The number of M&A transactions by foreign investors in Germany has continued to rise, certainly until the third quarter 2019. Among these foreign buyers, investors from the US have traditionally held a dominant position, and 2019 was no exception – over 20% of foreign M&A investors were from the US.1
W&I insurance has become a standard feature in the international M&A market, especially in Germany. Likewise, US investors are very familiar with this type of insurance in M&A transactions. However, the standards for this in the US market differ, just as they do with regard to the actual Share Purchase Agreement (SPA).
In the past, markets tended to develop independently of one another, but in recent years this has shifted more towards a global market approach. One of the most noticeable trends in this context is that US investors expect to have certain US-style enhancements included in the W&I policy offered by European insurers.2
A general heated discussion point is whether a fact or circumstance is deemed to have been ‘disclosed’, thus excluding any claims the buyer may have (both against the seller and against a W&I insurer) based on a breach of warranty. In this context the parties need to agree how they will deal with disclosed documents and other information in the (mostly virtual) data room. In the event of a claim, such disclosure very often becomes the focus point on any claims negotiation between the insurer and the buyer in its capacity as an insured.
2. Sales-Purchases-Agreement: exclusion of seller’s liability based on buyer’s knowledge
2.1 Statutory exclusion of liability based on buyer’s knowledge – the legal analysis in Germany
As a rule, under German law buyers cannot raise claims based on a breach of warranty in an SPA if they knew the circumstances constituting the breach at the time of entering into the agreement, cf. § 442 BGB (German Civil Code). A seller who can prove that the buyer had knowledge of a specific fact or circumstance is not liable for potential damage the buyer may suffer as a result of a breach of warranty related to such fact.
‘Knowledge’ in this sense does not only refer to anything the buyer currently – i.e. at the time of entering into the agreement – actually knows; German jurisprudence extends this also to ‘knowledge on record’.3 However, mere access for the buyer to the relevant information is not sufficient. Buyers are not obliged to actively acquire knowledge of all the details available in the data room, in the Q&A process and in the Due Diligence Reports; they can rely on information that has been compiled for them e.g. as part of an Executive Summary.4 Furthermore, a buyer would have to be aware, or at least consider the possibility, at the time of entering into the agreement, that the facts in question render the warranty inaccurate.
If the relevant facts or circumstances have not been appropriately disclosed to the buyer, the buyer cannot be deemed to have ‘knowledge’ and therefore it cannot be assumed that at the time of Signing he was aware (taking into account the standards described above) that the warranty was inaccurate. Uploading the relevant information to the data room does not, on its own, constitute sufficient disclosure in this context.5 The principle of ‘fair disclosure’ requires that the disclosure is specific enough to point to a concrete breach of warranty, i.e. it must be possible to identify the relation between the disclosed facts (e.g. a contract on a property lien) and the respective warranty (e.g. a warranty stating the property is free from liens and encumbrances). Specifically, it is not sufficient to include discreet references in the data room, where – given the complexity of the transaction and due to the fact that due diligence usually involves dividing up areas and responsibilities – a disclosure relevant to this context cannot be reasonably expected (e.g. uploading a contract on a property lien to the virtual data room exclusively in the ‘financial’ or ‘tax’ sub-folders).6 So ‘knowledge’ on the part of the buyer requires adequate disclosure as a matter of principle.
2.2 Typical knowledge and disclosure concepts in German SPAs
It is still uncertain, when exactly does the buyer’s knowledge of certain facts or circumstances preclude the seller’s liability for damage resulting from a breach of warranty based on such fact or circumstances. It is also unclear when and to what extent disclosures made by the seller as part of the due diligence process may justify the assumption that the buyer had knowledge of specific facts or circumstances. This concern, in particular, facts and circumstances which can be extrapolated from documents the seller uploads to the data room.
In the European M&A market, the prevailing view is mostly that as a matter of principle, a buyer should have no claims against the seller if he had actual knowledge of the facts and circumstances which constitute the breach of warranty. Typically, in these cases the SPA will contain wording that buyer’s knowledge shall be assumed if the relevant circumstances have been disclosed in the data room. The same principles of ‘fair disclosure’ are applied when specifying in the agreement what form the disclosure should take. This is commonly achieved by wording such as ‘Fairly Disclosed means fully and fairly disclosed with sufficient detail to enable Buyer, acting reasonably, to identify the nature, scope and significance of the relevant matter’ or ‘Fairly Disclosed means disclosed in such manner and in such detail as to enable a reasonable buyer to make an informed assessment of the matter concerned’.
Furthermore, there are specific stipulations as to whose knowledge shall count as relevant (so-called Relevant Knowledge Bearer). In most transactions, the buyer is a legal entity to whom the knowledge of natural persons is attributed. It is not always possible to precisely identify who these persons should be, even based on the criteria developed by the courts and stipulated by law. According to these criteria, Relevant Knowledge Bearers are persons who within their principal’s organisation have been tasked to act as the principal’s representative in legal transactions, handle specific matters on their own responsibility and take note of any information that emerges and forward it if appropriate.7 The parties can remove such uncertainly by agreeing to it contractually.
There is an increasing tendency, particularly in transactions where the buyer is in a strong negotiating position, to explicitly exclude the statutory rules on exclusion of liability in the case of buyer knowledge (§ 442 German Civil Code). This leads to liability on the part of the seller even in the case of buyer’s knowledge if the buyer gained knowledge of the relevant circumstances by other means than through the information provided in the data room (or additionally disclosed in the sales agreement and its appendices), e.g. in the case of oral disclosures by employees of the target company, or if the information is public. This helps prevent costly and time-consuming testimony in the event that there is a dispute and encourages the seller to ensure that the disclosure is highly diligent and comprehensive.
2.3 Disclosure concepts in the US market
The market standard in the US is more far-reaching regarding the relevance of specific disclosure by the seller. Risk allocation, and thus the exact drafting of warranties and seller’s liability clauses in particular, generally favours the buyer, more so in the US than in European transactions.
The US market is dominated by the concepts of specific disclosure that oblige sellers to disclose facts or circumstances that might lead to a breach of warranty expressly in relation to the warranty in question if they want to exclude their liability. If this is not done, buyers can claim damages based on a breach of warranty even if they have gained knowledge of a (potential) breach of warranty by other means. Thus, under these US concepts, disclosure of certain circumstances in the data room does not relieve the seller of liability. In the US, the due diligence process is seen as solely in favour of the buyer.
In the US, clauses that exclude seller liability for circumstances known to the buyer at the time of entering into the agreement are called ‘anti-sandbagging clauses’. Clauses clarifying that seller liability is not affected by any disclosure are referred to as ‘(pro-)sandbagging clauses’.8
3. Interaction of SPA and W&I insurance policy
A W&I insurance covers damage claims by the buyer resulting from a breach of warranty contained in the SPA. In case of a breach of warranty the insurer assumes the position of the seller and therefore, the question whether the buyer has a claim that is covered by the insurance is answered first and foremost by looking at the contractual agreed position in the SPA. This includes provisions regarding the amount of damage that can be claimed and other liability restrictions in favour of the seller, such as provisions for calculating the amounts which during the negotiations have already been taken into account as reducing the sales price, or for which there are accruals in the relevant annual financial statements.
Generally this includes De Minimis, claims threshold, liability caps and limitation periods. However, these provisions are usually modified in the W&I insurance and divert from the contractual position in the SPA. Unlike the SPA, the W&I policy will contain only a De Minimis instead of the usual De Minimis and claims threshold in an SPA, a maximum liability cap (the insured limit) instead of various caps on liability and the limitation periods are also usually extended compared to the limitation period in the SPA.
Similarly, the W&I policy can also modify the SPA’s provisions regarding the exclusion of claims based on buyer knowledge.
Such modifications in favour of the buyer as policy holder are also referred to as ‘enhancements’.
4. Practical experiences with the ‘VDR scrape’
In the case of a ‘VDR scrape’, the W&I policy enhances that buyer’s knowledge of circumstances which the seller has disclosed in the data room is disregarded and that the buyer has a claim for damages against the insurance despite such disclosure. This basically corresponds to the typical disclosure concepts contained in US-Style SPAs. In order to achieve this, the W&I policy must, first, state that the SPA’s provisions excluding seller’s liability in the case of buyer such disclosure are disregarded for the purpose of the policy. Furthermore, the policy must not – contrary to common practice – list the data room as part of the disclosed documents which would ultimately lead to any disclosure of a fact, matter or circumstances in such a disclosed document to be excluded under a policy.
To the best knowledge of the authors, currently only three insurance companies in the European market are willing to offer a data room scrape subject to onerous conditions. A VDR scrape will typically trigger an additional premium of 30 to 50 per cent.
In German transactions, an insurer can, as a rule, not rely on the seller’s motivation to disclosure relevant facts or circumstances to the same degree as this would be the case in US transactions. This is intensified by the fact that in a majority of the cases, seller liability under the SPA is excluded altogether or limited to an amount of EUR 1 (so-called Zero or Nil Recourse Liability concepts). The risk for the insurer is even higher given that for some time now, the amount of the retention agreed upon in the W&I policy has been decreasing and no longer amounts to 1% of the transactional volume by default. Furthermore, so-called Tipping to Nil Retentions are becoming more common, retention clauses which stipulate that when the retention is exceeded, after a certain time the insurer must pay out not only the excess but the full amount of the damage, i.e. without deducting the retention. Against this background, insurers are very reluctant to offer a VDR scrape. In any case, this requires an exceptionally thorough due diligence by the buyer and a systematic examination of the disclosure by the seller. In this context, some insurers request that the buyer documents and proves which documents have been reviewed in the data room in order to ensure a deep and thorough due diligence.
In practice it is important that the seller provides specific disclosure in addition to a general one. A seller who is aware of circumstances that constitute a breach of warranty must list these specifically in a Disclosure Schedule, which is attached to the SPA as an appendix, or in individual Disclosure Appendices that are referenced in the individual warranties. Circumstances listed there are then exempt from the scope of the warranty, and the buyer cannot claim damages in this respect. In German transactions, such specific disclosure in Disclosure Appendices in the context of warranties is quite common. In other jurisdictions however, for example in Sweden and Norway, where specific disclosure is not part of a typical transaction, buyer and seller have to agree that a specific disclosure is to be included in the SPA. This may complicate the negotiations between buyer and seller and sometimes also significantly delay the entire transaction process.
If a policy contains a VDR scrape clause, insurers may not be happy with the concept altogether if the seller is made of aware of the VDR Scrape. Insures want to ensure that the seller continues to go about the disclosure as diligently as if this would expose potential liability of the seller and thus of the insurer’s liability. It is therefore advisable for buyers to coordinate their communication closely with their insurer and their broker and to obtain the insurer’s consent in writing before disclosing a draft of a policy or the intent to agree on a VDR scrape. In practice most insurers will agree, but they will want to keep the seller from learning about the VDR scrape until shortly before the Signing.
5. Relevance of the No Claims Declaration, the Deal Team Knowledge Exclusion and the Disclosed Documents Exclusion in the W&I policy
As a result of the VDR Scrape a buyer and insurer can agree that the insurer’s liability is not excluded if the relevant fact or circumstances have been disclosed in the data room. However, in the context the W&I policy, coverage may still be limited in relation to the disclosure of information by the seller and to buyer’s actual knowledge of certain facts or circumstances.
5.1 No Claims Declaration
The buyer as the insured is required to deliver a No Claims Declaration signed by the Deal Team Members on inception of the policy, which is usually the signing of the SPA. In the event the warranties are repeated at closing an additional no claims declaration is required to be provided by the Deal Team Members of the insured. In this declaration, the Deal Team Members state that they have no knowledge of any facts, matters or circumstances that might give rise to a breach of warranty. In this context, the relevant members of the Deal Team on the buyer’s side are those who carry out the bulk of the transaction negotiations and due diligence. If the buyer or a Deal Team member has actual knowledge of circumstances that might constitute a breach of warranty, they are obliged to disclose this at the time the No Claims Declaration is issued.
If a buyer, when incepting the W&I policy, violates his obligation to disclose facts or circumstances of which he has knowledge, this may lead to the insurer’s right to reduce a pay-out of damages pursuant to general rules governing insurance agreements.
5.2 Deal Team Knowledge
Furthermore, W&I policies regularly contain clauses that exclude circumstances actually known to the Deal Team of the buyer at the time the insurance policy was incepted, or which should have been disclosed in the No Claims Declaration. If the insurer can prove that a member of the Deal Team had actual knowledge of such circumstances (whether such knowledge was gained from documents in the data room or by other means), this exclusion of liability cancels the insurer’s obligation to pay despite a VDR scrape. Again, the data room could be referred to as evidence for the facts and circumstances that were known to the buyer upon concluding the transaction. In this regard, a German (arbitration) court would resort to general legal principles.
5.3 Disclosed Documents
As a standard rule, all risks that have been disclosed in the buyer’s Due Diligence Reports and, if applicable, in the seller’s Due Diligence reports or Fact Books are excluded from coverage pursuant to the provisions of the W&I policies, irrespective of disclosures in the data room.
6. Bring Down Mechanism impacts for the VDR scrape
Where the warranties are repeated, i.e. are given not only at Signing (Signing Warranties) but also at closing the transaction (Closing Warranties), as a rule insurers will only offer coverage if the seller performs an additional disclosure exercise on closing. In this context, the seller must declare that he is not aware of any facts and circumstances that have occurred in the time between Signing and Closing which could lead to a breach of warranty; if he is aware of any such facts and circumstances, he must describe them in precise detail (so-called Bring-Down Mechanism). If the buyer gains any relevant knowledge from the so-called Bring Down Certificate, which documents the Bring Down process, he must disclose this knowledge to the insurer in the Closing No Claim Declaration.
Typically, in the time between Signing and Closing the data room is no longer updated. Rather, the status of the data room is documented at the time of Signing and secured as evidence, should the need arise. Disclosures, if any, will take place specifically outside the data room. In this respect, a data room disclosure in the time between Signing and Closing is not relevant, which means that initially the VDR scrape does not pose any additional risk for the insurer if the Closing warranties are also insured.
Still, the establishment of a Bring Down Mechanism and the diligent execution of the same becomes more relevant for the insurer if a VDR scrape has been agreed to. Often a breach of warranty which emerges at a later point but has not been assessed (or not assessed properly) in the Due Diligence can be traced back to documentation and information contained in the data room. In principle, the risk that the buyer or his advisors have missed or misjudged certain facts or circumstances remains with the buyer, i.e. the insured, if the insurer is able to refer to disclosure in the data room with regard to these facts or circumstances. As this is not possible in case of a VDR Scrape, the insurer must rely on both buyer and seller categorising certain facts and circumstances correctly with regard to a breach of warranty and that this is documented as part of the Bring Down Mechanism.
A VDR Scrape avoids the automatic assumption that a disclosed item in the data room was actually known to the buyer . Furthermore, the insurer also cannot argue that such a disclosure leads to an automatic exclusion under the W&I policy’s general disclosed information exclusion.
However, if the buyer has gained actual knowledge of specific circumstances by other means than via disclosure in the data room, standard W&I policies will exclude damages resulting from such circumstances from coverage, even if the SPA contains provisions saying that actual knowledge on the part of the buyer that has been gained by other means is excluded. Such exclusion is implemented by the obligation of buyer in its capacity as the insured to disclose any facts or circumstances that might lead to breaches of warranties in the No Claims Declaration and by the general exclusion of facts and circumstances known to the Deal Team Members.
Furthermore, risks identified in the Due Diligence Reports are excluded from coverage. These reports contain those risks that, after careful review of the data room, have been identified by the advisors carrying out the due diligence. Given that, in the event a VDR scrape has been agreed in the insurance policy, the insurer will pay even more attention than usual to a diligent disclosure on the part of the seller and thorough review on the part of the buyer, the essential operative risks should be described in these reports anyway and thus excluded from the insurer’s obligation to pay.
After all, a VDR scrape is an enhancement in favour of the seller. If a claim is made, the seller can save himself a lot of arguing about whether the claim is based on circumstances that have been disclosed in the data room in cases where there is no other proof of actual buyer knowledge of the circumstances in question. However, this does not mean that German transactions apply a US-style disclosure concept throughout, since even in the case of a VDR scrape, buyer knowledge – and consequently an exclusion of liability – may be established not only by specific disclosure on the part of the seller in the Disclosure Schedule or the Disclosure Appendices but also by other means.
- PWC Report Destination Deutschland – M&A Aktivitäten ausländischer Investoren, Dezember 2019, available at www.pwc.de. ↩
- W&I insurance: A Global perspective on a growing product, available at https://www.dlapiper.com/de/germany/insights/publications/2019/07/w-and-i-insurance/ ↩
- Meyer-Sparenberg § 45 Rn. 78 in Meyer-Sparenberg/Jäckle, Beck’sches M&A-Handbuch, 2017. ↩
- Meyer-Sparenberg § 45 Rn. 78 in Meyer-Sparenberg/Jäckle, Beck’sches M&A-Handbuch, 2017. ↩
- Wilhemi in Gsell/Krüger/Lorenz/Reymann, beck-online GROSSKOMMENTAR § 453 ↩
- Meyer-Sparenberg § 45 Rn. 84 in Meyer-Sparenberg/Jäckle, Beck’sches M&A-Handbuch, 2017. ↩
- Schubert in Münchener Kommentar zum BGB, 8. Auflage 2018, § 166 Rn. 28. ↩
- Meyer-Sparenberg § 45 Rn. 70 in Meyer-Sparenberg/Jäckle, Beck’sches M&A-Handbuch, 2017. ↩