- Introduction to W&I insurance
Warranty and indemnity insurance (“W&I insurance”) provides cover for losses suffered in connection with warranty or indemnity claims in an M&A context. In the last few years, W&I insurance has increasingly become a standard feature on UK and European transactions involving the sale of shares, units, or partnership interests in a target SPV or group where the value of the SPV or group is substantially derived from underlying real estate interests (“corporate real estate”).
In most cases, the policy of insurance will be for the benefit of the buyer. Under a policy for the benefit of the buyer, the buyer typically claims against the seller up to the agreed cap under the sale and purchase agreement (“SPA”), and then claims against the insurance for liability above the cap. As discussed at paragraph 2(a) below, the agreed cap under an SPA on corporate real estate deals is usually £1.
In some cases, a policy of insurance will be for the benefit of the seller. Under a policy for the benefit of the seller, the buyer claims against the seller under an SPA in the normal way and has no direct claim against the insurance. The seller remains liable to the buyer under the claim, but can recover any losses incurred against its W&I insurance, with the insurer subsequently controlling any defense or settlement of the claim.
- Reasons for W&I insurance on a corporate real estate deal
As a general statement, W&I insurers see corporate real estate transactions as “cleaner” and “less risky” than transactions involving a trading vehicle or group of vehicles. As a result, on a corporate real estate deal, W&I insurers are often prepared to cover claims from the first £1 of liability (subject to certain conditions). This means the buyer can generally accept that the seller’s liability under an SPA can be correspondingly capped at £1, with the buyer claiming wholly against the W&I insurer for any relevant loss. This gives the seller a “clean exit” – an attractive proposition for a seller, especially institutional or fund sellers, who prefer no tail liability or funds escrow and to distribute funds as soon as possible after a sale.
One notable exception is that a buyer will often insist that a seller stand behind “title and capacity warranties” without the benefit of a £1 cap, being warranties relating to the seller’s title to the shares and capacity to enter into the SPA, and the target’s title to the relevant target real estate interests (“Title and Capacity Warranties”), on the rationale that these are fundamental and should be easy warranties for the seller to give. Whether a seller accepts this is a matter of commercial negotiations as well as the circumstances of the parties.
By way of comparison, on the sale of a trading group, W&I insurers are often only prepared to cover liability above a certain minimum aggregate claims threshold. In such circumstances, a well advised buyer will usually insist on linking the maximum liability threshold of the seller under the SPA to the aggregate claims threshold under the W&I insurance policy. For example, if a policy will cover all losses above £500,000, the seller’s liability under the SPA would be capped at £500,000 (meaning there will still be potential tail liability for a seller after completion).
On corporate real estate transactions, the covenant strength of a seller or warrantor can sometimes be a concern for a buyer, especially if the seller is a SPV holding vehicle, a sovereign wealth fund, in financial difficulties, or has minimum onshore assets. However, if a deal is underwritten by W&I insurance, the buyer (most often) has the benefit of an investment grade counterparty underwriting a claim.
Other transaction dynamics
The availability of W&I insurance can also make it easier to execute certain types of deals. For example:
- A seller or warrantor may have an ongoing management or trading relationship with the target group. In this context, W&I insurance may be useful to transfer liability to the insurers instead of the management seller/warrantor (although, in some instances, insurers may require management sellers/warrantors to stand behind some warranties above the nominal £1 cap to keep them accountable with “skin in the game”).
- Auction sales may include W&I insurance as part of the sale package, or bidders may themselves suggest W&I insurance to reduce the seller’s potential liability and enhance the attractiveness of their bid.
- A seller may be distressed, or otherwise be unwilling or unable to give warranties. For example, the seller may be subject to insolvency, or the assets may be part of a distressed sale. In these situations, W&I insurance (either in the traditional form, or a “synthetic” form*), may provide the comfort needed for a buyer to get its deal across the line.
* Synthetic W&I insurance offers a more standardized set of protections which are usually weaker for a buyer than that offered under a negotiated SPA and W&I insurance policy (and so should only be used as a last resort). It provides warranties and tax indemnity protection which the seller is not prepared or is unable to give, but which “synthetically comes into existence” for the purpose of the W&I insurance underwriting process. Synthetic W&I insurance can be provided with little or no disclosure from the seller, and so is useful when a seller has little incentive or ability to cooperate in the sale process, such as in an NPL/distressed/insolvency scenario.
Scope of coverage
In theory, W&I insurers are usually willing to cover any quantum of liability, including liability of 100% of the property value or purchase price paid under an SPA (subject to underwriting capacity).
In practice, on European and UK corporate real estate transactions, a buyer is usually comfortable with coverage of 10% to 25% of the property value (rather than paying the additional premium for full 100% coverage), as the risk of a high quantum of liability as a consequence of a warranty or indemnity breach is considered less on a corporate real estate transaction versus a sale involving a target with an active trading business.
As a bolt on to standard W&I insurance coverage, insurers also offer Title and Capacity Warranties “top up insurance”, which provides additional coverage above the usual liability limits for breaches of Title and Capacity Warranties only. Most buyers opt to not take this coverage due to the higher absolute increase in premium and because breach of Title and Capacity Warranties is considered low risk and comparatively easy to diligence – nevertheless, it is available for a cautious buyer.
In terms of the customary duration of coverage, insurers are usually willing to cover two - three years for general warranties and seven years for breach of tax warranties and any general tax indemnity, which align with a buyer friendly position under an English law governed SPA.
Potential buyers should note that W&I insurance does not provide absolute protection. For example:
- A policy holder cannot claim against a W&I insurance policy in relation to known facts or matters (whether these facts or matters are identified in due diligence, disclosed by a seller or otherwise)^.
- Certain categories of warranties will not be covered by an insurer^, for example, environmental warranties, or forward-looking warranties.
- Certain tax matters are generally excluded from coverage e.g., transfer pricing and secondary tax liabilities.
- Certain heads of loss are generally excluded, e.g., consequential loss, or loss deriving from or related to civil or criminal fines or penalties.
- A policy will not cover loss in connection with post-completion adjustments to the consideration, including completion accounts adjustments or, on locked box-deals (which are rare in a corporate real estate context), non-leakage covenants.
^ Some insurers are willing to underwrite specific policies for certain known or disclosed facts or matters on a case-by-case basis if the risk is deemed by that insurer to be reasonably low – the cost of this will vary depending on the circumstances. Specialist insurers also cover certain excluded categories of warranties, such as environmental warranties.
Insurers are also increasingly willing to consider enhancements to the standard W&I insurance policy – for example, insurers may offer a “knowledge scrape”, where warranties given by a seller that are qualified by awareness (e.g., “so far as the seller is aware, the company has complied with all material applicable laws”) are insured on an absolute basis (e.g., “
so far as the seller is aware,the company has complied with all material applicable laws”).
Tan Pawar, Senior Vice President of Paragon International Insurance Brokers comments:
“In the current market, we are usually seeing premiums ranging from 0.6% to 0.9% of the insured value on W&I insurance on corporate real estate transactions. This is subject to a minimum premium of around £30,000 - £40,000 excluding fees and insurance premium tax, which may be relevant on smaller sized deals.
Subject to a de minimis threshold, the excess for corporate real estate deals is typically nil, although in circumstances where the target group has a substantial trading business [e.g., a self-storage facility or a hotels group], insurers may insist on a retention/excess of between 0.5% and 0.75% of the insured value. These retention structures can either “tip” or “drop” after a period of time (usually 18-24 months from completion).”
Given W&I is related to a seller’s liability being reduced under an SPA, there is an in principle argument that any cost of the premium should be borne by the seller. However, this is subject to commercial negotiations and dependent on the bargaining power of the parties. For example, in a competitive auction scenario, a well advised seller may include a mandatory bid condition that any successful bidder must accept that the seller’s liability is capped at £1 and use W&I insurance, with the cost of W&I insurance being borne wholly by the buyer. The seller’s lawyers and brokers may also procure non-binding indicative quotes and insurance terms to be included as part of the sale/bid material.
In other situations, the costs may be split between buyer and seller. In these circumstances, a well advised seller should agree to only contribute to a W&I insurance policy up to an agreed cap to prevent a buyer obtaining a policy on overly favorable terms at the seller’s expense. The seller will want to agree any caps on contribution at an early stage of a deal (e.g., heads of terms or before exclusivity), when the sale process remains more competitive and when it may have a greater bargaining power.
As a general note, parties should carefully review the SPA and W&I insurance policy together to ensure there are no unexpected gaps which could expose it to unexpected liability. For example:
- Scope of coverage: An insurer may not cover every warranty given by the seller. If this is the case, a prudent buyer will need to take a view on whether the seller should stand behind the warranties not covered by W&I insurance without the benefit of a £1 cap.
- Seller fraud carve out: The cap on a seller’s liability will not apply in the case of Seller fraud. A well advised seller may insist that this carve out should be limited to fraud of the seller only, whereas a well advised buyer may insist on the carve out applying to fraud and reckless or negligent acts by a seller, its agents, officers, employees and representatives.
- Waiver of rights of subrogation: A prudent seller should insist that the buyer’s W&I insurer expressly waives the insurer’s “rights to subrogation” against the seller, and that the seller should have the right to enforce this waiver against the insurer (except in the case of seller fraud). If this is missed by a seller, an insurer which has made a payment under a buyer-side policy may be entitled to step into the shoes of the insured and directly recover from the seller or warrantor.
- Assignment: If an insured party wants to assign the benefit of a W&I insurance policy to a third party (e.g., to a related group company or a finance party), relevant provisions should be included in the W&I insurance policy.
- Gap between exchange and completion: If there is a gap between exchange and completion of an SPA, a W&I insurer will typically require a buyer to give a “no claims declaration” at exchange and again at completion which confirms that, at completion, the buyer does not have any knowledge of any facts or matters which may give rise to a claim under the W&I policy (“New Breach Knowledge”). The W&I policy will also typically provide that any such New Breach Knowledge will limit the ability of a buyer to claim for loss in relation to that fact or matter.
New Breach Knowledge provisions are challenging for a buyer, as it may find itself in a situation where: (a) the SPA exchanges; (b) it then acquires New Breach Knowledge (e.g., via supplemental disclosure by a seller); (c) it then is obligated to complete the SPA; and (d) after completion, it cannot claim under its W&I policy (due to the New Breach Knowledge) and it cannot claim against the seller as the seller’s liability is capped at £1. This is especially difficult for a buyer in the context of an English law governed corporate real estate deal, where termination rights in the period between exchange and completion are customarily weaker for a buyer than on traditional M&A deals. There may be some protections via a completion accounts process, but this is also often limited.
Goodwin is experienced acting for buyers alongside experienced W&I insurance brokers and negotiating with W&I insurers and sellers where there is a gap between exchange and completion. We have successfully obtained protection for buyers, including mitigating risk in a New Breach Knowledge context, where the gap between exchange and completion has been as long as three months.
Neo Combarro Partner of Lockton Transactional Risks comments:
“Some insurers, dependent on sector and jurisdiction may provide what is known as “New Breach Cover”, which provides cover for a buyer despite “new knowledge” of potential breaches acquired by a buyer in the period between exchange and completion. If available, insurers will typically provide “New Breach Cover” on a rolling four week term, subject to an additional premium for each period and subject to a no claims declaration at the anniversary of the four week period. The key is to have brokers and an experienced legal team engage potential insurers early on an underwriting timeline, and to keep the insurers updated as the deal progresses.”
The use of W&I insurance is not a replacement for comprehensive buyer due diligence and seller disclosure. In fact, an insurer will expect that due diligence and disclosure, as well as negotiations in relation to the SPA, are conducted wholly on arms’ length and as though the deal did not involve W&I insurance. Any evidence to the contrary (e.g., overly seller friendly or un-negotiated warranties, a disclosure letter with little or no specific disclosures, missing due diligence reports, etc.) may spook an insurer to seek more comfort or even refuse cover.
In any event, a seller will want a proper disclosure exercise to be undertaken to preserve its liability caps which may be compromised in the case of fraud or dishonesty (see paragraph 6 above).
Similarly, a buyer will want to undertake full due diligence to deal with any potential diligence issues upfront and opposite the seller before exchange and to ensure the broadest cover under the W&I policy, rather than face the costs and risk involved in making a claim after exchange/completion.
From a timing perspective, an insurer’s diligence and underwriting process can be time consuming, and all stakeholders should build this into any transaction timetable and engage lawyers, brokers and underwriters early in the deal process.
Goodwin has comprehensive experience executing transactions using W&I insurance, and working collaboratively with all stakeholders, including buyers, sellers, lender, brokers and underwriters, and across a range of corporate real estate situations, from real estate M&A involving trophy single assets, to multi-jurisdiction portfolios, from auction scenarios with multiple bidders, to sales in connection with non-performing loans, distress and insolvency.
For questions or more information on W&I insurance in the context of UK and European real estate M&A, please contact James Spence or Ray Fang based in the London office.