26 October 2018

Warranty and indemnity insurance: A game changer in hotel sales and acquisitions


Warranties and Indemnities: their role in a sale and purchase transaction

Warranties and indemnities play a key role in a sale and purchase transaction for both vendors and buyers. Broadly, a warranty is a statement of fact in relation to a target asset / business and a party’s capacity to enter into an agreement. Normally, if a vendor discloses against a warranty as part of the disclosure exercise, the buyer will not be able to claim damages for a breach of that warranty to the extent the disclosure qualifies the warranty statement. To address the risk of loss arising for these “known risks”, apart from renegotiating the purchase price if the issues are sufficiently major, the buyer may look for a specific indemnity in the sale and purchase agreement (SPA).

Commonly the principle of caveat emptor (let the buyer beware) or “sold as is” principle applies, meaning that without warranties the buyer assumes the risk that a target asset may fail to meet expectations or have defects. Absent any price adjustment, warranties provide to the Buyer an avenue for recourse from the vendor for such failures or defects relating to the target asset and vendor’s title thereto. On the other hand, the vendor seeks protection either by not giving certain warranties, limiting a buyer’s recourse (through time and quantum) or by way of disclosing against the warranties as part of due diligence process.

It is clear from the above that a robust due diligence process in a sale and purchase transaction is important. On the one hand, a buyer has to undertake a comprehensive legal, financial and tax due diligence on the target hotel and land and operating business (and, in the case of a “share deal” as opposed to an “asset deal”, any target holding entity or entities) in order to determine the risks. The buyer then seeks to either renegotiate the price, mitigate such risks prior to completion of transaction (for example, as part of conditions precedent or completion deliverables), or protect its position on significant issues by way of specific indemnities. A vendor, on the other hand, is incentivised to give as full a disclosure as possible about the asset and the target business (and entities, if relevant) on the basis the buyer will usually not be entitled to make a claim on any matter which had been duly disclosed in due diligence materials.

Due to the importance of the disclosure exercise, buyers often seek a separate warranty that all information disclosed by the vendor before or during negotiations leading to closure of the transaction, is complete, accurate and not misleading.

Warranty and Indemnity Insurance: a Game Changer

In the context of a buyer’s recourse to the vendor for a loss arising from target asset defects, along with the disclosure exercise and negotiations of a comprehensive set of warranties and limitations of vendor’s liability under the SPA, both parties have to consider thoroughly the prospects of enforcement of a breach of warranty claim after completion of transaction.

Ordinarily, a buyer would usually require a vendor to set aside a certain pre-agreed amount in an account (an escrow or retention) as collateral security in order to cover for losses and damages in the case of a breach of warranty by the vendor/warrantor under the SPA. This clearly impacts a vendor’s proceeds.

However, with Warranty and Indemnity (W&I) insurance, buying and selling hotel businesses can become much more attractive to the parties, especially to the risk-averse.

W&I insurance is an insurance product tailored to protect either the buyer or a vendor in a transaction from the financial loss that arises from a breach of warranties given by a vendor in the SPA.

A W&I insurance policy can be taken by either a buyer (buyer’s policy) or a vendor (vendor’s policy).

W&I insurance is commonly relevant in transactions where:

(i) for a buyer, they have concerns over their level of recourse or ability to claim against the vendor for warranty breaches post-completion under the SPA, particularly:

  • a disparate number of vendors,
  • a vendor that will disburse the sale proceeds shortly after closure of the transaction,
  • a vendor that is a company with no substance or with a weak balance sheet,
  • a vendor that is a bank in a distressed asset sale, or
  • a vendor that has a special status e.g. a sovereign wealth fund or other quasi-governmental entity etc.

In certain occasions for trophy assets that attract a great deal of interest from numerous potential buyers, a buyer may wish to enhance its bid by means of W&I insurance to reduce a vendor’s potential liability under the SPA.

(ii) for a vendor, they may wish to cap (in terms of time and/or quantum) their potential liability to the buyer for claims under the SPA (e.g. redeploying sale proceeds).

W&I insurance aims to mirror the risks and limitations of liability provided in the SPA (albeit in the buy-side policy the coverage can extend beyond the limitations of liability provided in the SPA).

W&I insurance does not, however, cover all things and there are inherent limitations/exclusions (e.g. known matters, forward-looking statements, and a sell-side policy does not cover fraud by the vendor/warrantor).

In order to ensure that the parties do not use W&I insurance to replace the normal negotiations process, the insurer sets out certain policy limits around the claim thresholds and timelines (i.e time limits and uninsured amounts/deductibles) before the insured can claim against the policy, although this varies depending on transaction, jurisdiction, quality of disclosures in the due diligence process, and the parties.

In terms of claims, the key points are:

(i) for a buy-side policy, W&I insurance’s principal purpose is that it allows the buyer to claim against the insurer without going against the vendor (although a buyer can claim against a vendor for loss not covered by the W&I insurance policy).

(ii) for a sell-side policy, the buyer claims against the vendor under the SPA and the vendor in turn claims under the W&I insurance policy.

The time required to effect the insurance policy varies between 3 to 4 weeks and to ensure this does not drag the negotiation process it is highly recommended to get the insurance brokers specialised in W&I insurance involved at the early stage of the SPA negotiations.

However, where W&I insurance cannot be procured before completion of transaction under the SPA, the good news is that in certain cases W&I insurance may be acquired post-completion.

W&I insurance is a valuable tool for the parties seeking additional protection for their bargain under the SPA, and is gaining pace globally in a hospitality space. Our Hotels team has a great deal of experience in implementing W&I insurance in hotels acquisitions and disposals and are uniquely placed to assist you with advice on using W&I insurance in your next sale and purchase transaction.

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