Academic journal article Business Law International

Transaction Liability Insurance: Optimising the Risk Allocation in New-Age M&A Deals

Academic journal article Business Law International

Transaction Liability Insurance: Optimising the Risk Allocation in New-Age M&A Deals

Article excerpt

In the course of a deal, existing and potential risk items are often identified during the buyer's due diligence exercise. These risk items can range from a potential misrepresentation regarding the financial statements to potential litigation involving the target company for non-compliance with applicable laws. The allocation of such risks can become a sticking-point in negotiations and stall the deal.

Traditional risk allocation measures such as holdback, escrow, post-closing adjustments or parent guarantee are now few and far between in merger and acquisition (M&A) deals. Even the scope of customary representations, warranties and indemnity is continuously shrinking with the inclusion of high materiality and de minimis thresholds and a low cap on aggregate liability. This shift is driven by the interplay of several trends such as maturing markets, evolving legal systems, competitive M&A markets where too much money is chasing too few deals, increasing dry powder with investors and increased sensitivity of the sellers towards post-deal liabilities. This evolving trend in the M&A deal landscape is particularly unsettling for financial investors who have a penchant for doing deals on buyer-friendly terms specifically on risk allocation packages. Against this backdrop, transaction liability insurance (which includes warranties and indemnities insurance (also known as representations and warranty insurance), tax liability insurance, environmental liability insurance, litigation buyout insurance and contingent liability insurance) is increasingly finding favour among both buyers and sellers as an alternate risk allocation mechanism offering the primary or sole recourse for transactional risks.

Over the past three to five years, transaction liability insurance has evolved from a relatively esoteric product into a strategic tool regularly employed in M&A transactions to optimise negotiations and improve the overall outcome of the deal. Today the product is much more widely accepted and understood among M&A practitioners and its use is gaining traction across geographies, industries and asset classes. In most of the current auction sale processes, transaction liability insurance is factored into the structure of deals from the outset. Underwriters and brokers with ample experience and expertise are willing to insure novel risks1 by stepping outside standard market norms. Brokers and underwriters have recruited M&A specialists (including financial advisers and commercial lawyers) making product and policy negotiation more adaptable to deal requirements and more compatible with deal timelines.

Historically, the 'sweet spot' for transaction liability insurance has been deals with a purchase price exceeding US$50m but massive expansion in insurance markets and the increased risk appetite of insurers are resulting in smaller deals now qualifying for insurance and it is rare to see an uninsurable M&A transaction today. The increasing interest has also been driven by the significant reduction in the cost of obtaining such insurance since it first began being sold.

There is currently a penchant for limited or no recourse deals, driven by the strong desire of sellers to achieve the holy grail of a 'clean exit'. This desire is more prevalent where the seller is an individual and looking to retire, where the seller has chosen to offload the business due to financial stress or where the seller is an investment fund looking to wind up and issue the final distribution to its investors. Transaction liability insurance allows a seller to ensure a clean exit by replacing its financial obligations to stand behind the warranties made by it in the acquisition agreement and earning the entire or majority of sale proceeds without the long-tail exposure to claims or the inefficient lock-up of capital in escrows or holdbacks. For a buyer, transaction liability insurance provides an additional protection if the seller does not have deep enough pockets or if the seller has limited or no liability in the acquisition agreement. …

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