buyer). Policies should identify one or more specified deal team members of the buyer for this purpose and also limit the knowledge of those members to “actual knowledge” only (i.e. excluding imputed or constructive knowledge).

Check: Does the Policy provide coverage unless there has been buyer fraudulent non-disclosure or misrepresentation and is the knowledge of the buyer limited so that it is the actual knowledge of one or more identified buyer deal team members?

5. Excluding certain types of loss

Policies will invariably include a number of exclusions for certain types of losses, some of which will be generic for insurance contracts and some transaction specific. These typically include, among others, specific issues identified through due diligence that the underwriter will not want to insure, “non-market” warranties, forecasts, known risks, consequential loss, pension underfunding and changes to the purchase agreement without the approval or consent of the underwriter.

One Policy exclusion which is customary to see is loss arising from fines and penalties and punitive and exemplary damages. We recommend clients discuss an express carve back of this exclusion so that it only applies when insuring the fine, penalty or damage is unlawful and to define what “unlawful” means for this purpose by reference to specific legislative provisions or a court judgment which result in the underwriter not being permitted to pay the fine, penalty or damage.

Check: Does the Policy specifically exclude coverage for loss arising from civil fines and penalties and punitive and exemplary damages? If so, seek to expressly define the parameters of the limitation as described above.

6. Other insurance recoveries

An underwriter’s liability under a Policy is customarily expressed to be net of amounts recovered (or, sometimes, recoverable) by the buyer or target group from other sources such as other insurance policies (except any excess policies above the limit of liability of the Policy’s primary layer). In addition, amounts recovered by the buyer or target group under any such other insurance after a payment by the warranty and indemnity underwriter are required to be repaid to the underwriter (net of the buyer’s costs in achieving the recovery).

Clearly, it is preferable for the buyer that any such netting be restricted as much as possible to actual recoveries the buyer or target group obtain and it does not extend to amounts that merely are, or may be, recoverable (including tax credits and other tax relief to which the buyer and target group may be entitled). Ideally, only the amount by which a tax liability of the buyer and target group is actually reduced in direct consequence of the matter giving rise to the insured loss is netted off from the W&I Insurance payout.

The buyer and target group should not be required to litigate to recover under another insurance which also covers the relevant matter – the buyer and target group should only be required to request payment. An even more preferable framing for the buyer would simply be an obligation on the buyer to advise the underwriter of the other more specific insurance with no requirement to claim upon that insurance before claiming under the Policy. In that case, the underwriter could exercise whatever rights it has itself to mitigate its loss by claiming from the other underwriter (resulting in the underwriter assuming the credit and collection risk against the other specific underwriter).

Check: Are secondary insurance coverage qualifications in the Policy restricted? Ideally, the underwriter under the Policy should assume the credit and collection risk against the other specific underwriter.

7. Covering warranty breaches after signing the purchase agreement

New breach cover provides (at an additional premium cost) insurance coverage for breaches of the seller warranties that arise from circumstances occurring between signing of the purchase agreement and completion. Absent this cover, warranty breaches that arise in this period which become known to the buyer and which are required to be disclosed in the completion "no claims declaration" will not be covered. If the expected period to completion will be long, the underwriter may not be prepared to offer new breach cover for the entire pre-completion period.

If the underwriter is prepared to provide new breach cover, it will likely insist on an exclusion for material adverse changes in the target group’s business that occur between signing and completion. This can raise a potential problem for the buyer if the purchase agreement does not include a material adverse change termination right because, if a material adverse change occurs, the buyer will be left in a situation in which it does not have the benefit of the new breach cover, has no recourse against the sellers for the new breaches and has no right to terminate the purchase agreement.

Careful thought also needs to be given to the operation of the buyer’s completion “no claims declaration” in the context of the Policy. If a matter disclosed in a completion no claims declaration is both a breach of warranty given at signing and a warranty given at completion and knowledge of the breach was first obtained after Policy inception, the disclosure should not limit the buyer’s right to claim for the breach of the signing warranty. If new breach cover has been obtained, then the Policy should also provide that disclosure in the completion no claims declaration does not limit the new breach coverage.

Check: If new breach cover is sought, does the buyer’s MAC position in the purchase agreement allow it to terminate the deal should the new breach be serious enough to warrant the underwriter denying covering on the basis of a MAC event? Do disclosures in the completion no claims declaration only limit claims for completion warranty breaches?

8. Flexibility to get to completion

It would be customary for a Policy to require the buyer to obtain the underwriter’s consent to any amendment to the purchase agreement, including a waiver of the buyer’s right under the purchase agreement. It should be possible to restrict this consent requirement to any amendment which could adversely affect the underwriter‘s liability under the Policy and to obtain an acknowledgement from the underwriter that it would be unreasonable for it to withhold, condition or delay its consent to an amendment which does not adversely impact the underwriter’s rights or liability under the Policy.

At first glance this might sound like a “nice to have” but bear in mind that any failure to insist on strict seller compliance with the purchase agreement in the run up to completion will trigger the underwriter’s consent right. Almost invariably, there will be conditions and/or completion deliverables which the buyer will waive and it won’t want to, nor will it necessarily be practical to, seek underwriter consent, to those waivers.

Check: Does the no waiver or amendment provision in the Policy extend only to amendments that could adversely affect the underwriter's liability and does the Policy include an underwriter acknowledgement that it would be unreasonable for it to withhold, condition or delay its consent to any such amendment?

9. Liability for underwriter breach

It is usual for a Policy to provide that if the underwriter pays the full amount of the Policy limit, the underwriter has no further obligations under the Policy. However, we recommend carving out from this limit loss if the underwriter breaches the Policy or a duty it owes the insured. In these circumstances, the agreed limit of the underwriter for seller warranty claims is irrelevant as the buyer will have suffered loss as a result of the underwriter’s breach (not as a result of a further seller warranty claim).

Check: Does the Policy allow for separate recovery against the underwriter (regardless of whether the Policy limit has been met) if the underwriter breaches the terms of the Policy or a duty it owes?

10. Third party claims

It is usual for the Policy to provide that the consent of the underwriter is required before the buyer incurs costs defending a third party claim related to a warranty breach, and also that the underwriter must approve the legal representatives that the buyer proposes to engage.

Buyers should try and ensure that they have the right to incur emergency costs up to a prescribed amount without the underwriter's prior consent - otherwise they could be left in a difficult situation when a quick response is required to preserve their rights.

Whilst the underwriter will not have the right to conduct the defence of a third party claim, the Policy will invariably give it rights to be involved in the defence, to be kept fully appraised of developments and to approve any settlement. A buyer should ensure that the Policy does not oblige it to give the underwriter any documents protected by legal professional privilege unless that privilege is protected (because the underwriter has become interested in the matter and common interest privilege exists or the underwriter has given undertakings around the use of the privileged materials that are satisfactory to preserve the insured’s privilege).

Check: Does the Policy give the buyer an adequate allowance to incur initial costs in relation to a claim without seeking the underwriter’s prior consent? Does the Policy regulate information provision to ensure that legal professional privilege in information is not lost if provided to the underwriter?

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