5. Specifics of W&I insurance in carve-out transactions
5.1. Specifics of due diligence
The key areas to be reviewed and documented during the due diligence in a carve-out transaction are the target operating model and carve-out plan, the pro forma consolidated carve-out financial statements, and the assets, contracts and employees that are the subject of the carve-out. While the target operating model and the financial statements are crucial for the valuation of the business to be carved out, the carve-out plan as well as the scope of the assets, contracts and employees to be transferred are essential for the assessment of the stand-alone functionality of the target company after the completion of the carve-out (“sufficiency of assets”). The latter regularly requires the provision of transitional and other services by the former parent company. It should also be noted that jurisdictions, entities or legal areas that have not been reviewed as part of the due diligence are usually excluded from insurance coverage. Therefore, in global transactions, local experts and advisors should be regularly consulted to avoid gaps. The more detailed the due diligence is carried out and documented in the reports, the greater the assurance provided to the insurer, which usually has a positive impact on the scope of insurance cover.
a) Target operating model, carve-out plan and carve-out financial statements
Since the target operating model as such has not yet proven itself on the market, it must be thoroughly examined. It forms the basis for the future cost base and business model of the target company and is thus a decisive factor for future earnings and profit potential. The target operating model established in the preparation phase has a significant impact on the carve-out financial statements. As it is an integrated business unit, separate historical financial data, especially on the cost side, will only be partially available and no financial statements will be available on a standalone basis for the business unit concerned. Therefore, pro forma consolidated financial statements must be prepared that adequately reflect the historical costs of the business unit in question and explain the underlying assumptions and accounting policies. This is where the target operating model comes into play, projecting the conception of the integrated business unit into that of a legally independent entity after the carve-out has been implemented. Ultimately, in order to prepare their business valuation, bidders need (pro forma consolidated) financial statements that provide a true and fair view of the historical situation and performance of the business to be carved out. Insofar as these are not certified by an auditor, the insurance cover is restricted to the effect that the insurance provider does not assume any liability for the presentation of a true and fair view of the assets, liabilities, financial position and profit or loss of the division. Instead, it merely assures that the financial statements do not materially misstate the assets, financial position and results of operations. This standard falls short of the protection afforded by the “true and fair view” standard.
b) Scope of the carve-out
From a legal due diligence perspective, reviewing information about the business unit’s workforce (including employment contracts, compensation structure, benefits provided and retirement plans) and the assets and contracts to be transferred is essential.
Due to their outstanding importance for the business opportunities of the business to be carved out, the employees and the benefits granted to them as well as the underlying individual and collective contracts and regulations within the scope of the warranty catalogue of the purchase agreement are of great importance, which in turn has an impact on the due diligence to be performed. A carve-out generally leads to a transfer of undertaking pursuant to Section 613a German Civil Code (BGB) with the consequence that the employment relationships are transferred by operation of law with all associated rights and obligations, including all rights and claims under collective bargaining agreements, to the acquiring legal entity, unless the affected employees object to the transfer. Since the terms and conditions of employment remain unchanged and cannot be changed without the consent of each individual employee being transferred, a detailed analysis of the remuneration package and the terms and conditions of employment from a legal, financial and operational perspective is essential.