1. The new normal
Historically, very few transactions concerning insolvent or distressed targets have been insured, primarily due to a lack of insurer appetite. Insurers have been concerned about (i) a potential lack of proper disclosure, as management is typically not in charge of the business anymore, (ii) poor quality of available information, and (iii) the target’s history, which resulted in a distressed situation. However, Covid-19 is challenging insurers’ perceptions and their appetite for such deals is growing.
The availability of warranty & indemnity insurance for such transactions is widely expected to translate into a growing interest of potential buyers in distressed targets. This, in turn, might lead to sellers and insolvency practitioners (IPs) leveraging the competitive tension in the process and thus achieving higher sale prices.
This article details the key considerations for parties seeking to implement M&A insurance on distressed or insolvent share or asset sales.
2. Factors influencing insurance solutions
Target sector, jurisdiction and solvency position
W&I insurance solutions are available for distressed targets and for targets that are subject to formal insolvency proceedings (and anything in between). All else being equal, the range of policy options and insurers interested in insuring a transaction will be greater: (i) the less financially distressed a target is; (ii) the more management / sellers are engaged and willing to support a meaningful disclosure exercise; (iii) for targets operating and/or headquartered in Central, Western, and Northern Europe, North America, Japan, South Korea, Singapore, Australia and New Zealand; and (iv) for targets in sectors insurers deem “less risky” (for example, real estate versus oil and gas).
3. Who gives the warranties?
To the extent the management and/or sellers are willing to give warranties (capped at USD/EUR/GBP 1), insurers will cover such warranties as they would in transactions involving non-distressed targets. Subject to their review of the transaction documents, insurers might be willing to provide so called “knowledge qualifier scrapes” for knowledge-qualified warranties included in the acquisition agreement. This means that warranties will be insured on an objective basis, even though they have been given subject to the seller’s knowledge in the acquisition agreement.
Where it is impractical or impossible to obtain warranties from management or sellers (which will be more common where formal insolvency proceedings have commenced), several insurers will now insure warranties on a synthetic basis1. This insurance solution involves the insurer negotiating a suite of warranties directly with the buyer, but does require material input into the Q&A process from the seller/management.
Discussions with IPs indicate that historically, both limited recourse and synthetic warranty structures have been underutilised for distressed and insolvent transactions. This is expected to change as understanding of the benefits of insurance grows amongst IPs and insurer appetite for these types of transactions continues to grow. Importantly, synthetic warranties do not increase the contractual liability of the IPs while allowing buyers to be more bullish in their valuations, given the insured warranties provide them with increased certainty and downside protection.
4. Due diligence and scope of cover
M&A transactions concerning distressed or insolvent targets are frequently conducted on an ‘as is’ basis, under compressed timetables and with limited opportunity to undertake thorough due diligence. Prima facie, such transaction structures are not well suited to W&I insurance which, as a key principle, requires the accuracy of warranties to be confirmed by due diligence. However, three possible solutions to bridging this gap exist: (i) narrower cover offered by insurers at signing reflecting curtailed due diligence, with cover broadened post-signing if the buyer is able to undertake a focused top-up due diligence exercise; (ii) broader cover offered by insurers at signing, but with higher premiums, retentions and/or de minimis, with the ability to lower the retention and/or de minimis if the buyer is able to undertake top-up due diligence post-signing; and (iii) in case an auction process is initiated by the sell-side, utilising vendor due diligence and a hard-stapled policy2.
It remains to be seen whether sellers and IPs will use the recent relaxation of wrongful trading laws in Europe and elsewhere to relax transaction timelines and facilitate more fulsome disclosures from sellers. If so, more fulsome warranty cover will be available.
5. Management’s role and Q&A
Whether management gives warranties or not, insurers will expect the management team to be involved in preparing the data room and responding to the Q&A – either directly or, in the case of insolvency, in a supporting role to the IPs. In particular, where insurers insure warranties on a synthetic basis, they will look to the Q&A instead of formal disclosures for underwriting comfort. As such, it will be particularly important in this context to show that a robust Q&A process has been conducted. Also, for insurers to become comfortable, they will require that certain questions are raised in the Q&A process.
6. Repeated warranties
Provided disclosure is updated at closing with respect to interim-period events, insurers have historically been willing to cover the repetition of warranties at closing. However, given current market dynamics, insurers will now scrutinise repeated warranties in more detail. Given cover for repeated warranties is subject to updated disclosure, synthetic warranties are less likely to be covered at closing without an updated Q&A process (which will likely prove commercially challenging). It may however be possible to secure cover for fundamental warranties3 on a synthetic basis at closing without an updated Q&A process.
A key consideration for policies taken out on distressed or insolvent transactions is the valuation of the target and how loss is calculated under the policy in the event of a warranty breach. It is often inappropriate to determine loss on the basis of the reduced value of the shares (as customary in the UK) if only a nominal value has been attributed to the shares. Rather, the level of debt in the business as well as the value of the assets should be considered in any loss calculation. On recent transactions concerning distressed targets, different solutions were implemented, depending on the SPA’s loss mechanics and the buyer’s requirements. One potential solution is that loss is calculated under the W&I policy on an indemnity basis.
The insurance market is more open than ever to insuring distressed or insolvent transactions. These transactions present challenges that require careful management to ensure policies provide an adequate degree of risk transfer. Choosing an experienced M&A insurance broker advising investors involved in such processes will facilitate addressing these challenges, securing broad policy cover and allowing sellers and IPs to achieve higher sale prices.
9. Case Study
- A struggling global retailer in the midst of a multi-year restructuring plan with creditors was selling off one of its independent subsidiaries active across Europe. The rationale behind the sale was to focus on its core business and reduce liabilities significantly by paying off debt with the sale proceeds.
- Large and complex restructurings have many stakeholders, ranging from sellers, creditors, employees (represented by trade unions), the national governments to local authorities. Negotiations are therefore more protracted than in M&A transactions concerning non-distressed targets, and the contents of the data room and of any due diligence reports will be outdated more quickly. To secure fulsome cover under the W&I policy, it is key that the contents of both the data room and the due diligence reports are updated close to the signing date.
- Discussing the methodology behind the transaction value calculation with insurers at the beginning of the W&I work stream is key. Equally important is that the methodology for accounting for debt and debt-like items withstands a critical scrutiny. This is fundamental as the buyer is likely to communicate a low transaction value so that key parameters of the W&I policy like deductible and de minims are set as low as possible, whereas the insurer on the other hand will be keen on understanding the real magnitude of the potential liabilities to be insured. At the same time, the buyer should avoid negatively impacting its own position by lowballing the transaction value, as this may adversely affect the way the quantum of loss is established once there is an insured breach of warranty or a claim under the tax indemnity. In any event, transparency on these matters is the best approach (and the one mandated by insurance law), bearing in mind that the actual numbers with respect to the transaction value are a sensitive information subject to high confidentiality. Therefore, precise numbers can be discussed if required closer to the inception of the W&I policy.
- For these types of transactions, the insurers’ underwriting will likely focus on (i) audited annual accounts, as well as financial information since the accounts date, (ii) employment matters and recent or ongoing redundancy plans, (iii) material contracts and the effect of the distressed situation on commercial relationships, and (iv) potential carve-outs and other restructuring measures implemented between signing and closing. As such, the due diligence on these matters should be particularly thorough, detailed and up to date. As opposed to M&A concerning non-distressed targets, tax matters can be of less concern to insurers in these types of transactions, given the loss making nature of the targets. The whole suite of due diligence documents must nevertheless meet the standards of any M&A transaction where taking out W&I insurance is contemplated.
- Against the background of an imminent bankruptcy, a state-sanctioned redundancy plan involving over a quarter of the workforce and multiple store closures, each of the seller, creditors and buyer had a vested interest in shifting the risk of post-closing liabilities to a third party: an insurance company.
- By utilizing W&I insurance, the seller was able to sell off the business unit in accordance with the wider restructuring plan ensuring the survival of the group. The buyer was able to obtain approval by its investment committee due to the adequate warranty & indemnity protection provided by the W&I insurance policy.
- Warranties are not given by sellers under the share purchase agreement (SPA) and are only negotiated and “synthetically” agreed between the insurer and the buyer in the W&I policy. ↩
- With a hard staple, the seller is able to approach the insurance market with copies of the SPA, information memorandum, VDD and the target’s financial accounts. Following negotiations with insurers, the broker will submit its non-binding indication report to the seller. The seller will then select an insurer and underwriting will proceed based on the VDD. Following the initial underwriting stage, a draft of the W&I policy would be produced which is approximately 70% of the way to being finalised, depending on the scope of the VDD. Typically, this W&I policy would be uploaded to the virtual data room alongside the SPA. Once a preferred bidder is selected, the process will ‘flip’ to the buyer. At this stage, the broker and insurer will require access to the buyer’s top up due diligence and, based on these additional reports, the policy will be finalised. ↩
- Warranties speaking to title and capacity. ↩