Non-recourse warranty and indemnity insurance

Exits, in insurance terms, pose a major challenge for venture investors, purchasers of portfolio companies and management alike, says Aon's Teresa Jones.

Teresa Jones is an Associate Director with Aon's Transaction Liability Unit in London.

When a UK venture capital firm is looking to exit, it doesn’t want to give warranties, but neither does it want to put management on the hook for an inequitable proportion of the consideration. Meanwhile the purchaser also needs to know that they have a reasonable level of recourse in the event of a breach of warranty. So how can all these  objectives be squared away?

From an insurance perspective, exits provide VC firms and their advisors with a particular challenge, and the perception that the non-recourse Warranty & Indemnity insurance product (W&I) is no longer available in the market place has led many to explore alternative methods of security available to them when it realising an investment.

What is non-recourse W&I?

Consider the following scenario. At the time of exiting an investment by way of a trade sale, the venture capital investor does not wish to give any warranties other than title. In view of their obligations to their funds, they are not in a position to give long-term commitments that would tie up these funds. Moreover, given that they generally do not have any more than a supervisory role in the running of the business they’re invested in, they are realistically not able to make warranties relative to the state of this business.

The incumbent management is generally happy to give warranties but only up to the level of consideration they are getting from the deal. More often than not this is insignificant when compared to the overall size of the deal and inadequate to give the purchaser sufficient comfort that they have a suitable level of recourse against the agreement in the event of a breach of warranty.

Historically, VCs firm and prospective purchasers, when faced with this kind of situation, often reached a point of stalemate and so began investigations to overcome the problem.

A solution was found in the form of the non-recourse W&I product. A clause was built into the sale and purchase agreement stating that the purchaser would have no valid claim against the vendor for a breach of warranty unless the claim was payable under an insurance policy.

Depending on the deal dynamics, some agreements were 100 per cent non-recourse for the full extent of the financial cap, whereas others would have a second cap, which would drop down to a level acceptable to the management warrantors in the event that the insurance policy did not respond.

This solution effectively enabled the VC’s to get the right price for the deal by giving them the ability to offer a reasonable financial cap under the agreement. This in turn gave purchasers sufficient comfort to proceed with the deal, having satisfied shareholders' concerns that they would have recourse against an insurance policy in the event of a warranty breach. The management warrantors had peace of mind that there was no recourse (or at least reduced level of recourse reflective of the consideration they actually received) against them.

In addition to this non-recourse product, the purchasers could take out a fraud wrap policy, which wrapped around the vendor's policy, excluding the vendor's fraud or deliberate non-disclosure. Furthermore to give the purchaser total confidence in the efficacy of the product, the policy could be designed so that the purchaser was the loss payee.

The insurance market wholeheartedly adopted this modified W&I product and in a buoyant M&A market, the use and profile of W&I insurance soared.  It was a win-win situation for all concerned.

Why was it withdrawn?

A couple of years after this product was established, the legal profession began to question its reliability and expressed doubts as to whether the policy complied with one of the fundamental principles of insurance, namely insurable interest. Whilst this point had been touched upon in the past it had been addressed by insurers through the insertion of a clause into the policy whereby the limitation of the insured's liability under the sale agreement was noted. However, after further analysis it was concluded that this insurance clause was not enough to overcome the problem.

Insurable interest is a basic requirement of any contract of insurance. The insured must have a particular relationship with the subject matter of the insurance; the absence of which would render the contract void or simply unenforceable. This insurance principal is intended to avoid the insured from benefiting from the proceeds of an insurance policy without having to have ever suffered a loss or have ever been capable of suffering a loss.

This principle dates back to the Life Assurance Act of 1774 and more recently the Marine Insurance Act, both which established the requirement for the assured to posses an interest in the thing insured. It is this principle which distinguishes insurance from gaming and wagering.  The courts have upheld the application of this principal when insurers have repudiated claims, as demonstrated in MaCaura v Northern Assurance Co (1925).

Turning back then to the non-recourse policy, this was a policy of indemnity, i.e. a policy designed to put the insured back in the position they were in before the loss. If, through limitation of the sale agreement, it was not possible for the insured to suffer a loss, (the non-recourse clause meant that the only loss to be suffered was that by the underwriter under the policy) then there was no insurable interest and the policy was null and void.

QC’s opinions were sought and their findings concurred that these products were fundamentally flawed.

What about non-recourse policies that were bound – are they worthless?

At the time these policies were written, they were placed in good faith by all concerned and with underwriter's full knowledge of the limitation.

It was inconceivable that the underwriter was/is ever likely to deny a claim for lack of insurable interest on their policies given the importance of upholding their reputation and retaining their underwriting license.  Strict underwriting regulations mean that an underwriter who takes premium for a risk that he knows can never be paid out on is likely to risk having his underwriting licence revoked. However, what was of greater concern was that reinsurers sitting behind the direct insurer would refuse to pay out under their reinsurance treaty on the basis that the primary insurer had no liability. Once these facts were unearthed, the industry sought alternative solutions.

The present day alternative

What came out of one of the QC’s opinions was an alternative but equally acceptable structure.  The suggestion was that there be two policies put in place, one small vendor policy which catered for the management warrantors consideration and reflected the financial cap agreed under the sale and purchase agreement and a 2nd purchaser’s policy which sat in excess of the vendor’s policy.  There were no rites of subrogation under this purchaser’s policy as the vendors had limited their liability under the sale agreement to a limit, which was mirrored under the vendor’s policy.

This programme has proven to be an invaluable alternative, even though non-recourse in its strictest sense is no longer available in the market.

In a VC exit scenario, each case will be considered on its own merits but in terms of reviewing what might be an acceptable level of cover under the vendor policy, the underwriter would wish to see a “sensible” limit, which reflects the management consideration. Underwriters will also consider the debt to equity structure of the deal and any element of consideration that the management warrantors are rolling over to the newco.

This structure works not only for VC exits but can also be adapted to overcome situations of an insolvent vendor by the use of a first party purchaser’s policy.  The vending company must still provide warranties, but subject to purchaser's agreement, the financial cap in the sale agreement could be set at a relatively low level and the purchaser's policy can sit in excess of this low limit. Alternatively a higher cap can be negotiated under the sale agreement and underwriters may agree to waive their subrogation rites against the vendor in respect of any payment made out under the purchaser's policy. This has the effect of ensuring that the purchaser has the means of recourse against a 1st party policy and does not have to worry about an arduous process in recovering funds from a liquidated company.  For the liquidator it also means that he does not have to tie up funds in an escrow or alternate security and can release cash to creditors at a far earlier stage.

The W&I market place is continually developing in order to meet the needs arising out of the corporate transaction arena. Whilst the traditional non-recourse product is no longer available for both legal and technical reasons the alternative is a more sophisticated and reliable product which removes uncertainty as to whether the policy will respond in the event of a claim due to insurable interest.