W&I policies – the what, why and how

As noted in our "Global M&A Outlook for 2024: Ready for take-off?", there are good reasons to believe that 2024 will be a stronger year for M&A transactions. An uptick in deal activities could also potentially signal a rising demand for warranty and indemnity ("W&I") insurance, which has become an increasingly popular risk allocation tool for parties in M&A deals.

Key advantages offered by W&I policies

A W&I policy is, in essence, a bespoke insurance product that offers coverage for losses arising from breaches of warranties in a sale and purchase agreement in the context of M&A transactions. Either sellers or buyers may take up such a policy but buy-side policies have become more commonly used, and following are some notable advantages offered by W&I policies:

1. A risk allocation tool instrumental in getting deals across the line – warranties given by sellers in respect of target entities tend to be one of the most contentious parts of a transaction and an area that is often heavily negotiated between the parties. While buyers want the comfort that the entities they are purchasing match the quality, condition or descriptions as promised, for various reasons sellers may be unwilling or unable to stand behind these contractual statements. When an agreement cannot be reached between the parties in this regard, taking out a W&I policy could be the way forward. With this policy in place, buyers will continue to benefit from the protection of warranties just like in any traditional M&A transaction, with the only tweak being that it is a third-party insurer (instead of the sellers) that will be liable for any untrue warranties.
    
2. Preservation of commercial relationships crucial for the ongoing success of target entities – for transactions where the sellers will remain shareholders or the management team of target entities post-closing, buyers may be reticent to claim against the sellers for breaches of warranties, as any such litigious actions can strain the commercial relationships of the parties. A W&I policy could be useful in this respect as it allows buyers to be compensated for the losses they suffer due to incorrect warranties without requiring them to institute claims against the sellers, thus preserving their business relationships going forward, which are especially important in a joint venture context.
    
3. Clean exit for sellers' peace of mind while making a purchaser an attractive bidder – sellers, especially private equity firms, place significance on a "clean-exit" following their proposed disposals. W&I insurance, especially one that has "zero recource" against sellers, can help achieve this objective because by transferring liability to a third-party insurer, it reduces sellers' exposure to disputes and claims following closing. By the same token, where a sale is structured as a competitive auction process, buyers who offer to take up an W&I policy would make themselves more attractive bidders compared to other interested buyers who do not anticipate having a buy-side policy in place.

Key considerations when putting together W&I policies

There is no one singular approach to incorporating a W&I policy into an M&A transaction, as in practice this can often be impacted by different factors, including, for example, the features and stage of the transaction in question, the bargaining position of the parties, and the different requirements of insurers. This notwithstanding, having worked with multiple insurers to put together W&I policies, we know what to look out for, and the following are important considerations to bear in mind when parties (especially buyers) are looking to arrange a buy-side W&I policy for their transactions:

1. Due diligence – having a W&I policy does not diminish the need for buyers to carry out a comprehensive due diligence process on the target(s). Quite the contrary, to manage their own risk exposures, insurers would expect buyers to have undertaken a thorough investigation into the affairs of target entities, by performing a careful legal, commercial, technical, tax, financial, and environmental due diligence review. The idea is that insurers would insure matters protected by warranties only to the extent that such matters have been sufficiently reviewed by a buyer, and any "known" issues or risks revealed from a due diligence exercise will be excluded from coverage. Further "top-up" due diligence is possible but this is not always feasible especially from a timing perspective when the signing of a deal is imminent. Thus, for buyers intending to take up a W&I policy, it is important to coordinate their due diligence exercise from the start so that it covers the scope and depth of diligence generally expected by underwriters for deals of a similar nature and size. Where materiality thresholds are used in a diligence exercise, they should also be reasonable against the size of the transaction and in line with the limitation thresholds that may be expected by insurers. Proper disclosures of documents and information, either through a complete data room, Q&A process and disclosure letter should also be implemented.
    
2. Drafting of transaction documents - we have seen how transaction documents are reviewed by insurers, who, in essence, want to have sufficient comfort that there are adequate buyer-seller negotiations of the documents, especially clauses pertaining to warranties, indemnities, disclosures and limitations of liabilities. The rationale is that if a transaction document is very much buyer-friendly where claims of warranties can be made easily made against sellers, then the insurer's risk exposures would also increase correspondingly. Thus, some helpful questions to consider are - do the transaction documents contain market-standard limitation of liabilities and are the relevant warranties appropriately qualified by knowledge or materiality qualifiers? Additionally, if a transaction contemplates split signing and completion, and the warranties will be repeated on closing, then an insurer would often require a bring down disclosure process to be provided for in the transaction document.
    
3. Exclusions – Parties should be mindful that the coverage under a W&I policy will not be perfect because there will inevitably be certain matters which will not be covered by a policy. Particularly, in practice, we generally see that a policy will exclude coverage for losses pertaining to, for example, known issues, corruption, fraud, environmental matters, consequential losses, sanctions, and the conditions of properties. Being mindful of what will be excluded from coverage is important so that parties can agree in advance different risk allocation mechanisms among them (including a potential adjustment to purchase price), or to source for alternative protections such as other standalone bespoke policy for coverage.
    
4. Timing / Process – While a W&I policy can usually be put in place rather quickly, parties are advised to initiate the process as soon as possible to ensure a timely and smooth underwriting process. To kick-off the process, certain customary preliminary documents, including for example, a non-disclosure agreement and fee letter, will have to be signed with the insurer. During the underwriting process, the insurer and its advisors will review the buyer's due diligence reports and the transaction documents, before the parties jump on an underwriting call (which usually lasts for 1 to 2 hours) for the insurer to raise any further questions to get comfortable with the due diligence process undertaken by the buyer. The policy terms will also be negotiated in parallel, while at the same time the insurer will ask to be kept informed on the negotiation of the documents in case any changes to the policy terms are warranted. Assuming the policy terms are agreed upon, the insured will then be required to issue a no-claims declaration before the policy is put "on risk" where coverage will commence. Arranging for a W&I policy may not always be straightforward and can be time-consuming. Therefore, obtaining support from counsel who is well-versed in this process can be particularly helpful to ensure that the process is managed efficiently in line with the key milestones of the underlying M&A deal.

Our team has a wealth of experience in helping either insurers or transacting parties put together W&I policies for M&A transactions. If you have any questions in relation to the above or if there is anything that we can be of help, please do not hesitate to reach out.