Warranty and Indemnity or Representations and Warranties (W&I) insurance is a strategic tool utilized in merger and acquisition transactions to transfer risk of financial loss for seller warranty breaches in a sale agreement to an insurer.
W&I has a number of well-known benefits for both buyers and sellers but the focus for this post is on highlighting where W&I could add significant value over uninsured deals in protecting ongoing business relationships between parties post-closing of a transaction. This is an area that is often overlooked but a crucial component of deal success.
In the event of a warranty breach, a buyer must consider the commercial realities of bringing a contentious action against the seller regardless of a claim’s legitimacy. In many cases there is significant risk, particularly for public proceedings, that such an action could damage goodwill with management and employees or jeopardise existing relationships with established customers and suppliers of the business. Particularly in the Asia context, saving ‘face’ and the concept of guanxi, where one relies heavily on social connections and networks, are fundamental values which permeate business relations and cannot be ignored post-closing of a transaction. With a buy-side W&I policy, the insurer stands as a neutral and credit worthy third party to handle any potential warranty claims confidentially with the buyer.
Some common deal scenarios which W&I can help to address post-closing include:
When a buyer acquires less than 100% of the business there will always be the need to manage on-going relationships between the new acquirer and existing vendors. A warranty claim raises the potential for contentious disputes amongst the parties that could disrupt the post-integration process at a time when fostering goodwill with new business stakeholders should be a priority.
Where founder led businesses are sold with existing obligations to work within the business post-completion, the drivers for its continued success are intrinsically linked to those providing the warranties under the sale agreement. Claims against the founder or management shareholders who are crucial to the business could be severely detrimental to the operation of the acquired business and its key customer and supplier relationships.
Large corporate divestments
In today’s economic climate, many transactions are undertaken to streamline businesses by divesting or spinning-off non-core assets. Large corporate groups often require complex transitional service arrangements whereby buyers and sellers continue working together post-closing. A warranty claim could sour this relationship and significantly impair the acquired business during this important transition period.
Joint ventures or mergers
Parties in a joint venture or merger seek to combine existing businesses to achieve a shared goal. In this situation a bespoke W&I solution can be structured so that both parties’ liabilities under the warranties in the merger agreement can be insured. This frees the combined management to focus their attention on the future success of the venture.
Warranty breaches in an uninsured transaction can put significant strain on relations where post-closing obligations between parties exist. Accordingly, M&A participants should consider the value of W&I insurance as a risk mitigation tool in these common deal scenarios above. Beyond offering secure financial recourse for a buyer, a W&I policy may help provide additional peace of mind that important relationships can continue to be maintained well beyond the parties signing on the dotted line.