W&I Insurance as Deal Facilitator in Distressed Transactions: A Lawyer‘s Perspective

1. Introduction

W&I insurances are insurances covering risks in relation to sell-side warranties and/or indemnities given to the benefit of a buyer; most often, buyers conclude W&I-insurance.¹ Such insurances can, however, also be concluded as seller-policy. In recent years, the German M&A market has seen a rise of W&I insurances and the market is well developed with professional brokers and underwriters often open to discuss creative tailor-made solutions for a specific transaction. This also applies to the distressed/insolvency area of M&A transactions where the general willingness of insurers exists to offer coverage despite the fact that sellers of distressed targets are reluctant or even unable to give comprehensive warranties and indemnities or, in case the sale will be conducted by an insolvency administrator, generally no warranties are given.

This article will provide an overview of selected practically relevant aspects of W&I insurances in distressed/insolvency scenarios and will also provide a brief update of the influences of the Covid-19 pandemic on important aspects of W&I processes to be taken into account.

2. W&I insurances in distressed/insolvency scenarios

Traditionally, W&I coverage in distressed deals is limited, primarily due to the rather low-level of due diligence that a prospective buyer can undertake and the fact that the parties negotiate very limited, if any, warranties and indemnities. First, it is crucial to determine in which stadium the relevant distressed M&A transaction shall take place, i.e. before or after the opening of insolvency proceedings in relation to a target. The acquisition of a distressed target before the formal opening of insolvency proceedings is comparable to a “normal” acquisition from the seller(s) being the shareholder(s) of the target.² The characteristic of such a transaction is that the buyer should have a restructuring concept in place, the basis of which is reviewed in the buyer’s due diligence and which is secured by respective contractual provisions.³ W&I products for transactions prior to the opening of insolvency proceedings are generally broad and even insolvency related voidance risks (Anfechtungsrisiken) are coverable.

If formal insolvency proceedings have been opened, the insolvency administrator takes over responsibility⁴ and control over the process, and, typically, no (or only very limited) warranties and indemnities are given by the insolvency administrator in the transaction documentation.⁵ Usually, the lack of substantial warranties and indemnities is considered by buyers in their purchase price calculation. Against this background, the use of W&I policies could be seen as deal facilitator to potentially increase purchase prices for distressed transactions by providing buyers with a solvent debtor under the W&I policy.

Currently, we mainly see the following options to include W&I insurance in insolvency scenarios:

Option 1: Fully synthetic warranties under the W&I policy

Fully synthetic warranty coverage means that warranties or indemnities are offered by the insurer to the buyer solely under the W&I policy as if they had been given by the seller in the transaction documentation.⁶ The transaction documentation does not include any warranties or indemnities and the seller thus incurs no liability (not even EUR 1.00). However, fully synthetic coverage is generally a more expensive insurance solution⁷ and the suite of synthetic warranties is limited⁸ since, in the absence of warranties or indemnities in the transaction documentation, there is no recourse of the insurer against the seller for fraud or willful misconduct. Further, the scope of the potential coverage generally depends on the level of diligence and disclosure. The more comprehensive the diligence and disclosure, the larger the insurance coverage can principally be. It is for example conceivable that the management of the target provides a disclosure letter (excluding personal liability) to the W&I insurer confirming that the data room has been prepared and provided with due care and that no documents have been withheld.⁹ Finally, as the seller does not provide warranties under the transaction documentation, the usual bring down mechanism for closing warranties by the seller is missing so that generally warranties would be coverable only as at signing. Given the rather limited disclosure in distressed transactions, fully synthetic warranties are still rather exceptional and depend on the individual case.

Option 2: Warranties given with EUR 1.00 cap for seller and (synthetic) increased insurance coverage under W&I insurance

In this scenario, the seller gives a suite of warranties and indemnities and seller’s liability under the transaction documentation is limited to EUR 1.00 (except for certain fundamental warranties), but the W&I policy contains an increased coverage amount. This option is already a well-established mechanism for normal M&A transactions and, thus, the pricing can be more competitive than in the aforementioned scenario. The limitation of liability to EUR 1.00 is however subject to willful misconduct and fraud of the seller in which case the insurer would have a recourse against the seller. It is to be noted that also so-called “statements into the blue” (i.e. statements which are not assessed by the relevant person and given despite the (known) lack of knowledge) are considered as fraudulent misrepresentation (arglistige Täuschung).¹⁰ However, in particular given the very severe case law regarding “statements into the blue”, it leaves the seller with the risk of claims for breaches of warranties for willful misconduct or fraud, if the seller has not carefully assessed the respective suite of warranties/indemnities. Even if in an insolvency scenario the insolvency administrator would conduct a due enquiry with the management of the target and, thus, would have a minimum basis of information, the insolvency administrator would still be exposed to a residual risk of claims, which could prevent insolvency administrators from providing warranties and indemnities.

3. Influence of the Covid-19 pandemic on W&I processes

The Covid-19 pandemic influences the risk assessment of W&I insurers and underlying W&I policies, particularly in sectors affected most by the crisis such as travel, retail, aviation, automotive and hospitality. We expect a number of impacts to come in the (short or long-term) future, but in particular, due diligence aspects and potential exclusions in W&I policies are to be named.

Given the substantial effects of Covid-19, robust due diligence becomes more and more key. Insurers will – in addition to the usual scope – require more reliable due diligence executed in areas likely to be affected by the pandemic such as on the financial forecasts, supplier and costumer contracts, valuation methodology, employment matters, credit agreements/covenants and healthcare compliance. Insurers will assess risks of the Covid-19 pandemic very carefully in the underwriting process and question the buyer’s risk assessment on the impact of the Covid-19 pandemic on the target (e.g. in underwriting calls). Due diligence review may therefore additionally focus on aspects, which, pre- Covid-19 have been diligenced with less attention to detail e.g. whether any material contracts have been or could be modified in light of Covid-19 or might be affected in relation to future performance, review of force majeure clauses and other termination provisions, minimum guaranteed financial commitments and consequences of breach as well as termination rights. It could also be the case that third parties to contracts perform their obligations below previous standards leading to financial losses of the counterparty which needs to be taken into account. All such aspects also need to be diligenced in light of potential insurance coverage for any such claims or business interruption and, thus, insurance due diligence becomes more and more important.

It is to be seen to what extent insurers underwrite warranties with specific reference to Covid-19-aspects. To the extent the insurer is of the opinion that the due diligence or risk assessment of the buyer is not reliable enough, it is likely that the W&I policy will contain respective exclusions for these aspects. Some insurers are already introducing rather broad specific Covid-19 exclu­sions in the W&I policy, e.g. exclusion of specific losses caused by Covid-19 (in particular if the insurer concluded that diligence is not robust enough on Covid-19-aspects), whereas other insurers offer tailor made solutions for the individual case. Policyholders should in any case carefully assess the scope of such (potential) exclusions and avoid the inclusion of a too broad wording in the final policy allowing the insurer to potentially walk away if a damage occurs. Generally, insurers are very keen to receive information on how Covid-19-aspects have been considered in the structure of the deal and the purchase price calculation to reflect a potential risk in the policy. Buyers in any case need to put particular attention to potential Covid-19-related aspects on the target business and respective negotiations of warranties and indemnities to be covered under the W&I policy. In our experience, W&I insurers are – despite the impact of Covid-19 on M&A transactions – largely pragmatic to find suitable solutions tailored to the individual transaction and client. Thus, if structured correctly, W&I policies will likely continue to be a deal facilitator for many transactions in order to allocate risks appropriately.

Covid-19 also affects share prices of many listed companies leading to an expected increase in public to private deals as many private equity sponsors have large amounts of “dry powder” to invest. Some insurers are generally willing to underwrite policies for public deals despite the fact that such public deals have not been insured in the past to a large extent. However, public deals follow their own rules and inter alia the particularities, such as capital markets laws and strict confidentiality rules are to be observed in the underwriting process. As with traditional W&I policies, also the level of diligence and disclosure will be relevant in determining if there can be coverage.

4. Conclusion

W&I policies can in specific cases be a deal facilitator in insolvency scenarios, but (except for fully synthetic coverage) require the cooperation of the insolvency administrator. In our opinion, in particular given the costs of the premiums, the conclusion of W&I insurance in a distressed scenario is (only) a value add if the purchase price can be significantly increased; otherwise, insolvency administrators would be rather reluctant to be exposed to any (even rather theoretical) risks. Specifically in distressed/insolvency scenarios, insurers will review the reasons for the distress in the underwriting process and a careful assessment/understanding of the economic situation of targets will be made by the insurers before coverage is provided. If it occurs that the target company was in distress already before the Covid-19 pandemic, insurers will likely be reluctant to provide coverage. In any case it is crucial for W&I insurers to understand if a reliable dataroom is provided and a sufficient level of disclosure is obtained in relation to the target. The implications of obtaining W&I insurance have to be considered in the structuring of the timing of the transaction which typically is even more ambitious in distressed scenarios than in normal M&A transactions.