Paulose M. AbrahamSenior Associate
The Indian mergers and acquisition (M&A) market has become increasingly prominent on the global stage. A significant number of M&A deals are being driven by a combination of venture capital/private equity investor exits on one side and strategic investments (from domestic and overseas investors) on the other. Many of these deals are being undertaken through a bid process where the seller (often funds that are nearing the end of their fund life) are looking to achieve a non-recourse or limited recourse deal, i.e., post-acquisition, the buyer has limited recourse to the seller. Typically, the most efficient way to achieve this is by using warranty and indemnity insurance (primarily on business warranties) as a substitute for seller indemnities. As a result, warranty and indemnity insurance (W&I Insurance) is now becoming an increasingly popular product in the Indian M&A market.
Acquirers in the Indian M&A space (whether overseas or Indian) have historically relied on a combination of holdbacks, escrows, price adjustments, and direct recourse against sellers for coverage on seller warranties. W&I Insurance is a form of general insurance and can be procured either by the buyer or seller in an M&A deal.
Key Features of W&I Insurance
An M&A deal covered by W&I Insurance affords comfort to both the buyer and the seller, as the risk is assumed by an insurer. The buyer is assured that its losses from breach of warranties will be covered, and the seller does not, in most scenarios, bear the ongoing risk of having to compensate the buyer for any such losses (because most W&I Insurance is a non-recourse insurance other than for losses due to fraud or wilful misrepresentation). In other words, W&I Insurance allows for the seller to effectively cap its potential liabilities in the deal after closing.
W&I Insurance replaces the cover provided by holdbacks and escrows to some extent. However, the buyer will typically retain its demand for a holdback or escrow to cover the deductible under the W&I Insurance policy. Given that the insurer is effectively assuming the risk of breach of the seller’s warranties, the insurer will typically:
- review and assess the risks identified by the buyer as part of its due diligence exercise by the buyer on the asset; and/or
- undertake its own diligence (which may or may not be limited in scope) on the target and the seller; and/or
- review the scope of warranties set out in the transaction documents and propose read downs of the warranties in some instances.
An M&A deal covered by W&I Insurance affords comfort to both the buyer and the seller, as the risk is assumed by an insurer.
Any adverse findings from these diligence exercises in addition to the specific indemnity events, disclosures made in the disclosure letter, and information contained in documents placed in the data room or any virtual platform, are carved out from the coverage under the policy. The buyer would typically seek to cover such risks through alternate mechanisms such as a holdback or escrow. However, insurers may on occasions waive their right to review the buyer’s diligence findings in the event the premium on the policy is increased and the buyer confirms it has no knowledge of a claim it can make under the policy as on the date of the policy.
As mentioned above, the scope of W&I Insurance covers risks arising from business warranties. Accordingly, the coverage under the policy is usually aligned with the liability caps and other limitations for such warranties under the purchase agreement for the deal. For instance, if the parties to the M&A deal have agreed to cap the liability for breach of business warranties at 25% of the purchase price and fix the liability period at three years from closing, the W&I Insurance cover would ordinarily be aligned with those positions. Therefore, W&I Insurance policies are bespoke contracts and not ‘one size fits all’. Sometimes insurers may include additional requirements or pre-conditions to provide cover for certain warranties. For instance, the insurers may require a section 281 certificate from a practising chartered accountant to cover warranties in relation to section 281 risk under the Income Tax Act, 1961. In some deals (especially those involving cross-border transactions where the buyer may be exposed to withholding tax risks), the buyer may seek additional insurance coverage since such risks are usually not included in the standard W&I Insurance cover.
Another key factor is that the deductible or the ‘de minimis’ under a W&I Insurance is normally linked to the enterprise value of the target entity and not to the amount of the policy cover. Given that the amount of the policy cover is usually a fraction of the enterprise value of the target entity, the deductible or the ‘de minimis’ is a significantly higher threshold relevant to the policy cover as compared to the enterprise value. In other words, if the negotiated deductible or the ‘de minimis’ is 0.1% of the enterprise value and the policy cover is 10% of the enterprise value, for the purposes of recovery under the W&I Insurance policy, the deductible or the ‘de minimis’ is effectively 1% of the policy cover.
With respect to pricing, the premium on W&I insurance is determined on a case-to-case basis but is usually 1% to 3% of the policy cover (subject to the insurer’s minimum premium). From an M&A deal perspective, this premium is viewed as a transaction cost and parties usually agree on which party bears the liability for the premium or whether such liability is shared between them in an agreed proportion.
W&I Insurance in India
W&I Insurance is not governed by a special or specific statute in India. W&I Insurance policies are issued by general insurers in India which are regulated by the Insurance Act, 1938.
If the acquirer is a foreign investor or a non-resident, then such policies are usually procured from a foreign insurance company in compliance with the applicable law in the jurisdiction where such party is present. If the acquirer is an Indian resident, such acquirer usually procures the W&I Insurance policy from the Indian counterpart of foreign insurance providers. This is primarily because the W&I Insurance policy product is more developed and recognised in the global market as compared to Indian markets where it is still at a nascent stage.
The success of M&A deal-making backed by W&I Insurance is evident from its large-scale acceptance in the global market. It is particularly advantageous in situations where: (a) the sellers are venture capital or private equity funds wanting a clean exit post-closing, or (b) the seller is a limited-life entity whose remaining term of existence is shorter than the potential claim period for the withholding tax risks.
While there is definitely a notable surge in the number of transactions being covered by W&I Insurance, this is still a relatively new concept in India. Firstly, not too many insurers are offering W&I Insurance in the Indian insurance market as yet. Secondly, the stakeholders in the Indian M&A market are not very familiar with the advantages and scope of W&I Insurance.
However, it is a growing product in a growing market, and we expect W&I Insurance to become more popular and an integral part of deal-making in India given its ability to provide a tailored risk-coverage in an uncertain economic environment.
The success of M&A deal-making backed by W&I Insurance is evident from its large-scale acceptance in the global market.