Even before the outbreak of the Corona pandemic, experts expected a significant decline in M&A activities in Germany. A rise in insolvencies was feared due to the general economic situation, which were already apparent in the first weeks of 2020.
Looking at the developments since the beginning of March 2020, the massive increase in so-called distressed M&A deals, i.e. transactions that are carried out either shortly before or during the insolvency of the target company or the seller, is no longer just a possible scenario, but certainty. The consequences of the measures to mitigate the Corona pandemic will have a lasting impact on the global economy.
The use of warranty & indemnity insurances (W&I insurance) in connection with distressed M&A deals is not new. However, for various reasons it has not been widely used so far. The current situation gives reason to take a closer look at this topic.
II. General characteristics of Distressed M&A Deals
In order to classify the challenges and opportunities associated with the use of W&I insurance in distressed M&A deals, it is helpful to first consider the general characteristics of these transactions.
1. Crisis of the company – impact of the Corona pandemic
The insolvency of a company is usually the result of an economic crisis of the company. A crisis can have various causes and characteristics. In particular, such causes include a business model that is not or no longer viable or a poor corporate governance.
In any case, there is a company crisis if the company is threatened with insolvency without extensive performance or financial restructuring measures being carried out1. Reasons for opening insolvency proceedings are the insolvency or overindebtedness of the company. A company is deemed illiquid if it is unable to meet its mature obligations to pay, which is generally presumed if it has stopped payments (section 17 (2) German Insolvency Code). Overindebtedness exists if the assets no longer cover the existing obligations, unless it is highly likely, that the company will continue to exist (section 19 (2) German Insolvency Statute). If the company itself requests the opening of insolvency proceedings, imminent insolvency shall also be a reason to open insolvency proceedings. There is imminent insolvency, if the company is likely to be unable to meet the existing payment obligations on the date of their maturity (section 18 (2) German Insolvency Statute).
The official orders to mitigate the Corona pandemic since March 2020 have prompted companies to face serious liquidity problems within a truly short time. Even if certain sectors – such as the gastronomy or tourism industry or the textile retail trade – are affected more than others, the current situation is proving to be an enormous challenge across all sectors. In contrast to other corporate crises, the causes are not wrong strategic decisions but are externally determined by uncontrollable and sometimes temporary factors.
Often, the possibilities of short-time work and the use of quick loans from KFW (German Reconstruction Loan Corporation) are not sufficient to avert insolvency. The legislator has tried to counteract an impending wave of insolvencies with the German Act on the Temporary Suspension of the Obligation to File for Insolvency and on the Limitation of the Liability of Corporate Bodies in the Event of Insolvency Caused by the COVID 19 Pandemic (German COVID 19 Insolvency Suspension Act – COVInsAG). This law was announced in the Federal Law Gazette on 27 March 2020 and entered into force retroactively as of 1 March 2020.
The COVInsAG suspends the obligation to file for insolvency until September 30, 2020, unless the insolvency is not due to the COVID 19 Pandemic and there is no prospect to eliminate an existing insolvency. If the company was not insolvent on December 31, 2019, it is assumed that the insolvency is due to the consequences of the COVID 19 Pandemic.
However, the suspension of the obligation to file for insolvency do not change the fact that, under the current legal framework, a company is insolvent and is in fact burdened with massive liquidity problems. Distressed M&A deals in the current time will therefore often involve “hidden” insolvent target companies.
2. Transaction speed
In distressed M&A deals, a major difference to “normal” transactions is the time factor. Of course, this applies if the transaction is intended to avert the insolvency of the distressed company. Every week the company continues to operate without the saving sale taking place, the economic crisis deepens. Even if the company is already insolvent, time plays an important role. Insolvency payment (Insolvenzgeld) is only granted for a period of three months. This is particularly important in personnel-intensive industries in order to continue the business operations of the company.
3. Disclosure and due diligence
Even the preparation of data in a distressed company often proves to be more difficult, as does the answering of queries, since the employees concerned often lack the time or the relevant knowledge bearers are simply no longer with the company. The situation becomes even more difficult if the sales process is controlled by an insolvency administrator who only has limited knowledge of the target company. Therefore, the disclosure exercise often only has a limited quality compared to normal transactions. In addition, there is the time factor. A due diligence of a target company in crisis is therefore often only possible to a limited extent.
4. Typical transaction structures and characteristics regarding liability law
a) Crisis of the target company before insolvency – distressed share deal
If the target company is merely in a crisis without already being insolvent and is to be acquired by way of a share deal, this is essentially a “normal” corporate transaction2. However, since the risk of insolvency is inherent in a crisis, the challenges with regard to such transactions are usually similar to those for the acquisition of an insolvent company, especially with regard to the time frame.
b) Insolvency of the target company – usually “restructuring by transfer“ (Übertragende Sanierung)
If the target company is insolvent, the transaction usually takes place by way of a so-called “restructuring by transfer” (Übertragende Sanierung): The target company or the insolvency administrator acting on its behalf sells the valuable assets to the purchaser, the liabilities remain in the (insolvent) seller company, which is then liquidated after the transaction is completed. The advantage of this transaction structure is that specific features under insolvency law apply in favour of the purchaser with regard to various liabilities under commercial, labour and tax law.
c) Acquisition of the target company within the framework of an insolvency plan
Within the framework of an insolvency plan procedure, in a first step, the insolvent company is partially restructured and then transferred to the purchaser by way of a share deal, free of existing liabilities.
5. Characteristics with regard to the seller’s warranties
In a distressed situation, the seller has few personnel resources and hardly any time for the internal preparation of information. Accordingly, he or she has no detailed knowledge of whether certain statements of fact usually contained in a warranty catalogue with regard to the operational risk areas of the company are correct. Moreover, an external insolvency administrator hardly knows the company itself and is potentially personally liable for warranty claims (§§ 60, 61 German Insolvency Statute). Strict warranties on the operational condition of the company are therefore generally not given or only given to a limited extent and the liability under the SPA is limited as far as possible. The liability on the part of the insolvency administrator is regularly completely excluded.
In addition, a possible claim for damages would typically not be enforceable, since the seller company is either liquidated itself – as in the case of the restructuring by transfer (Übertragende Sanierung) – or at least does not have sufficient funds for the payment of the claim for damages.
The purchaser usually takes these circumstances into account when determining the purchase price and makes an appropriate risk deduction.
III. W&I insurance in case of a distressed or insolvent target company
A risk deduction on the purchase price could be avoided if the purchaser were entitled to enforceable and valuable claims for damages arising from the breach of operational warranties, even in the context of a distressed M&A deal. The use of W&I insurance can make this possible under certain circumstances.
1. Securing of transaction risks through conventional W&I insurances
W&I insurances serve to secure the risk that the purchaser may suffer a loss due to the incorrectness of a seller’s warranty in the SPA. In principle, they apply to both share and asset deals, although – with the exception of real estate transactions – share deals have been insured in most cases to date.
The insurance is generally taken out by the purchaser. The seller will be disregarded during the claim’s settlement process, so that his possibly poor solvency does not affect the economic value of the claim for damages. A later recourse of the insurer against the seller does not take place except in cases of fraudulent behaviour or fraud by the seller.
2. Relevance of the underwriting process for coverage
The extent to which coverage is agreed under the W&I policy is determined during the underwriting process of the insurer, a thorough risk assessment of the transaction and the target company. This includes a comprehensive analysis of the SPA including the liability regime contained therein as well as the information and documents disclosed in the course of the due diligence process, the data room, any fact books or vendor due diligence materials as well as the purchaser’s due diligence reports.
For the insurer it is important to convince itself of the honesty of the parties, the robustness of the process and the professionalism of the respective advisors on the purchaser and seller side (lawyers, tax adviser, etc.). An insured transaction should be set up, reviewed, and negotiated as if there were no insurance.
During the underwriting process and in accordance with the concrete risk profile of the target company, its business activities and the warranty catalogue, the insurer further particularly and in detail looks into the scope and depth of the purchaser’s due diligence and the disclosure process conducted by the seller, which ultimately provides the essential basis for the purchaser’s due diligence.
In order to be able to provide broad coverage under the policy, the quality of the management of the target company, the reporting lines and internal processes as well as the monitoring and control of the operational processes are also crucial for the insurer.
3. Synthetic warranty catalogues
With regard to transactions in which the seller (possibly in the person of an insolvency administrator) gives no warranties whatsoever, e.g. due to the inherent liability or lack of detailed knowledge of the company, the insurability of so-called synthetic warranties was already being discussed before the Corona crisis. These warranties are called “synthetic” because they are not agreed between seller and purchaser in the SPA, but only between the purchaser as policyholder and the insurer in the W&I policy.
a) Risk of seller’s liability despite “zero liability” or “nil recourse” concept
The seller’s liability for breaches of warranties is now usually limited to EUR 1 in the SPA (so-called “zero liability” or “nil recourse” concept). However, this limitation of liability is only effective as long as the seller does not act intentionally. Intentional behaviour already exists if the seller considers the incorrectness of his statements possible and makes “gratuitous remarks, i.e. assertions without any factual basis (“Angaben ins Blaue”)3.
In the case of intentional acts, the limitations of liability in the SPA do not apply. In addition, the seller is also liable for the violation of statutory pre-contractual disclosure and due diligence obligations (culpa in contrahendo). In this context, it is of particular importance that the giving of independent warranties in the SPA can give rise to such liability, even if there was no disclosure obligation at all with regard to the declared facts, since voluntary statements must also be correct in this respect4.
By giving warranties in the SPA, the seller thus increases the risk of his legal liability for damages. Even if it can generally be assumed that the seller is not acting intentionally if he has checked the warranty catalogue with the relevant knowledge bearers in the target company and the correctness of the statements has been confirmed (due enquiry process) by them, in practice, especially in complex transactions and in the case of short-term changes to the warranty catalogue prior to signing, residual risks remain. If these residual risks are unacceptable for certain sellers (e.g. insolvency administrators) or if resulting claims for compensation by the purchaser are not recoverable, often less warranties are agreed upon, which in turn may reduce the purchase price.
It is therefore of great interest to the seller to avoid these risks. A synthetic warranty catalogue offers this possibility.
b) Experience with the insurability of synthetic warranty catalogues
While certain synthetic components of coverage such as the synthetically extended definition of loss, the synthetic tax indemnity or the so-called knowledge scraping have become standard, fully synthetic warranty catalogues, which are agreed exclusively between purchaser and insurer, have so far only been used in individual cases.
In most transactions outside distressed situations there is no motivation of the parties to use synthetic warranties that might be comprehensible to the insurer and goes beyond the mere avoidance of liability by the seller.
But also, in the context of distressed M&A deals synthetic coverage regularly fails due to the limited quality of the disclosure process and the (crisis-causing) deficiencies of the target company (mismanagement, lack of control, etc.).
Finally, the pre-crisis market environment with a large number of transactions involving profitable and fast-growing companies kept market participants busy. However, against the background of the Corona pandemic and the characteristics of the corporate crises it created, compared to previous distressed situations, insurers are more willing to insure synthetic warranties.
4. Characteristics for the underwriting process and coverage in synthetic warranty catalogues
As is already the case for the synthetic components of coverage commonly used to date, such as knowledge scraping and the synthetic tax indemnity, the most important prerequisite for W&I insurance on a fully synthetic basis is comprehensive disclosure by the seller and due diligence by the purchaser corresponding to the scope of the warranties to be insured5.
However, in comparison to conventional W&I insurances, there are some specifics that apply within the framework of synthetic warranty catalogues.
a) Individual case specific solutions
First of all, it is important to note that coverage on a synthetic basis is case-specific and that there is no generally applicable, standard solution suitable for every transaction, especially in a distressed M&A environment6 –. Synthetic coverage, especially in the context of distressed M&A deals, is hardly accessible to the use of general sample warranty catalogues.
b) Content and scope of the synthetic warranty catalogues
The content and scope of synthetic warranties are often likely to be significantly less than what the purchaser would be able to obtain from a seller in a “normal” transaction. A rough indication of what can be insured on a synthetic basis is provided by warranty catalogues, as one would expect in a first seller’s draft for a competitive auction.
Apart from the usual title warranties, it will be necessary to examine in detail to what extent and in which other areas warranties are possible with regard to insolvency and operational warranties and depending on the specific risk. It must also be paid attention to financial statements warranties, insofar as it is assumed that these can be insured without further conditions as long as they are audited and given an unqualified audit certificate. On the one hand, it is questionable to what extent appropriately audited and meaningful or current financial statements are available for the target company or individual subsidiaries. On the other hand, it is questionable, especially in the case of restructuring by transfer (Übertragende Sanierung), to what extent these are relevant at all. Ultimately, however, as with the other warranties, a careful due diligence on the purchaser’s side will have to be demanded.
In case of a fully synthetic warranty catalogue and depending on the size of the respective target company, a limitation of the warranties to the major group companies or jurisdictions is conceivable. In contrast to “normal” transactions, the scope for commercial flexibility with regard to areas not covered by purchaser’s due diligence (so-called blind spot coverage) is likely to be limited, while smaller group companies or jurisdictions with less activity depending on turnover or number of employees will otherwise be covered on a regular basis, provided there was appropriate disclosure and the insurer has obtained the necessary comfort with regard to the processes at the target company.
c) Consequences of lack of participation by the seller
In the absence of participation by the seller within the framework of fully synthetic solutions, it will not be possible to provide coverage for operational warranties as of Closing due to the lack of a so-called bring-down (a declaration by the seller that, upon review of the warranties given as of closing and due inquiry with the relevant knowledge bearers, the seller has no knowledge of any breaches of the closing warranties that have occurred in the meantime).
Finally, synthetic coverage will not be on the same commercial terms as normal W&I insurances have been used to in the past. Underwriting effort and risk will be reflected in higher premiums. Furthermore, the recent steady decline in retention and de minimis amounts is likely to increase significantly for fully synthetic solutions.
The fact that, in contrast to conventional W&I insurance or even synthetic tax indemnities7, there is no clear right of recourse in the event of fraudulent intent and no corresponding disciplining effect of the liability risk is one of the major challenges of insuring fully synthetic warranties.
5. Relevance of the viability of the business model for coverage in distressed M&A deals
Due to the importance of the quality of the management and the structures and reporting lines of the target company as well as the control over the operational processes already within the scope of conventional W&I insurances, the use of W&I insurances in distressed M&A deals is an option especially for well-managed companies where sustainable structures, functioning processes and reporting lines are in place to the greatest extent possible. This could be the case for some companies that are in economic difficulties mainly due to the measures taken to mitigate the consequences of the Corona pandemic. It is conceivable, for example, that liquidity problems could arise as a result of the lockdown, but without the otherwise frequent causes of “normal” corporate crises (lack of a viable business model or mismanagement).
Finally, valuation issues are likely to be a further focus of underwriting of distressed M&A deals. This is not least for a reasonable determination of retention and de minimis amounts, but also because policies for poorly performing investments are likely to be more prone to losses than in cases where the purchaser’s expectations are fulfilled. Key questions here will be what the purchaser sees as the factors that create or increase value, on what basis and methodology the valuation was made and, above all, on what figures (in the absence of current and meaningful audited financial statements of the target company).
6. Special significance of the involvement of the seller in the scope of coverage in distressed M&A deals
As already explained, the essential prerequisite for granting the widest possible coverage is the comprehensive and conscientious disclosure of the seller and a due diligence that is essentially appropriate to the content and scope of the warranties to be insured.
In the context of insuring distressed M&A deals, underwriting will therefore focus on the disclosure process (including Q&A). Central questions will be to what extent knowledge bearers having the necessary information or access to it are still in the company and what motivation these knowledge bearers and management have to disclose in a proper and comprehensive manner and to populate the data room. Provided that the managing directors, knowledge bearers and other key employees who are significantly involved in the disclosure process participate in the company’s long-term success, for example within the framework of a management participation program, and remain with the company, this should have a positive effect on the quality of the disclosure and increase the comfort level of the insurer.
Overall, the intensity of the participation of the seller and the management of the target company in the disclosure has a major influence on the willingness of the insurers to grant broad coverage. If, for example, the seller or the insolvency administrator confirms that they themselves have no positive knowledge of breaches of warranties, especially after due enquiry, or if the relevant knowledge bearers themselves confirm this, it will have a positive effect on the scope of coverage8. It remains to be seen how sellers, insolvency administrators and knowledge bearers will assess the residual risks remaining for them in this context (e.g. due to “gratuitous remarks / “Angaben ins Blaue”) and position themselves in this respect.
Ultimately, with a careful disclosure and intensive involvement of the seller in a distressed M&A deal, it is also conceivable that gaps in the purchaser’s due diligence with regard to certain warranties can be closed by an additional, selective due diligence of the insurer in the Underwriting process. This concept has been little tested to date but is increasingly being discussed. In this context, however, increased underwriting fees are to be expected, depending on the scope of the examination to be carried out.
W&I insurances can also be applied to distressed M&A deals and create added value for the parties to the contract. In addition to the usual advantages, this solution offers, in particular to the insolvency administrator the possibility of achieving a higher purchase price for the sold company, as the purchaser will positively consider the possibility of asserting claims for damages in connection with the breach of operational warranties against a solvent insurer when determining the purchase price.
However, the distressed environment does not provide a framework for a greater degree of standardization, for example by a typical “distressed guarantee catalogue” which would be widely synthetically insurable. Rather, the solutions offered must be flexibly and individually coordinated between the parties involved. This includes not only the parties to the purchase contract and the insurers, but also the insurance brokers involved.
Comprehensive disclosure by the seller as well as due diligence by the purchaser corresponding to the scope of the warranties to be insured is the most important prerequisite for synthetic coverage. The more carefully the disclosure is carried out by the seller, the further coverage is offered by the insurers. Disclosure includes not only the disclosure of relevant information in the due diligence and Q&A process, but also, if necessary, a statement by relevant experts on the agreed warranty catalogue. This is especially true if the warranty catalogue is not provided by the seller, but is agreed solely between the insurer and the purchaser as a synthetic catalogue for the purpose of coverage under the W&I policy.
The background of the crisis of the target company is also of particular relevance when deciding on the scope of coverage. If this is not due to strategic mistakes or mismanagement and if the company is also solidly positioned in terms of control over operational and organizational processes, then, subject to disclosure and due diligence, quite broad coverage should be possible. This applies in particular to companies which, despite having a viable business model, have run into a liquidity crisis due to the official measures to mitigate the Corona pandemic and its (indirect) consequences.
- Blech: Distressed M&A: Begriffe und Interessenlagen in Meyer Sparenberg: Beck’sches M&A Handbuch Planung, Gestaltung, Sonderformen, Anspruchsdurchsetzung und Streitbeilegung bei Mergers & Acquisitions. Beck, Munich, 2017, § 60 recital 3 ↩
- Blech in Beck’sches M&A Handbuch, § 60 recital 3 ↩
- BGH NJW 1981, p. 864 ↩
- Mellert: Selbstständige Garantien beim Unternehmenskauf – Auslegungs- und Abstimmungsprobleme. In: BB 2011, p. 1667, 1673 ↩
- cf. also Ratz/Tachezy: W&I-Versicherungsprodukte für „Distressed Assets“ und identifizierte Steuer-Risiken – Chancen und Risiken für Geschäftsführer und Insolvenzverwalter? In: BB 2020, p. 219 (222) ↩
- cf. also Ratz/Tachezy, BB 2020, p. 219 (222) – maßgeschneiderte Versicherungslösungen ↩
- In order to provide the insurer with a possibility of recourse against the seller in the event of fraud, the purchaser or policyholder is sometimes also obliged to assert (non-synthetic) breaches of warranty (such as the financial statements warranty) in case of a synthetic tax indemnity, if the claim under the indemnity also constitutes a breach of a warranty. ↩
- cf. also Ratz/Tachezy, BB 2020, p. 219 (222) ↩