By Dr. Sandra Link, LL.M. King & Wood Mallesons’ Frankfurt office.
During the last years, the number of Chinese outbound transactions to Germany have increased considerably and reached a record high in 2016. M&A transactions are quite complex processes, presenting a wide range of potential pitfalls for both buyers and sellers. Often, Chinese investors are not familiar with the particularities of the European market. Against this backdrop, the need to mitigate transactional risk is increasing in particular for Chinese investors.
The use of Warranty & Indemnity (W&I) insurance, has become commonplace in the US and European M&A markets over the last years. Whilst the product is less well-known in the Chinese market, the gap is starting to close and a leading W&I insurer has already established a Chinese desk in Germany to meet the special needs of Chinese clients. With SASAC having emphasized the importance of risk insurance in the context of outbound investments for SOEs in their regulation of 7 January 2017, we expect the importance of W&I insurance for Chinese outbound M&A to further increase.
What is W&I insurance?
In an M&A transaction, it is market standard that the sale document contains certain warranties and indemnities relating to the target company. The breach of such warranty or indemnity usually results in a claim of buyer against seller. W&I insurance policies provide cover for losses suffered in connection with such warranty or indemnity claims and may be taken out by either the seller or the buyer.
Under a buyer policy, the buyer claims against the seller up to the liability cap agreed in the sale documents, and then claims against the insurance policy for any losses above the cap.
Under a seller policy, the buyer would claim against the seller under the sale documents in the normal way and may not be aware of the insurance policy. The seller would then make a claim under the insurance policy and remain directly liable to the buyer (the insurer would, however, have the ability to control any defence or settlement of the claim).
Seller policies are not so common because W&I insurance typically covers unknown risks and the seller is more likely to know about the risk then the buyer; however, in certain circumstances, insurance policies may be available for known but contingent and/or unquantifiable risks that may otherwise be dealt with as an indemnity from the seller. Most popular form of such special situation insurance is the insurance for a tax indemnity.
So-called Seller to buyer ‘flips’ are increasingly being used in auction processes, whereby the seller procures indicative pricing and coverage terms from an insurer for a policy that will ultimately be taken out by the buyer.
Benefits of W&I insurance
There are several reasons for the parties to insure the transaction. The main reasons are as follows:
1. Clean exit for seller: Many sellers, particularly private equity sellers, want to be certain about the amount of sale proceeds, so that they can make a distribution to their investors. However, they are commercially required to provide a market-standard warranty package to the buyer so that there is uncertainty on potential future liabilities.
2. ‘Topping-up’ the seller’s liability: The W&I insurance may be used to increase the level of recourse available to the buyer if it is not comfortable with the cap proposed by the seller, or to extend the time limit for making a claim. Buyers in a competitive auction process may also introduce W&I insurance as a means of enhancing their bid by offering low liability caps to the seller.
3. Recoverability: Even with extensive contractual protection, a buyer will still be exposed to the risk that it will not be able to recover damages against the seller. This will be a concern if the seller is an individual, an SPV, in financial difficulty or in another situation where enforcement against the seller may be difficult in the event of a successful claim. Timing is also an important factor, as a claim against a seller in a foreign jurisdiction may take several years, whereas a claim against an insurer located in Germany would be expected to be resolved in a significantly shorter period of time.
4. Relationship with the sellers: Some buyers, particularly private equity sponsors, will be unwilling to make a claim against the warrantor sellers as they are likely to be involved in the continued management of the target business. Although buyers (and insurers) may require the warrantor sellers to have some liability (‘skin in the game’), insurance may be used to reduce this and mitigate the risk, enabling the buyer to make a commercial decision not to recover against the warrantors if that is in its best interests whilst still recovering the balance (usually any loss above the first 1% of enterprise value) from the insurer.
The importance of diligence
W&I insurers are particularly focussed on ensuring that the transaction has been negotiated as if insurance was not in place and that there has been both a thorough diligence process by the buyer and disclosure process by the seller.
As insurance is intended to cover unknown risks, it is important that buyers intending to insure a transaction agree to a due diligence scope with their advisers that covers the areas that the warranties relate to. The insurance will usually not cover known risks (discovered in the due diligence) for which a solution needs to be agreed between seller and buyer.
Experience shows that Chinese clients tend to agree on a rather limited due diligence scope to save due diligence costs. With a W&I insurance on the table, such approach could become rather expensive in the end as a W&I insurance will not cover warranties that relate to areas where no due diligence has been conducted. The W&I insurance policy usually includes a so-called warranty spreadsheet that lists in details whether specific warranties are subject to insurance coverage or not.
Terms and Pricing
Costs for a W&I insurance usually amount to 0,7 to 2 % of the insured amount depending on the business of the target, the amount of deductible agreed, the scope of warranties, the term of the insurance coverage and the quality of due diligence and data room. Special situation insurances covering known but contingent and/or unquantifiable risks are usually more expensive (2 – 10% of insured amount).
The insured amount is in general lower than the deal volume. Usually, a W&I insurance covers between 20 and 50% of the deal volume and will contain a deductible (i.e. an amount of the insurance claim that is the responsibility of the insured while the insurance policy will only cover the remaining claim up to a cap agreed with the insurer). The deductible usually is 0.5 – 1 % of the deal volume and the seller remains liable under the sales document up to the amount of the deductible, so that the deductible will often be identical with the cap agreed with the seller.
The insurer or the insurance broker usually requests to review the draft sales document, the information memorandum or management presentation, draft due diligence reports, financial statements of the target and asks for access to the data room. Following review of the information provided, there will be an underwriting call, in which questions of the insurer are clarified. Based on these information, the insurer provides a draft of the insurance policy that is then negotiated with the insured. The process usually takes 10 to 14 days.