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Warranty & Indemnity Insurance vis-à-vis Due Diligence: Mitigating Buy-Side Risks in M&A Transactions

Published: Jun 22, 2021

By Prashanth Shivadass & Sneha Philip*

Introduction

Consider the position of a buyer in a Merger and Acquisition ("M&A") transaction. The buyers require sellers to afford wide range of warranties and indemnities concerning revenues, operations, expenditures to ascertain the financial stability (or instability) of the target and to gauge the potential future impact of having to acquire the target. The target company, however, may tighten the scope of disclosures. This gap of disclosures between the buyer and seller, exposes the buyer to a broad range of risks concerning mispricing of the asset, probable sellers' fraud, etc.

Traditionally, to assess such risks, the buyer conducts due diligence on the target. Post due diligence, the buyer makes his investment choice contingent upon the warranties and indemnities afforded by the seller. Yet, the buyer is exposed to risks as the scope of due diligence is limited to the information afforded by the seller.

While the traditional protections afforded by indemnity-backed representations and warranties have a strong foothold in the M&A landscape, Warranty and Indemnity Insurance ("W&I Insurance"), an insurance product that claims to be a risk mitigation tool, 1 is gaining traction in India. 2 In this regard, the conundrum which needs to be resolved is whether W&I Insurance is a hit or a miss in mitigating buyer risks associated with M&A transactions and whether buy-side due diligence can be compromised in light of W&I Insurance.

W&I INSURANCE

W&I Insurance provides cover for obligations to indemnify losses arising out of a breach of warranties. 3 Warranties and indemnities are a staple of any M&A transaction. 4 They are frequently the most negotiated clauses in the agreement as they can result in a large variance of damages in the event of a breach. 5 Considering the risks at stake for buyers, W&I Insurance can be a deal saver.

While the W&I Insurance cater to both the buyer and seller, a sell-side policy is a contract between the seller and the insurer, wherein the seller can claim reimbursement for defence and investigation costs incurred in case the buyer brings a claim for a breach of warranty. 6 In contrast, in the buy-side policy the insurer agrees to cover losses to the buyer in the event of breach of warranties and indemnities.

BUY-SIDE RISKS AND THE ROLE OF W&I INSURANCE

In M&A transactions, the buyers are exposed to several risks. The first instance of risk is typically reflected through the warranties afforded by the seller to the buyer, which the buyer assumes to be true To mitigate the risks associated with the issue, the main objective of W&I Insurance is to offer protection to the buyer against unknown monetary losses arising out of the breach of such warranties.

Another aspect of risk for a buyer is 'fraud' wherein the seller intentionally conceals a material fact or discloses incorrect information in order to close the deal. In fact, seller's fraud is of immense concern in M&A transactions and in this regard, the elements of contractual fraud have been elucidated under Section 17 of the Indian Contract Act, 1872. Typically, if a buyer faces fraud post completion of due diligence, the seller might not be held liable for fraud if the buyer who is being defrauded was capable of discovering the truth through due diligence. 8 However, in such situations, the W&I Insurance guard the buyer by allowing for recovery of losses incurred, if such losses arise due to sellers' fraud.

LIMITATIONS OF W&I INSURANCE

While W&I Insurance bridges risks between the buyer and seller, the coverage comes with certain prerequisites. For instance, the De minimis threshold (explained below) is a condition precedent. Additionally, requisites such as "warranty sheet" which sets out whether a particular warranty is covered under the policy or not, is vital.

DE MINIMIS THRESHOLD

W&I Insurance comes with a de minimis threshold. 9 Insurers under a W&I Insurance policy are not obligated to cover a loss unless such loss exceeds the de minimis threshold (usually less than 1% of the purchase price). The de minimis threshold is a minimum claim amount below which an insurance claim is not entertained by the insurer. Any claim below the de minimis threshold would not be covered by the insurer.

EXCLUSIONS

While W&I Insurance envelops a few buyer risks with a safety net and on the other, there are several risks that are excluded from W&I coverage. Matters discovered through due diligences and matters that are within the knowledge of the insured, prior to the insurance, will not covered under the W&I Insurance. Further, the policy does not safeguard the buyer in cases of exemplary or punitive damages. It therefore becomes vital that the buyer negotiates the exclusions with the seller and the insurer beforehand in order to ensure maximum coverage of warranties under the policy.

CONCLUSION: MITIGATION V. ELIMINATION

With M&A, the buyer is exposed to a wide array of risks. W&I Insurance, for such scenarios, act as a requisite for undiscovered damages. However, buyers need to keep in mind that the product is not a panacea. Despite the protections afforded by W&I Insurance, buyers are required to be cautious that W&I provides mere 'Insurance' and not 'Guarantee' as the former provides immunity against certain losses attained by the beneficiary and the latter is a promise of performance to the beneficiary. While W&I Insurance covers mere undiscovered damages, pre-assessing of risks through the exercise of robust due diligence positively plays in favour of the buyer.

However, even due diligence has its downsides. The scope of buy-side due diligence is narrow as essential information may get slipped. Considering the same, the employment of W&I Insurance safeguards a buyer against undiscovered risks. The narrative that W&I Insurance must be used as a tool to fill in the crevasses created by due diligence and vice-versa should be pushed.

While both W&I Insurance and the exercise of due diligence have their downsides, the employment of them together would work well in filling crevasses left out by each other and aid in mitigating a wide range of risks. Ultimately, it is pertinent to note that while buyers can use several tools to 'mitigate' risks, there is no cure to 'eliminate' risks as an entirety.

[The authors are Partner and Associate respectively, with Shivadass & Shivadass (Law Chambers). The Authors would like to acknowledge the contributions of Ms. Shachi Gambhir, a 2 nd Year law student from National Law University, Odisha. The views expressed are strictly personal.]

1 Max Hyatt, Warranty and Indemnity Insurance: Proliferation of Moral Hazard or Legitimate Risk Mitigation Tool , 51 U.S.F. L. REV. 127 (2017).

2India M&A Practice Guides, supra note 1, at 55.

3 India Business Law Journal, https://law.asia/warranty-indemnity-insurance-can/ (last visited Jun. 18, 2021).

4 Baden Furphy, Damnien Hazard & Ben Landau, Market trends in W&I Insurance, LEXOLOGY , https://www.lexology.com/library/detail.aspx?g=36cf2f8f-f443-45bc-8a4d-2e1652d6eda4 (last visited Jun. 18, 2021).

5 Max Hyatt, supra note 3.

6 Id .

7 Max Hyatt, supra note 3.

8Shri Krishnan v. Kurukshetra University, AIR 1976 SC 376.

9 India Business Law Journal, supra note 8.

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