Economic crisis will not be a new experience for most companies and financial sponsors. Recent downturns have presented their own unique challenges. The speed and shock of the COVID-19 crisis has allowed little time to plan. With countries accounting for over 50% of the world GDP in lockdown and house-hold brands already filing for administration, McGill and Partners has been analysing how the M&A environment will be different once deal activity resumes.
While the crisis has, understandably, relegated M&A as an immediate priority, the volatility that has caused financial difficulties for many may soon present an upside for those looking to acquire or invest in companies that were previously off the market and now in need of capital. Corporates looking to sell non-core assets to bolster cash reserves to weather the storm or indebted sellers looking to reduce debt burdens present some of the many attractive opportunities for buyers / investors in this downturn.
At McGill and Partners, we have been advising clients on using warranty and indemnity insurance to de-risk liabilities acquired when buying or investing in distressed situations. There are many characteristics of a distressed sale process that impose limitations or present challenges; careful thought and planning are required to navigate them. Here are some of the considerations you may wish to give thought to if you are looking to obtain M&A insurance protection for your distressed transaction.
Insurance solutions using synthetic warranties
While a buyer can take advantage of a distressed situation to acquire a high-quality target at a lower price, it will often not be afforded the same contractual protections that it might otherwise receive in a non-distressed, private M&A transaction. Sometimes it may not be possible for a buyer to negotiate a meaningful set of warranties because the seller is unwilling or unable to give them (for example, if the seller or management team’s equity is underwater or will result in negligible proceeds or perhaps, in the case of an insolvency practitioner, reflecting the limitations on his or her ability to disclose against the warranties because he or she has not been involved in the historic management of the business). In each case, the seller is looking to achieve a sale for the best possible price while limiting their liability. In such scenarios, it may be possible to structure an insurance solution where a synthetic set of warranties is included within a W&I insurance policy that would give the buyer protection if a warranty is breached. The warranties are deemed to be synthetic as they are not given by the seller in the transaction documents but instead are negotiated between the buyer and the insurer and included solely in the W&I insurance policy.
For these types of policies, careful consideration needs to be afforded to the drafting and breadth of the warranties given by the insurer. Unlike a typical private M&A process, a buyer’s access to management teams and the level of diligence they can practicably conduct may be significantly restricted in a distressed sale process. Accordingly, the suite of warranties an insurer would be willing to cover may be more limited to reflect the matters that could reasonably be the subject of diligence by a buyer and its advisers with minimal engagement from the seller or management.
In addition to reviewing the diligence the buyer has already conducted, the insurer will prepare a targeted Q&A focussed around the scoping of the warranties in order to elicit information from the seller to give them comfort to provide cover. The collaboration between the buyer, seller / management and insurer during this broker-facilitated process is of importance in determining the breadth of warranty protection, as the insurer seeks to align the scoping of the warranties with the buyer’s due diligence and responses to its Q&A. Ensuring the insurer is comfortable with the quality of the diligence exercise and disclosure process is of particular importance as the insurer does not have a traditional right of subrogation against the seller in the event of fraudulent non-disclosure since the seller is not giving the warranties under the transaction documents. For these reasons, it is necessary to engage with the insurance workstream as early as possible to allow the insurer to provide direction on the buyer’s diligence scope to achieve a set of warranties that is sufficiently broad to suit the buyer’s aims.
Valuation and loss recovery
Maximising the proceeds from a sale is important irrespective of the nature of the sale, particularly where a seller urgently requires an injection of capital. Though for some distressed transactions, pressure from creditors, maturing debt and falling levels of liquidity (amongst other factors) might drive a sale that sees a trade-off between maximum return and speed of execution. Irrespective of whether the seller is willing to give warranties, or an insurer structures a synthetic policy, if warranty insurance protection is sought buyers should give particular attention to the target’s valuation and how this interacts with the quantification of loss that would be recoverable under the policy.
As recently reaffirmed by the High Court,[1] the correct measure of damages when quantifying loss for a breach of warranty in the relevant transaction document is the diminution in the value of the purchased shares, such diminution calculated by reference to the actual value of the target deducted from its market value had the breached warranty been true. While the courts will often look to the purchase price to determine the “market” value,[2] if expert evidence supports the conclusion that the company was sold at an undervalue (or indeed an overvalue) then the court will take this into account when determining the fair market value of the company and, therefore, the diminution in the value of the shares arising from the breach of warranty.
This approach was recently applied by the courts,[3] with the judge citing both the speed at which the sale was executed and the sellers’ desire to sell the company in the immediate future as factors contributing to their conclusion that the company was sold at an undervalue. It was also found that, had the sellers’ contractual cap on liability in the relevant transaction document not been limited to the purchase price, the total damages awarded would have been in excess of the purchase price.
Buyers should carefully consider the policy drafting to ensure the loss they would be able to recover aligns with their expectations, having regard to the target’s valuation. This is of particular importance where distressed targets are being acquired for a nominal value and buyers will need to give thought to the valuation methodologies applied, as these are likely to form an important focus of an underwriter’s review.
It is also common in distressed sales for management to be given equity in the new target structure, which sometimes may be disproportionately higher than a non-distressed transaction. Where the rolling management team acts as warrantors, insurers take caution that a valid claim against the policy may result in management indirectly benefiting from their own breach of warranty. Depending on the percentage equity the rolling management take in the target group, consideration should be given to the loss insurers are willing to indemnify both in terms of the proportion of loss and nature of the breach of warranty; for example, some insurers might only pay claims proportionate to the insured’s equity interest in the target group or may limit the portion that may be recovered for a fraudulent breach.
Minority investments
Businesses in financial difficulty looking for an injection of capital or those with healthy balance sheets looking for capital to be used to acquire struggling businesses to accelerate growth may present attractive opportunities for third-party investors to obtain a minority interest in companies at an attractive valuation or that might otherwise not have been seeking financial sponsorship. For these investments, minority investors may seek warranty protection from the target company or its management, but the reality of the commercial relationship between the investor and the warrantor(s) may make claiming against them impracticable (indeed, warrantors may cap their contractual liability at a nominal amount from the outset). Warranty and indemnity insurance is commonly used by investors in these scenarios to provide them with protection for a breach of the warranties they have been given. However, the practicalities of a minority investment will inform the structure of, and approach to, the insurance policy.
Following a claim, insurers will typically require access to certain information in order to properly assess the merits or quantum of a claim or require the insured to take or omit to take certain actions (e.g. to mitigate losses). Similarly, insurers will expect, usually at their own expense, to be entitled to fully participate in the defence, negotiation and settlement of third-party claims and, in particular, require the insured not to settle or compromise any third-party claims without the insurer’s prior written consent. In each case, a material failure to comply with these policy requirements is likely to prejudice the insured’s rights of recovery. Policyholders need to ensure that the drafting of these provisions has regard to the minority investor’s influence and reflect the contractual rights (either to information or participation) that the minority investor has to facilitate the insurer’s involvement in the claim.
As is commonplace in a warranty and indemnity insurance policy, insurers will waive all rights of subrogation against the warrantor save in the case of fraud. Dependent on the investment structure and level at which a minority investor invests, and assuming a target company gives the warranties, if the investor has a direct or indirect financial interest in that entity (e.g. because the vehicle through which the investment is made becomes the parent entity), the insurer’s subrogation rights need to be more closely considered. While the insurer agrees to indemnify the investor for an insured loss, if that loss arose from a warrantor’s fraudulent breach of warranty the insurer’s rights of subrogation could permit recovery of the loss amount from the warrantor. Thus, the investor’s financial interest in the warrantor would indirectly cause them to suffer a financial loss at a subsidiary level. Investors should make sure that insurers narrow their subrogation rights further to limit this application.
The bolder your ambition, the better we become
Combining true expertise with a fresh perspective to deliver market defining risk solutions, our experienced M&A team is committed to helping clients to navigate the current uncertainty and to capitalise on the opportunities presented. There are many other creative bespoke solutions our M&A team has developed to address deal issues, each tailored to the situation and the needs and objectives of the client.
If you would like more information on the solutions outlined, or to find out if we can use our expertise and creativity to help you to resolve any other deal issue, please contact:
James Swan | james.swan@mcgillpartners.com
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[1] Oversea-Chinese Banking Corp Ltd v ING Bank NV (2019).
[2] See Triumph Controls UK Ltd & Anor v Primus International Holding Co & Ors (2019).
[3] Cardamon Ltd v Macalister & Anor (2019).
