Axel Kuhlmann, Foreign Law Partner and Makoto Ohnuma, Senior Associate Lawyer, Nagashima Ohno & Tsunematsu gave a presentation on Warranty and Indemnity Insurance (W&II) in M&A Transactions during ALB’s first Virtual Japan In-House Legal Summit held on 9 June 2020. Given the overwhelming questions asked on that day, we sat down with them recently to get some of the key questions related to this topic answered.
Q: What is warranty and indemnity insurance?
A: Warranty and indemnity insurance or W&II is insurance that the parties to an M&A transaction can take out to insure against losses arising out of a breach of a seller warranty or an indemnity case. It shifts the risk away from the parties to an insurance company. W&II has been developed over the last decade and is frequently used in mature M&A markets such as the US and Europe.
Q: What kinds of risks does W&II cover?
A: Typically, W&II covers the entire catalogue of seller warranties contained in the transaction document (e.g., an SPA) with some standard exclusions. In principle, it covers only unknown risks, i.e., risks that are unknown to the parties and were not disclosed during the due diligence process (e.g., in the data room or the due diligence report).
Q: Who takes out the insurance?
A: W&II is usually taken out by the buyer but can also be taken out by the seller. In many transactions, the seller actually requests that the buyer take out insurance (so-called “stapled insurance”) and already procured non-binding indications from insurers. This often happens in auctions by private equity sellers. Once the buyer is selected, the process flips to the buyer and the buyer continues negotiations with the insurer.
Q: What are the benefits for the parties when taking out W&II?
A: For the seller, it is certainly the possibility of having a clean exit. This means the seller can sell the target with no or a very reduced liability risk since breaches of seller warranties will be covered by the insurer, who usually cannot take recourse against the seller. A clean exit also entails that the proceeds may be distributed immediately and there is usually no need for an escrow or other security mechanism. For the buyer, the insurance may offer better protection if the seller’s financial standing is doubtful. It also gives the buyer the possibility of bridging gaps in the warranties through enhancements. This means that the coverage under the insurance may go beyond what is provided for in the SPA. The “enhancements” we refer to are available for various issues (e.g., an increase of the liability cap and an extension of the time limitations). In an auction process, involving W&II can help the buyer differentiate its bid since the buyer can offer the seller a clean exit. Finally, if the seller remains involved in the business of the target (e.g., because the buyer only acquires a part of the shares or because the seller remains active in management), W&II can help protect the relationship between the parties by keeping them clean of claims.
Q: Can the seller exclude its liability completely?
A: Usually, insurance companies want the seller to remain liable at least to a certain extent. It is important for insurers to make sure that the seller has some “skin in the game” and does not give warranties lightheartedly. This is achieved through the so-called retention or excess under the insurance. This is an amount for which the buyer cannot receive payment under the insurance but has to turn to the seller under the transaction agreement. The liability cap under the transaction agreement usually corresponds to the retention under the insurance policy.
Q: You mentioned standard exclusions. What are those?
A: Typical exclusions are known matters, forward-looking statements or warranties related to transfer pricing or environmental contamination. Another type of warranty that insurers do not like are so-called sweeper warranties on, for example, the accuracy or completeness of provided information.
Q: You also mentioned enhancements. What are typical enhancements?
A: The most common enhancements are so-called knowledge or materiality scrapes. This means that, for the purpose of the insurance, knowledge or materiality qualifiers are eliminated from the relevant warranties. In addition, non-disclosure of the data room or the due diligence report or extension of the warranty period are quite common. Of course, all of those enhancements are only available to the extent the insurer feels comfortable with the related risks. They also trigger an extra premium.]
Q: How does the insurer get comfortable with the risk? Do insurers do their own due diligence?
A: Yes, insurers do their own due diligence. That being said, their due diligence follows a different approach in that they mostly rely on the due diligence report prepared by the buyer and their impression of the parties. One important point that the parties need to keep in mind is that the insurer expects the parties to do their due diligence and negotiate the transaction agreement as if there were no insurer involved. Consequently, if the insurer gets the impression that the seller generously gives warranties lightheartedly or the buyer is not doing the proper due diligence, it will likely increase the premium or refuse insurance completely for certain matters.
Q: What is the premium for W&II?
A: There is still a lot of movement in the market. Currently, premiums range between 0.8% and 1.6% of the policy limit (= around 10% to 50% of the purchase price). The premium depends on the insurer and the risk profile of the transaction. Usually, insurers request a minimum premium of around JPY 5-7M. Enhancements will trigger an extra fee.
Q: Is there a minimum transaction size?
A: The insurance market recognized the need to ensure smaller transactions and many insurers lowered their minimum premium accordingly. This now makes it possible to cost-efficiently ensure transactions in the JPY 500M to JPY 3Bn range.
Q: Whom should I ask if want to take out W&II for my transaction?
A: Ask your legal advisor to assess whether your transaction is suitable for W&II. They will contact brokers and insurers and collect the relevant information. It is key to have knowledgeable advisors on board to guide you through the process.
Q: How do you see the W&II market developing in Japan?
A: The use of W&II is still limited in Japan, especially in domestic transactions but this is changing. Many Japanese investors that are looking for international targets have experience with W&II since it is frequently requested by foreign sellers. Based on this experience, the concept of W&II has attracted more and more interest among Japanese investors and the W&II market is developing. We believe it is crucial for Japanese investors to pro-actively consider W&II and understand how it works and what its advantages and limitations are. Oftentimes, W&II can be a solution for deadlock situations in negotiations or a means to avoid poor compromises with respect to the protections under the transaction agreement.
Q: Lastly, please let us know what experience your firm, Nagashima Ohno & Tsunematsu, has in the field of W&II.
A: Nagashima Ohno & Tsunematsu is one of the biggest law firms in Japan, providing full legal services including domestic and cross-border M&A. As such, we regularly advise on transactions involving W&II and have developed a deep understanding of the W&II market. This is supported by the strong relationships we maintain with insurers and brokers providing us with first-hand information on market trends and conditions.
Contact Axel or Makoto for any questions you may have on this topic
Tel: +81 3 6889 7240
Axel Kuhlmann, Foreign Law Partner, Nagashima Ohno & Tsunematsu
Axel Kuhlmann is a corporate and M&A lawyer qualified in Germany and a Foreign Law Partner of Nagashima Ohno & Tsunematsu. He has wide-ranging experience in the German and European market advising Japanese and global companies on all kinds of German law issues and on their business activities in Germany and other European countries. Also, he regularly advises German clients on their business activities in Japan. Axel’s focus is on complex cross-border transactions including multi-jurisdiction carve-outs and international joint ventures.
Axel graduated from the University of Passau, from which he also holds a doctor iuris, and took his second state examination at the Higher Regional Court of Hamburg. He was admitted to the Hamburg bar in 2011 and to the Tokyo bar as registered foreign lawyer in 2017. Before joining Nagashima Ohno & Tsunematsu, Axel worked for one of Germany's leading business law firms as associated partner and member of the firm's Japan practice group.
Tel: +81 3 6889 7195
Makoto Ohnuma is a senior associate lawyer at Nagashima Ohno & Tsunematsu. Since he joined the firm in 2010, he has been working at its corporate and M&A practice group with the focus on M&A, joint ventures, and other strategic corporate transactions, and has broad experiences in cross-border matters between Europe and Japan. After his study at Columbia Law School (LL.M.), he was seconded to leading law firms in Germany, the Netherlands and Russia during 2016-2019.