Post-M&A arbitration has long followed an established pattern: In the course of the transaction the buyer assesses the characteristics of the target company by way of a due diligence review and based thereon determines what the buyer considers to be an adequate value of the target company. To ensure that the target company shows the expected characteristics when the buyer takes over the company from the seller, the buyer and the seller describe in their share purchase agreement (“SPA”) the most important characteristics the target company shall have at handover (e.g. that the target company owns certain intellectual property rights). To this end, the buyer and the seller agree on a conclusive catalogue of representations, warranty and indemnity provisions and exclude claims against the seller beyond these provisions. If the seller breaches its representations or warranties, the buyer has a legal basis for a claim for damages (or for indemnification). If the seller does not satisfy the buyer’s claims, the buyer initiates arbitration proceedings. The buyer argues that the seller has breached representations and warranties and is liable to damages or that the seller must indemnify and hold harmless the buyer from claims raised against the buyer by third parties. Often the claims are payable out of an escrow account on which a portion of the purchase price has been parked. This standard setting has been changed by the rise of warranty and indemnity insurance (“W&I Insurance”). While such insurance is regularly used in the U.S. and in the UK, it appears to be a new trend in the M&A transaction practice in other markets as e.g. in Germany. W&I Insurance does not only impact the setting and dynamics of the transaction itself, but also of the disputes that arise out of such transactions.
What Is Warranty and Indemnity Insurance?
A W&I Insurance is usually agreed between the buyer of a company and the insurer. The insurer undertakes to satisfy insured warranty and indemnity claims of the buyer against the seller under the SPA. If such insurance is established, the buyer can accept that the seller limits its liability under the SPA to a minimum (often around 1 % of the purchase price). Since with such limitation of liability the seller cannot be held liable for the full amount of damages resulting from a breach of its representations and warranties, the seller has little incentive to reduce its obligations in this regard. In the end, the insurer will be held responsible for claims arising out of the seller’s representations and warranties and will bear most of the risk. Therefore, the insurer must properly evaluate and assess the insured risk. To do so, the insurer is involved in the transaction (usually around two weeks before signing), especially by being granted full access to the due diligence process and the data room, and the insurer is kept fully informed about the negotiations of the SPA. If the insurer is satisfied and assumes a calculable risk, the insurance policy is granted. Due to the strong competition in the market, the premium to be paid is often around only 1-2 % of the total amount insured. The buyer will provide to the insurer a so-called “no claims declaration” by which the buyer confirms that at the time of the signing of the SPA the buyer is not aware of any breaches of the SPA other than those that have been duly disclosed to the insurer. Depending on the scope of the insurance coverage, a similar no claims declaration might be required also at the closing of the transaction. The buyer will make such declaration based on a written statement given to him by the seller that the seller is not aware of any breaches of the SPA, i.e. that the representations and warranties are materially correct at closing except as disclosed.
Impact on Setting and Dynamics of Post-M&A Arbitrations?
The use of a W&I Insurance does not only change the negotiations, e.g. because more attention must be paid during the negotiations to the insurance policy than to the catalogue of representations and warranties itself. This also impacts the disputes arising from such transactions. In this regard, we expect the following issues to become important:
Issue #1 “changed interests of parties involved”: The insurer is another “player” in the transaction and arbitration markets, i.e. it will be the actual defendant in post-M&A arbitrations. The insurer will be the new defendant solely or jointly with the seller as the standard defendant; in return the seller is now protected by the strict contractual limitation of liability provided for in the SPA. This setting significantly changes the dynamics in post-M&A arbitrations: (i) During the contract negotiations, the seller will have little incentive to negotiate hard for a limited representation and warranty regime. Since the seller will be protected by the limitation of liability agreed in the SPA, the seller does not need to reduce too much the scope of the representations and warranties it gives to the buyer. Rather the seller will try to increase the purchase price by giving representations and warranties – for which the seller might not be held liable anyway (or with a significantly reduced liability capped at 1 % of the purchase price). In line with this, the seller will have no interest to assist the insurer in defending claims based on alleged breaches of representations and warranties if a dispute arises after the transaction. (ii) The buyer has no incentive to carry out a detailed due diligence review of the target company. Rather the buyer will try to get extensive representations and warranties which are than covered by the insurance policy. (iii) Obviously, the insurer has a significant interest that such shifts in the dynamics of the contract negotiations do not happen. The insurer therefore closely monitors the negotiations and has a seat at the table. And only after knowing how the negotiations developed, the insurer will determine the final scope of the insurance coverage. In addition, to clarify breaches of representations and warranties, documents in the possession or control of the seller and/or the target company are relevant. The insurer is interested to have access to as much information as possible to be in a position to defend claims from the buyer. For example, it might be relevant of which issues the seller was aware and which of these issues the seller had communicated to the buyer before signing of the SPA. The seller will be reluctant to undertake to provide such information after signing, however it seems to become standard practice to agree that the target company itself retains all relevant documentation and that the buyer is obligated to give the insurer access to this documentation.
Issue #2 “changed situation in case of breach”: Having the insurer involved as a third party and looking at the changed interests of the parties, this new transaction structure will give rise to interesting and yet unresolved questions of liability in case of a breach: (i) To avoid abusive behavior of the parties the insurer will require the buyer to give a “no claims declaration” in which the buyer confirms that it is not aware of any breaches of representations or warranties that give rise to a claim. The buyer in this regard usually relies on a respective declaration given to him by the seller (as foreseen in the SPA). The question arises what happens if the seller (negligently or intentionally?) provides a false declaration? Is the seller then liable to the insurer although the seller has no direct contractual relationship to the insurer? Can the insurer argue that it has been misdirected or deceived by the seller and, thus, invalidate the insurance contract? Or can the insurer argue that, in this context, the SPA between the seller and the buyer provides the position of a third party beneficiary to the insurer? Further, the question will arise, which obligations the buyer had in order to determine potential breaches of representations and warranties before signing, i.e. to what extent the buyer had to carry out a due diligence review, which precautionary measures was the buyer obligated to take. In essence, it will be the question under which conditions can “knowledge” of a breach by the buyer be assumed. (ii) Regularly it will be unattractive for the buyer to start arbitration proceedings against the seller because the seller is protected by a strict limitation of liability. Therefore, the buyer will address the insurer with any claims the buyer has. The first question arises as to if and to what extent the insurer can refuse payment based on issues from the relationship between seller and buyer, e.g. can the insurer rely on wrong and deceiving statements by the seller made vis-à-vis the buyer? If the insurer satisfies the buyer’s claims, the insurer usually will have no effective recourse against the seller from a commercial perspective (again due to the contractual limitation of liability provided for in the SPA to the seller’s benefit). The exception is that the seller has breached representations and warranties intentionally, because in such a scenario, the limitation of liability does not apply. This might provide an incentive for the insurer to argue intent on the seller’s part to cover the losses under the insurance contract. Again, the question arises, to what extent issues from the relationship between seller and buyer have an impact here. The situation will be even more complicated if one considers that a pre-contractual or a contractual relationship exists only between the seller and the buyer, but not between the seller and the insurer. Scenarios are thus likely, where the breaches of contract happen in the relationship between seller and buyer while the damages occur only with the insurer (i.e. outside the relationship between seller and buyer). (iii) New legal issues will pop up in post-M&A arbitrations because the new standard claim “buyer vs. insurer” will be based not only on the representations and warranties provided for in the SPA, but mainly on provisions in the insurance contract. Those insurance contracts are yet not standardized, but are negotiated heavily between the buyer and the insurer individually. Hence, there is no tried and tested practice, let alone any court decision clarifying legal questions. The insurance contract is unlikely to anticipate and regulate any problem which will arise in the context. So its a safe bet to assume that many related issues must be decided by arbitral tribunals.
Issue #3 “relevance of confidentiality in arbitration proceedings”: The insurer often agrees on an arbitration clause (combined with a confidentiality clause) between the buyer and the insurer. This is noteworthy considering the reluctance many insurance companies have shown in the past vis-à-vis confidential arbitration proceedings. However, the insurance companies apparently have an interest not to disclose publicly – in a public lawsuit – how and to what extent they regulate claims of an insured party (= the buyer in the transaction).
To sum it up: The warranty and indemnity insurance are likely to keep many arbitration practitioners busy in the years to come.