DealMakers - Q2 2022 (released August 2022)
W&I insurance – a key consideration for M&A transactions (Part 2)
by Andrew Giliam and Anita Moolman
Key considerations in procuring W&I insurance
Whether to procure W&I Insurance
It is important that parties decide in the early stages of the transaction whether they wish to include W&I insurance in their deal. Parties need to cater for the underwriting process in the timelines of their transactions. Understanding how this process dovetails with deal negotiation and execution from the early stages can save the parties time and costs. Asking the right questions regarding W&I insurance at the commencement of a deal can shape the way that the deal progresses, and can also assist the parties, early on, in their understanding of what cover can be obtained and whether the benefits of insuring the transaction outweigh the costs involved.
Commencing with the W&I insurance process upfront is also important because the parties want certainty as to how the warranties and indemnities are covered when they sign the sale agreement. As a result, the W&I policy should typically be negotiated and signed simultaneously with the transaction agreements. Understanding that a deal will be covered by W&I insurance also allows the parties to draft the sale agreement with the insurance in mind, rather than having to amend the sale agreement to cater for typical W&I insurance provisions (which are discussed in further detail below) after it has been concluded.
Considerations regarding the inception date of the insurance cover
Where the parties wish to obtain insurance from the signature date of a sale agreement, the W&I policy will need to be negotiated and signed prior to the sale agreement. This has clear benefits. Where an insurer has excluded certain matters from its coverage, the parties can then decide to deal with those matters in another way or, alternatively, allocate risk for any losses that arise in connection with those exclusions between themselves in the sale agreement itself.
If the parties agree to procure W&I insurance after concluding the sale agreement, then the conclusion of the W&I policy should be catered for as a condition precedent to the sale agreement. For buy-side policies, it is important for the condition precedent to specify that the insurance policy be, in form and substance, satisfactory to the seller. This will afford the seller the opportunity to assess, before closing the transaction, whether the policy adequately covers the warranties and indemnities in the sale agreement, without residual claims arising against the seller.
More often than not, a sale agreement will not be signed and implemented on the same date. Prior to closing, the parties need to fulfil a number of suspensive conditions, which could involve a lengthy period between signing and closing. The parties may elect for the insurance cover to be in place in respect of signature date warranties from the signature date and, thereafter, closing date warranties from the closing date. There will generally be a bring down process on both the signature date and the closing date, where the insured party is required to confirm to the insurer that there are no known warranty or indemnity claims on each date. While the extent of insurance cover will differ from policy to policy depending on what is agreed in the circumstances, there is often a general exclusion relating to known issues that arise during the interim period between the signature date and the closing date of a sale agreement. In other words, where an insured party becomes aware of information during the interim period that will result in a breach of a closing date warranty, it will be obliged to notify the insurer of that information in the bring down process on the closing date (or earlier, if there are ongoing disclosure obligations) and may not receive cover for that issue once the sale agreement closes.
Parties should bear this risk in mind when determining the inception date of the policy, particularly in instances where there will be a lengthy interim period between signing and closing a transaction. In these instances, it may be worthwhile determining whether an insurer will be willing to provide insurance for new breach cover; that is, insurance for breaches that occur after the sale agreement is concluded. Whether new breach cover can be obtained will largely be a product of an insurer's risk appetite, the cost that the parties are willing to pay for the policy, the type of deal involved, the length of the interim period and the sufficiency of the due diligence.
Implications for due diligence
W&I insurance is not designed to replace due diligence. On the contrary, the extent of the coverage received under a W&I policy (particularly a buy-side policy) depends largely on the adequacy of the due diligence that has been performed, and whether the scope of the due diligence matches the scope of the warranties. In order to attract cover, the insured party needs to illustrate to the insurer that each warranty and indemnity has been adequately investigated, and that the accuracy of each warranty and indemnity has been verified.
W&I insurance has two major practical implications on the due diligence process.
Firstly, a sale agreement with a comprehensive "shopping list" of warranties and indemnities will not likely attract comprehensive cover under a W&I policy unless each of those warranties has been the subject of some form of due diligence. It is not uncommon for sale agreements to be packed with extensive warranties which have not been the subject of due diligence. These warranties are likely to be excluded from the cover provided under a W&I policy. For example, a buyer is not likely to conduct an extensive environmental due diligence for a business that has minimal environmental law risks, or an extensive immoveable property due diligence for a business that occupies few premises. If the sale agreement in these scenarios contains wide-ranging environmental or immoveable property warranties that have not been the subject of adequate due diligence, it will illustrate to an insurer that the parties have not properly negotiated or interrogated the warranties, which will likely result in qualifications or exceptions to the insurance cover. As a general rule, to attract maximum cover, the sale agreement should contain warranties that are tailored to the target's business, and which have been the subject of adequate due diligence. The scope of the due diligence investigation must be commensurate with the scope of the warranties and indemnities in the sale agreement. Where there is a large disconnect between the two, the parties may need to supplement their due diligence at a later date, in order to obtain cover under the W&I policy, which comes with adverse time and cost implications.
Secondly, the nature of the due diligence performed will differ where a deal includes W&I insurance, as opposed to a deal which does not. As part of its underwriting process, an insurer (or its counsel) will interrogate the data room and due diligence reports prepared by the parties' counsel to ensure that the warranties and indemnities included in the sale agreement have, in fact, been the subject of investigation. The more extensive the due diligence, the more comfort the insurer will have in standing behind the warranties. While a high level, brief due diligence report may be appropriate for a deal that is not insured, a more comprehensive due diligence report (both in terms of scope and detail of reporting) is strongly advised for deals involving W&I insurance.
There are some risks that insurers will not agree to cover in a W&I policy. There are also some risks and warranties that are difficult to fully investigate (either at all, or within the timelines contemplated by the transaction parties or not without great expense), such as a warranty that a target has complied with all laws. It may not be practicable for service providers to verify such a warranty in its entirety. However, the risk of a warranty claim arising from such broad warranties could be mitigated in other ways outside of due diligence that provide comfort to an insurer that the risk of a warranty claim is mitigated. For example, the parties could point to existing controls and audit functions within a target that have been the subject of due diligence, which are in place to ensure compliance with the warranties given.
It is always advisable to carry out the underwriting process and conclude the W&I policy simultaneously with negotiations on the sale agreement, so that the insured party is aware of any limitations to the insurance cover it expects to receive under the W&I insurance policy.
Giliam and Moolman are Directors in Corporate & Commercial | Cliffe Dekker Hofmeyr.