Key points

• Warranty and indemnity (W&I) insurance policies are now frequently taken out by buyers on European leveraged buy-outs and can be a key element of the security package for the lenders.
• Review of the W&I policy is a key aspect of a lender’s diligence on the transaction to avoid pitfalls in the granting of security over the benefit of that policy.
• In most cases an assignment of the policyholder’s right to be paid proceeds under the W&I policy will be the most suitable form of security.

The M&A Landscape: rise of warranty and indemnity insurance

In recent years there has been a steady increase in the use of buy-side warranty and indemnity (W&I) insurance policies in the European mergers and acquisitions (M&A) markets as limited recourse acquisition structures prevail and the premium rates and terms on offer have become increasingly flexible and competitive. A W&I policy can provide the buyer with reliable financial protection, in many cases giving the potential for a more straightforward and expedient route to financial recompense than the alternative of a claim against the seller under the sale and purchase agreement (SPA) or against management warrantors who may remain within the business.

Many sellers will favour a clean exit from the SPA so that the sale proceeds can be distributed without the potential for claims, avoiding the need for sale proceeds to be held subject to escrow arrangements. This is particularly important for private equity sellers who may be prevented from taking on SPA liabilities under the terms of their fund documentation or need to make immediate distributions to their investors. W&I policies with no recourse against the seller (and a consequential increase in the policy premium) may therefore be preferred in many circumstances.

In principle, the existence of a well-constructed W&I policy should be an attractive prospect from the perspective of lenders financing an acquisition and a key element of their security package. It is no exaggeration to say that if a target business becomes distressed after acquisition, a claim under the W&I policy may be the only remaining asset that provides a route to a recovery.

It is critical for lenders to ensure that the security taken over these rights is appropriate and that the considerations for enforcing that security is well understood.

Understanding the policy

The first step to a lender obtaining a robust security position in relation to the W&I policy is to review the terms and coverage of the policy itself alongside the review of the SPA, as the rights of the lender under the security can never be better than those afforded to the buyer under the policy itself and (subject to any enhancements contained in the policy) the insured warranties/indemnities in the SPA. The areas of the policy that will be of particular relevance to the lender will include the following:

• Coverage and exclusions: At its core, the policy should provide an agreed level of coverage in respect of the representations and warranties made by the seller under the SPA, subject to exclusions and, potentially, enhancements. The policy will typically contain a schedule in which the cover position on each warranty/indemnity is set out.  Warranties will either be marked as insured or not insured, or insured subject to certain deemed amendments set out in the policy schedule.  The exclusions will include general matters (for instance known risks, forward looking statements and buyer fraud) and specific matters that the insurer will not be prepared to cover (for instance, relating to secondary tax liabilities or pension scheme funding shortfalls, or deal specific areas which the insurer has determined have not undergone sufficient due diligence). It is often also possible to obtain top-up cover (in excess of the W&I policy) for matters that are likely to exceed its limit of liability (for example, in respect of fundamental warranties concerning legal and beneficial title to the shares), and such risks may be insured under a separate (title) policy. A buyer may also require enhancements (for an additional premium) that provide coverage beyond the warranties from the sellers under the SPA, for instance a synthetic tax covenant.
• Check for any restrictions on assignment of the policy: Whilst W&I policies do typically allow for assignment of the proceeds of claims under them to entities providing financing to the buyer, it is essential to check that this is the case if such an assignment is to be taken (as discussed below). It should also be ensured that the security agreement complies with any specific policy requirements to achieve an assignment, such as using a required form of notice to the insurer. The policy should prohibit any other assignments and transfers of the buyer's rights under that policy.
• Onerous terms: Any entitlement to amounts claimed under the policy will always be subject to compliance with the policy terms imposed on the insured buyer.  When assessing the security value of an assignment, it is worth checking that there are no onerous conditions to cover (such as onerous claims reporting provisions or third party settlements restrictions allowing the insurer to avoid liability if not followed).
• Premium: Typically the premium paid will be a single lump sum paid at completion or shortly thereafter. The lender will need certainty that the premium has been paid since most policies will not be on risk if the premium is not paid. This may be a condition of the SPA, or if the policy requires payment after completion, may need to be addressed as a condition subsequent to the facilities agreement.
• De minimis and policy retention: Policies will typically contain two liability limitation provisions.  First, the policy will often specify a “de minimis”, which is the amount that each loss must reach before it engages cover under the policy (and is often set at the materiality threshold used for due diligence).  Once reached, the policy may “drop down” to cover the whole loss (and not just the excess over the de minimis).  Other policies may only cover the excess.  In addition,  the policy will often specify that the buyer should bear the first aggregate proportion of claims arising under the policy by way of an aggregate retention. Similarly, the limit of liability under W&I policies is typically set at a value of between 10% and 30% of the transaction value (except in certain asset heavy transactions, where top up title cover may be obtained).  Lenders therefore need to assess whether or not the amount of insurance taken, and the retention/de minimis provisions are adequate when assessing the value which the  security assignment will provide.
• Excess policies: It is not uncommon for additional limits of liability in excess of the primary W&I policy’s limits to be purchased from other insurers, who would each provide their cover by issuing excess policies. If so, it should be ensured that any security extends to these excess policies too and notifications are given direct to those insurers (and that the terms of those policies are truly aligned with the primary policy so there is no risk of mismatch of claims outcome between policy layers).

Lenders may also look to include a specific undertaking in the facilities agreement requiring the policyholder to comply with any on-going requirements under the W&I policy.

Security

Assignment by way of security

Lenders would normally want to take an assignment by way of security over the buyer's contractual rights under the policy, being a mortgage over those intangible rights. In terms of the documentation, where the buyer is an English company, this will typically be included within the English law 'all asset' debenture granted by the buyer at exchange at the same time as the SPA and facilities agreement are signed.

Unless the transaction is structured such that there is very limited or no recourse against the seller, the lenders to the buyer are likely to require an assignment of the buyer’s rights under the SPA in addition to the security over the rights under the W&I policy.

Limiting the assignment to the proceeds of claims

It is important to ensure that such an assignment is in respect of the policyholder's rights to the proceeds of a claim, and does not purport to extend to an assignment of the policy itself. A transfer of the entire policy may more accurately be described as a novation of the insurance contract, where the assignee will become the insured party and assume the obligations of the policyholder. There is sufficient usage of the term "assignment" with this wider meaning, however, to lead to uncertainty if the drafting does not expressly limit the assignment to the rights to the proceeds of claims made by the policyholder under the policy.1

An assignment of the entire policy is to be avoided, first as the lender will not expect to become liable for the obligations under the policy, and secondly as a purported transfer of the policy itself could lead to the insurer denying claims. This denial would be on the basis that the assignee as the new policyholder does not hold any insurable interest – it was not the entity to which the warranties were given – and/or that its insurable interest was not the interest covered by the policy. This would be on the basis that the assignee’s interest is related to the risk of non-payment of its loan, but that this was not the interest covered by the policy (which is the risk of loss through acquisition of a business which was not as valuable as it was warranted to be).

Provided there is no relevant restriction on assignment under the terms of the policy, an assignment by way of security can transfer the policyholder's right to the proceeds of a claim to the lenders (subject to the equity of redemption, allowing the policyholder to have the rights to the proceeds transferred back to it once the secured obligations have been discharged). The policyholder will continue to be responsible for bringing and litigating any claim under the policy.

This structure would not entitle the lender to control the conduct of the making of a claim under the policy. This means that if the policyholder is not co-operative, the making of a claim through it may need to be achieved in another way in any enforcement scenario, such as by procuring a change of the board of directors after having enforced share security over the shares in the policyholder or by exercising voting rights contained in that share security or by the exercise of a security power of attorney.

In practice, however, it would be difficult for a lender to be in a position to make a claim under the policy without cooperation from the policyholder, management of the target business and/or the private equity sponsor. A disputed claim under a W&I policy will likely be complex and will require the support of the key persons with detailed knowledge of the target business and/or that were involved with the acquisition. The purpose of the security interest should therefore better be considered as a means of ensuring that the proceeds from such claim are controlled and applied in repayment of the debt in priority to other creditors.

Transforming the equitable assignment into a statutory assignment

If no notice of the security interest is given to the insurer, the assignment of the buyer's rights to the secured party will be an equitable assignment. This can be transformed into a 'legal' or 'statutory' assignment pursuant to s.136(1) Law of Property Act 1925 by giving written notice of the assignment to the insurer, provided that the conditions in that section are complied with.

S.136(1) Law of Property Act 1925 applies to the assignment of a debt or other legal thing in action where the following conditions are satisfied:

• There is an "absolute assignment", that is, an assignment that is not conditional. An outright assignment of a debt with a proviso for reassignment on repayment by the assignor of the money lent (as will be the case in the security package) is regarded as absolute. Care must be taken with the drafting however, as an assignment that is stated to operate only until repayment of the money lent is regarded as conditional, and therefore incapable of being transformed into a legal assignment;2
• The assignment is "by writing under the hand of the assignor". The recent High Court judgment in the case of Frischmann v Vaxeal Holdings SA [2023] EWHC 2698 has caused consternation among finance practitioners in ruling that, owing to this requirement, an assignment executed by an attorney of the assignor is not capable of becoming a statutory assignment. So long as this legal uncertainty remains a cautious approach will likely be taken with respect to the use of powers of attorney in the execution of assignments by assignors.
• Express notice in writing must be given to the debtor. In the case of an assignment of proceeds from a W&I policy, as previously noted this will be a notice from the secured party to the insurer in a form typically scheduled to the security document and/or the policy.

Transforming the assignment to a statutory assignment is advantageous as it would allow the assignee (the secured party) to commence proceedings for non-payment of the proceeds of a claim  against the insurer without the need for joining the assignor (the policyholder) to those proceedings, which would be the case if there were only an equitable assignment. In the context of leveraged buy-outs, the request for a notice to the insurer may be resisted or requested to be moved to a perfection step taken at the time of an event of default or declared default, in line with the general trend in negotiation of security documentation on transactions with strong sponsors to move all but the most essential aspects of security perfection to matters to be taken only in a distressed scenario. Given the key importance of a W&I policy to the acquisition structure and likely corresponding limited (or lack of) recourse against the sellers, in most cases there should be no proportional reason for the lender to forego the notification to the insurer as a condition to closing (which, as noted, may in any event be a requirement under the terms of the policy). Most insurers providing W&I insurance will be accustomed to engaging with and accommodating the financing parties, and there are unlikely to be any commercial sensitivities which may occasionally exist in delivering such notices to the sellers in the case of an assignment of rights under the SPA.

Other protections

Other forms of direct contractual protection for lenders may be seen but are generally less advantageous or are more cumbersome:

• The lender may theoretically be added to the policy as co-insured, although this does not tend to be seen in the market because its insurable interest is different from the borrower’s (as explained earlier) and therefore would be resisted by W&I insurers. This would also increase the cost of the insurance, but any failure to comply with policy terms by the buyer under the insurance policy would then not result in the lender (or security agent on behalf of the secured parties) losing the benefit of co-insurance. This would be an additional protection, and not a replacement to the security assignment over the buyer's rights under the policy.
• The buyer may instruct the insurer to note the lender (or security agent on behalf of the secured parties) as sole loss payee, requiring the insurer to pay out to the lender first, or having the lender's interest noted on the policy. However, without a security assignment or some direct contractual agreement with the insurer, there would be nothing to prevent the buyer from subsequently reversing its instructions.

Conclusion

It is clear that a watertight security interest over the W&I policy could be vital in a severe downside scenario where policyholder and/or target business have become distressed and the acquisition warranties and/or indemnities in the SPA have been breached giving rise to recourse under that policy. This can sometimes be overlooked as an area of focus in the heat of negotiation and there are plenty of traps for the unwary.