Warranty and indemnity insurance (W&I Insurance) continues to have an accelerated rate of take-up in the Australian mergers and acquisitions (M&A) landscape. Traditionally seen only in M&A transactions in respect of unlisted target companies, W&I Insurance policies have increasingly been written in M&A transactions in respect of ASX listed target companies.

Given the continued momentum for W&I Insurance, we have considered what effects it may have on public M&A deal-making going forward.

What is W&I Insurance?

W&I Insurance provides cover for buyers or sellers for breaches of warranties and indemnities made by sellers in sale agreements. W&I Insurance benefits both parties as it allows losses to be shifted from a buyer/seller to an insurer. With the exception of known issues and fraud, W&I Insurance policies will generally reduce to a large (or total) extent the seller's warranty and indemnity liability under a sale agreement.

The benefits of W&I Insurance

The well-known benefits of W&I Insurance include:

• an alternative to other traditional means of managing transaction risk including escrows, price adjustments, guarantees and hold-backs;
• provides a 'clean exit' for the seller;
• increases attractiveness of the offered price by allowing seller liability to be shifted to an insurer;
• better human relations – avoids the need to pursue management or former shareholders (who may still be involved in the business post close) for breaches;
• provides more security to sponsors in leveraged transactions; and
• less credit risk when making claims.

Process for writing a W&I Insurance policy

Extensive due diligence on the target must be undertaken before a policy will be underwritten – insurance is not a substitute for diligence. Seller due diligence can save time, but buyer due diligence is usually always required as well.

Insurers (together with the help of external legal counsel) will closely scrutinise the level of due diligence undertaken before writing a W&I Insurance policy. Warranties and indemnities in relation to issues that have not been adequately 'diligenced' will not be covered by the insurer.

If an issue is not covered by W&I Insurance, the seller may refuse to give the buyer a warranty or an indemnity in respect of that issue, which would leave the buyer with no protection in respect of that issue. Alternatively, if the issue is not covered by W&I Insurance and the seller is still prepared to give the buyer a warranty or an indemnity in respect of that issue, it means that the seller bears full liability for that uninsured warranty/indemnity.

Does W&I Insurance really pay out?

Recent statistics suggest claims under W&I Insurance policies have become more frequent, with approximately 21% of global W&I Insurance policies written in recent years resulting in a claim .

W&I Insurance for public M&A transactions

Despite a decent track record in the private M&A space, it is only very recently that W&I Insurance has been utilised for public M&A transactions, that is, M&A transactions in respect of ASX listed target companies. This is changing deal-making in public M&A.

The traditional difficulty in seeking warranties and indemnities in public M&A has been that the bidder has little recourse if a warranty is breached or an indemnity is triggered.

That is because, with an ASX listed target, the sellers are the shareholders in that target company and they can number in the thousands. As a matter of practicality, it would be difficult for the bidder to recover any payment from those many shareholders if a warranty was breached or an indemnity was triggered. 

Further, if the bidder was to seek warranties or indemnities from the ASX listed target itself rather than from its shareholders, the bidder would, in the event of a breach of a warranty or the trigger of an indemnity, be seeking payment from the target it now owns or will soon own (no point suing the company you are buying).

As a result of those practical limitations, the practice in public M&A transactions has been for the target itself to give a very limited set of warranties to the bidder. The warranties given by the target are limited to fundamental matters which would directly impact on the bidder's decision as to whether to proceed with the transaction or not (i.e. the warranties are usually limited to matters concerning the target's capital structure, capacity, authority etc). Those warranties are limited to those matters with the intention that, should a warranty be breached, the bidder would terminate the transaction rather than seek damages.

W&I Insurance for public M&A transactions can provide a mechanism to give a bidder recourse if a warranty is breached or an indemnity is triggered. Rather than recourse to shareholders of the listed company or the listed company itself, the bidder has recourse to the W&I Insurance Policy to seek payment if a warranty is breached or an indemnity is triggered.

By giving bidders in public M&A transactions such recourse, W&I Insurance now allows the practice in public M&A transactions to move away from just limited warranties as to fundamental matters. Instead it gives bidders more 'business'/'commercial' warranties and indemnities of the type typically seen in sale agreements for private M&A transactions. In particular, W&I Insurance allows bidders in public M&A transactions to proceed to complete the transaction despite a warranty being breached, and seek payment under the W&I Insurance policy later.

Implications for public M&A deal-making

Whilst solving the problem of giving bidders in public M&A transactions recourse if a warranty is breached or an indemnity is triggered, the use of W&I Insurance in public M&A transactions creates new issues that will need to be navigated by bidders and targets who wish to use W&I Insurance on such transactions.

One such issue is the need for the bidder to conduct greater due diligence on the target in order for the warranties/indemnities to be supported by W&I Insurance. A further issue is the need to manage underwriting process requirements. These issues will add further complexity for deal timetable management on public M&A transactions.

Cost is another important issue posed by using W&I Insurance on public M&A transactions. Often in private M&A transactions, the cost of W&I Insurance is shared between the bidder and the target. However, there are limitations on publicly listed targets giving bidders 'financial assistance' in relation to the acquisition of shares in the target, which may limit ability to share the costs of W&I Insurance. This may result in a practice developing on public M&A transactions that bidders will need to bear the cost of W&I Insurance, which may ultimately impact the price to be paid to target shareholders.

But the impact is not all negative, as the availability of W&I Insurance on public M&A transactions will foster greater confidence for all bidders, meaning more marginal transactions may proceed.