Breach of warranty and the related quantification of damages in the W&I context

The Warranty & Indemnity policy (W&I) is an insurance product used in mergers and acquisitions (M&A) transactions and designed to cover risks arising from breaches of representations and warranties (R&Ws) released by sellers in a sale and purchase agreement (SPA) or quota purchase agreement (QPA).

Originally developed in English law systems in the 1990s, W&I insurance has experienced significant growth across European markets, including Italy, due to the role of private equity players in transactions involving unlisted companies where the challenge  of information asymmetry exists between the seller and the buyer since the seller has a more in-depth knowledge of the target company than the buyer. 

To mitigate this asymmetry, the seller warrants the buyer that the R&Ws of the target company (e.g. its financial, tax or contractual status) are true and accurate.

From the seller’ s perspective, the W&I policy facilitates a  clean exit by limiting their post-closing liabilities, reducing holdbacks, escrows or other bank guarantees and allowing a prompt distribution or reinvestment of the transaction profits. Conversely, a W&I policy provides the buyer with a highly reliable counterparty (i.e. insurers) thereby mitigating the seller’s credit risk and enhancing the efficiency of the indemnification process. 

Additionally, W&I can maintain a good business relationship between the buyer and seller post-transaction.

In practice, W&I policies are generally structured in two main forms: buyer-side and seller-side policies. In the Italian market, however, buyer-side W&I policies are clearly predominant, representing over 90% of all W&I policies issued. 

It is worth noting  that cover under the buyer-side W&I policies (issued on a claims-made basis) is typically limited to breaches of R&Ws (i.e. facts and circumstances that that could reasonably result in a breach), that were not known to the buyer before policy inception. In practice, this means risks that were not identified during due diligence, were not disclosed in the data room or disclosure letter, and were not otherwise known to the buyer.  

As a result, issues identified during due diligence are typically excluded from coverage and are instead addressed through alternative contractual mechanisms, such as purchase price adjustments or specific indemnities provided by the seller (i.e. special indemnities). 

On a final note, buyer-side W&I policies offer the following advantages:

• they cover the buyer  against the seller's fraudulent or willful misrepresentations;
• they enable the buyer to claim indemnity directly against insurers without having to send prior notice of breach or third-party demand to the seller in accordance with the terms of the SPA.

W&I buyer-side policies are useful when sellers cannot or will not issue market-standard R&Ws or a market-standard cap of indemnity under the SPA. Buyer-side W&I policies, however, typically refer to the same R&Ws provided by the sellers in the SPA, such as title to and transferability of shares, the validity of the transaction, the legal, financial, organisational status of the target and the absence of undisclosed liabilities.

The policy may not necessarily cover all R&Ws. Therefore, it is essential to look at the policy to see whether some R&Ws are as “excluded” or “partially covered” (e.g. by adding or scraping a “knowledge” qualifier). This means a breach of the R&Ws only occurs if the insured can prove the sellers’ knowledge.

Furthermore, buyer-side W&I policies do not provide blanket cover but are subject to certain limitations.

As already mentioned, they do not cover known risks which have come to light during the due diligence process. In the case of VDR , however, it may be possible for an additional premium for such risks to be treated as “not disclosed” and thus covered under the policy.

Alongside this general exclusion, some losses are not insurable by-law (e.g. penalties, punitive damages and claims arising from the insured’s fraud) and the following losses are usually excluded:

• forward-looking statements, which are representations concerning future events or revenue projections;
• post-closing price adjustment mechanisms, which relate to price determination and not to breaches of R&Ws;
• covenants, which are commitments made directly by the seller in favour of the buyer that are not subject to warranties;
• the calculation of loss using multiplier mechanisms since the deal price might be based on enterprise value multiplied by a certain coefficient;
• consequential damages;
• leakage, which is any financial outflow from the target for the benefit of the seller (or parties connected to them) in the period between the locked-box date and closing (e.g. payment or distribution of profits, or intra-group payments);
• condition of the property in real estate transactions (i.e. “Condition of Asset”);
• certain tax risks (i.e. transfer pricing, secondary tax liabilities);
• product liability, cyber, social security contributions;
• anti-bribery,corruption and anti-money laundering. 

Another particularly significant factor is the possibility of negotiating the “policy enhancements”, such as by reducing the de minimis threshold and the retention or by providing for a longer period than the one set out in the SPA to notify a breach of the R&Ws.

Finally, most of the policies set a subrogation clause by which insurers, after payment of an indemnity, are subrogated into the insured’s rights against any third-party liable for the loss or against the seller only in case of wilful misconduct.

Following the commencement of a W&I policy, the parties are subject to specific obligations governing the notification and management of a claim. 

As general rule, an insured must notify insurers of a breach of R&Ws as soon as practicable when made aware of circumstances that may give rise to a claim. This requirement applies even when the expected loss exceeds the de minimis but does not exceed the retention, as the ultimate loss may erode the aggregate retention. 

An insured is required to provide a detailed description (supported by documentation) of the underlying facts specifying the R&Ws that have been breached and  proof of the loss.

Following notification of a claim, the buyer-side W&I policies usually set out timeframes (i.e. 15 to 20 days) when insurers must provide acknowledgement of receipt of the claim notice, and (around 20 to 30 days) when insurers must confirm or deny cover or request further information in order to complete the coverage analysis.

A late notification could entitle insurers to deny cover if they can prove intentional delay or reduce the indemnity in proportion with the prejudice suffered as a result of that delay (as per Articles 1913 and 1915 of the Italian Civil Code). If insurers fail to meet the above deadlines, however, the insured may be entitled to claim further damages only by proving prejudice suffered as a result of the delay.

When receiving a claim notice, an insurer will assess whether a breach covered by the policy has occurred, whether exclusions apply and the quantum. In case of disagreement between the insured and insurers, the dispute will be resolved according to the dispute resolution mechanism set out in the policy (i.e. arbitration or litigation before local Courts). 

The determination of a loss under a W&I policy is both fundamental and, in practice, not always a straightforward exercise. As general principle under Italian law (specifically article 1223 of the Italian Civil Code) and most EU jurisdictions, the loss must be the result of the direct and immediate consequence of the relevant breach of the R&Ws.

In certain cases, the loss corresponds to clearly identifiable and quantifiable damage. This is typically the case where a breach gives rise to a third-party claim, such as a tax assessment against the target company or its subsidiaries. For example, following a tax audit carried out by the Italian Tax Authorities, the target company may be subject to formal findings of irregularities, leading to a tax assessment determining specific tax liabilities along with sanctions and interests. The amount of loss suffered by the buyer is quite clearly identifiable along with any potential reasonable defence costs incurred by the insured during the tax proceedings.

In other cases, however, the quantification of the loss might be significantly more complex. For example, where the breach of R&Ws is related to inaccuracies in the target’s financial statements or underlying accounting records, it may be difficult to prove the exact amount of the loss incurred by the buyer. 

In these circumstances, the loss must be determined through an evaluation process, often requiring financial experts to ascertain the extent of the negative impact of the breach of R&Ws on the target company’s equity and on the buyer.