Warranty and indemnity insurance

Europe’s economic situation remains uncertain. Fears of continuing recession are still present. This, however, is not stopping M&A activities from returning to the daily menu of financial and legal advisers. Cash is king and strategic corporate buyers with strong balance sheets have an advantage. Private equity funds are renewing their activities and banks are interested in financing acquisitions of economically sound targets by investors with good track record of successful investments.

One of the dominant trends which M&A advisers are detecting these days is risk aversion and resulting risk control by the buyers. Investors are much more cautious, they want to know that their target is free of any potential liabilities and issues and they wish to hedge against any potential residual risks.

One useful risk management tool which has appeared on the Czech market is a warranty and indemnity insurance (W&I insurance).

One useful risk management tool which has appeared on the Czech market is a warranty and indemnity insurance (W&I insurance).

To understand how W&I insurance works we must first understand the principles of risk allocation between buyers and sellers in M&A transactions. The most commonly used risk allocation method was brought into Czech law by Anglo Saxon practitioners during the privatisation wave of the 1990s and is based on warranties.

Warranties are statements confirming a particular set of facts existing in relation to any particular target company on which the buyer places reliance and on the basis of which it offers to pay a particular price for the shares or an interest in the target.

If a warranty proves not to be true the buyer is entitled to compensation the amount of which is equal to the difference between the value the shares would have had had the warranties been true and the value of these shares if any of the warranties turned out to be untrue.

A warranty could state, for example, that the target is not engaged in any litigation. If such a warranty proved to be untrue and the company was, at the time of its acquisition, involved in a litigation of which the buyer did not know and this litigation resulted in compensation which the target company had to pay to a third party thus reducing the target´s assets, the buyer would have a claim against the seller based on a breach of the litigation warranty.

Despite lengthy academic discussion and lack of basis in the Czech statutes the principle has been proved to be valid under Czech law in the light of recent judicial decisions in various high profile dispute resolution processes.

What next?

So far so good. We have a mechanism how a buyer can negotiate a set of warranties in effect guaranteeing the state of the target at the time of its acquisition and can ask the seller for a remedy if the factual situation of the target was, in fact, different.

But even if the buyer is successful and wins the relevant action for breach of warranty, what if the covenant of the seller is not good enough to pay the awarded compensation? What if the proceeds of the sale have already been spent? What if the seller is a private individual or a private equity fund which, according to its rules, cannot carry potential liability for many years after the sale of its investment?

Well, there are several potential remedies. The buyer can ask for retention from the purchase price but the seller is unlikely to favour this solution. The buyer may ask for a parent or a bank guarantee. With a parent guarantee the problem is being passed further up in the seller’s group and a bank guarantee may be too expensive for the seller.

W&I insurance

The new instrument appearing on the market, W&I insurance, provides insurance of potential seller´s liability flowing from breaches of warranties set out in the relevant sale and purchase agreement. As far as the writer knows, at the time of this article the first W&I insurance on the Czech market was underwritten by Chartis and since then a couple of other policies have been written up. There are more in the pipeline.

The mood in the M&A market is that W&I policy is a tool which is likely to become very popular. The writer has certainly been in situations when a W&I insurance either saved or substantially simplified a deal. And this is the ultimate goal of all of us involved.

Milana Chamberlain is a corporate finance lawyer and the managing partner of the Prague office of the law firm Norton Rose v.o.s. She specialises in cross-border M&A transactions and joint ventures in CEE markets, insurance, employment and procurement law.