The buyer of a business will typically require the seller to provide various ‘warranties’, ‘indemnities’ and ‘tax covenants’ in the business sale agreement – these are all vital tools for re-allocating risk between the parties.
What are ‘warranties’, ‘indemnities’ and ‘tax covenants’?
Warranty – in this context, a warranty is a statement given by the seller to the buyer as to the state of affairs of certain matters relating to the business. These can be used to cover a wide range of areas, including; employees, litigation, pensions and contracts.
If it transpires that a warranty is untrue or misleading, this could give rise to a claim by the buyer for breach of contract.
Indemnity – is essentially a promise by the seller to cover the buyer against losses.
Indemnities are generally easier to enforce than a claim for breach of contract. A well drafted indemnity will cover the buyer against losses on a pound for pound basis so they are commonly used to protect the buyer against known issues and where it is unlikely that a warranty will provide sufficient protection.
Tax Covenant – works like an indemnity and covers the buyer for the businesses’ unpaid pre-completion tax, subject to exceptions agreed between the parties.
Where there are multiple sellers, warranties, indemnities and tax covenants will often be provided on a joint and several basis – the buyer can pursue a claim, in full, against any or all of the sellers.
The parties can agree certain limits on the seller’s liability under warranty, indemnity and tax covenant claims – usually liability is subject to a cap and claims cannot be brought after a certain period.
Warranty and Indemnity Insurance (“W&I Insurance”) provides cover for losses arising from a breach of warranty and, depending on the policy terms, claims under an indemnity and/or tax covenant. W&I Insurance can be taken out by the buyer (buy-side) or the seller (sell-side).
Sell-side policy – will cover the seller against losses suffered as a result of a claim by the buyer.
Buy-side policy – allows the buyer to claim direct against the insurer to cover its losses arising from a claim.
Under both sell-side and buy-side policies, the seller will usually bear the first portion of any claims by way of an excess.
Buy-side policies are more common than sell-side policies as they effectively provide protection for both the buyer and the seller and can also help to facilitate completion of a deal. In fact, sellers will often instigate a buy-side policy.
Coverage & Exclusions – The policy coverage will depend on a number of different factors – these are bespoke policies intended to reflect the unique requirements of the insured party and the transaction.
The insured party must pay close attention to the terms of the insurance contract and any exclusions to ensure that the policy provides adequate cover. In the case of a buy-side policy, the buyer must ensure that there are no ‘gaps’ between the liability of the seller and the insurer.
Insurance cover will not always be forthcoming where there is a known liability. There may also be matters which are not covered such as investigating the claim.
In the event of a claim, the insured party must co-operate with the insurers to benefit from the policy.
Amount Insured – For lower-value transactions, the cost may not be proportionate to the risk – cover of less than £1 million is likely to be uneconomical.
Premium and Costs – The premium is calculated as a percentage of the total limit of insurance. Typically, premiums range between 0.9% to 1.5% of the insured limit for both buy-side and sell-side policies plus insurance premium tax (6% of the total premium in the UK) – the premium will be payable in full when the policy is taken out.
Insurers may also charge due diligence fees and these can range between £2,500 to £15,000 plus VAT.
Timeframes – An insurer will need to have a good understanding of the transaction and the level of due diligence undertaken – additional time allocated to the insurer’s due diligence and negotiations surrounding the policy should be factored in to the deal timetable.
Well drafted seller protections in the business sale agreement along with proper attention to disclosure will often provide sufficient armour in a seller’s defence of claims without the need for insurance but as always, it will depend on the circumstances of the transaction and the parties appetite for risk.
If the parties know that the business being sold is very clean and the risk of a warranty claim is therefore very low, the cost of a W&I policy may not seem worth it (although applying the same logic the W&I the premium is likely to lower).
The contents of this newsletter are intended as guidance for readers. It can be no substitute for specific advice. Consequently we cannot accept responsibility for this information, errors or matters affected by subsequent changes in the law, or the content of any website referred to in this newsletter. © Mundays LLP 2019
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