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
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.
What is Warranty and Indemnity
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
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 or Sell-side?
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.
Why would I use Buy-side Warranty
and Indemnity Insurance?
- It can ‘bridge
the gap’ between the level of protection required by the buyer and the level of
liability the seller is willing to accept.
- It can
help to protect the ongoing relationship between the buyer and seller where the
seller will be managing the business following completion.
- The buyer
has recourse against an established financial entity.
- It should
enable the seller to negotiate a shorter liability period and/or lower
structured correctly, a buy-side policy should provide the seller with a
cleaner break from the transaction and allow it to have immediate access to the
sale proceeds – ideally a buyer will waive the requirement for the seller to
retain part of the sale proceeds in an escrow account.
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.
Is it appropriate for my deal?
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
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