W & I insurance and sell-side due diligence – managing exposure to risk
Warranty & indemnity (W&I) insurance is being increasingly used on corporate transactions. At a very high level it provides insurance to cover losses arising from a breach of warranty or tax indemnity claims contained in a sale and purchase agreement (SPA).
Warranties and a tax indemnity though are only as useful as a seller’s ability to pay any sums due and/or willingness to accept a reasonable level exposure of risk in the SPA. A claim of £500,000 where a seller has £0 or is only willing to expose himself to that or another de-minimis amount due to the competitive nature of the deal does not afford a buyer a level of protection that it would ordinarily require. That, coupled with:
• an ever changing market where on competitive sales in particular sellers will look to sell with very little or no risk;
• institutional sellers (private equity houses, for example) being unwilling or unable to assume any liability (for example on secondary buy-outs); and
• the desire to protect the relationship between a buyer and a seller (particularly in the context of a management buy-out),
has led to an increase in the popularity and availability of W&I insurance.
As is the case with the age old concept of supply and demand, it has been reported that (given the number of insurers operating in the market) prices are now 39% cheaper than in 2015 so W&I insurance is now more affordable than ever. That said, you can expect to pay in the region of 0.75%-1.5% of the policy limit as a premium for trading businesses (with minimum premiums usually in the region of £70,000).
We have worked on a number of competitive auction transactions where sellers have commissioned vendor due diligence (VDD – financial, tax and legal) with the clear message that they expect to sell with little or no risk and on that basis have provided indicative W&I insurance terms as part of the latter stages of the bidding process.
So, if a transaction does have the benefit of vendor due diligence what does a buyer need to do? It is clear from our experience that the insurers are looking for a buyer to ‘kick the tyres’ of the VDD reports and ‘stress test’ the scope and assumptions (and we use these imprecise terms because the terms required are, ultimately, imprecise). Additionally, on a deal where there is VDD but no W&I a buyer may rely on the disclosure process to fill in the gaps. In our experience that is not an option on a W&I insurance deal.
In our experience, ‘kicking the tyres’ and ‘stress testing’ means:
• reviewing the VDD reports, the underlying documents and enquiries and replies which were relied upon in producing the VDD reports and verifying that the report is factually correct and that the buyer agrees with the recommendations/proposed solutions contained in the report;
• topping-up the VDD reports to bring the due diligence up to date and address any issues identified above. This will include issuing buy side due diligence enquiries;
• reviewing the scope, materiality thresholds and assumptions in the VDD reports and commenting on the thoroughness or not thereof. Again, to the extent that there is a concern with any of these points, questions should be asked as part of the buy side top-up process; and
• ensuring that the subject/substance of each warranty/tax indemnity in the SPA has been diligenced.
The outcome of the above is to be recorded in a set of buy-side due diligence reports. Our understanding is that the buy side reports must be carried out by a suitably qualified individual. In our experience some underwriters have been comfortable with the VDD providers carrying out the buy-side top up due diligence or suitably qualified people in-house at the buyer (this should be checked on each occasion to ensure that the underwriter is comfortable with this approach).
If the underwriter is not comfortable with the buy-side exercise being carried out by the VDD providers or people in-house at the buyer, the due diligence exercise and the associated costs will be duplicated by a set of independent buy-side advisers.
Whilst VDD has its uses, in the context of W&I insurance and the possibility that the due diligence process will be duplicated on the buy-side, is it money well spent?
The due diligence process takes time. On competitive auction deals where it has been agreed that there will be W&I insurance and there is VDD, tackle the issue at the earliest opportunity.
From a buyer’s perspective, signing up to an offer with a tight timetable to completion which does not give sufficient time to carry out the required ‘tyre kicking’ and ‘stress testing’ exercise could compromise the coverage of the W&I insurance.
From a sell-side perspective if you are responsible for providing indicative terms and then passing the baton in relation to W&I insurance to the buyer, if the point is not addressed early in the process and you do not highlight what the underwriter’s expectations are in relation to buy-side due diligence, a buyer may ask the sellers to stand behind the warranties with suitable cap on liability.
In either case, it takes you to a place that you would want to avoid when you are in the throes of a transaction.
Ryan Brown is a corporate finance solicitor at Browne Jacobson in Manchester