Back to Basics | Corporate Wrapped Real Estate

Published in April 2023

This Back to Basics note follows our key concepts briefings on holding real estate in a structure and the features of a corporate-wrapped real estate transaction, which are available here: CMS Funds Group | Back to Basics briefings.

The final instalment in the series focuses on the use of transactional risks insurances or M&A insurances in corporate-wrapped real estate deals. There are many different types but this note covers the most common: buy-side Warranty and Indemnity insurance (W&I insurance).

The W&I insurance market has grown significantly over the last ten years and is used in both single jurisdiction and cross-border corporate-wrapped transactions. It requires input from local advisors in the relevant jurisdictions but the insurance product remains familiar.

WHY USE W&I INSURANCE?

W&I insurance is popular because it can facilitate transactions by enabling a seller to limit its on-going liabilities whilst at the same time giving the buyer reassurance that it will have recourse should a claim arise in the future.

Under the sale and purchase agreement (SPA), a seller will typically warrant certain facts about what is being sold, the nature of the entity or entities being sold and its or their affairs. The seller may also give a tax covenant promising to reimburse the buyer for taxes incurred by the target or events leading to an increase in tax liabilities which, in each case, were not otherwise accounted for in the period up to completion.

In both scenarios, the buyer’s recourse would ordinarily be to the seller, however, this may be unsatisfactory to all parties for a number of reasons, in particular:

• once the seller has disposed of the target, it may wish to wind up its holding structure and the residual liabilities under the SPA may prevent this;
• from the buyer’s perspective, it may be unclear as to whether the seller has any substance after it has disposed of the target and the seller’s parent or investors may be unable or unwilling to provide a guarantee; and
• the seller may be located in a different jurisdiction, complicating the process of making a claim.

W&I Insurance is a way to address some of these issues.

On a deal backed by W&I insurance, the seller’s liability is capped at a nominal sum and the buyer’s primary recourse for general warranty or tax claims (either in connection with the tax warranties or tax covenant) will be to the insurance policy.

PROCESS

The policy will be arranged through a broker. It will obtain non-binding pricing indications from insurers early in the process to give the insurers’ initial view of what the likely costs of cover will be, usually also expressed as a percentage of the transaction value. The selected insurer(s) will then be given the opportunity to look in greater detail at the data room, transaction documents and due diligence reports as part of its underwriting in order to confirm its pricing and finalise the insurance policy.

KEY FEATURES

The W&I insurance policy has its own set of terms and will insure the warranties negotiated in the SPA (subject to agreed disclosure matters for the transaction and any specific underwriter exclusions or modifications). The insurance broker will lead on negotiating the terms of the policy itself with the insurer(s). The key provisions are:

Limit of liability: the policy has a maximum amount that can be claimed. This figure will be determined by the buyer’s attitude to risk and is usually expressed as a percentage of the enterprise value of the deal, with the cover limit informing the cost of the policy. It is possible to carve-out a separate (higher) limit for certain warranties, for example, those relating to capacity to sell and ownership (fundamental warranties) or indeed obtain a standalone title policy that has a liability cap at or closer to the enterprise value;

Premium: the amount payable will be determined by the amount of cover (the limit of liability that the buyer wishes to obtain) and the risks. A buyer may require a seller to pay for / contribute towards the cost of the policy in exchange for agreeing to give the seller its ‘clean-break’ or, alternatively, the insurance costs can be priced into consideration;

Other limitations: the policy will have time limits for making claims, such as two years for general warranty claims and longer for tax claims and fundamental warranties. There is usually a de minimis claim limit and a policy retention (i.e. the amount the insured will need to pay itself / claim from elsewhere before the insurance applies);

Cover and exclusions: the policy will include a schedule of cover commenting on the warranties in the SPA and tax covenants to confirm whether a particular warranty or tax covenant is covered, excluded or modified. We discuss coverage in more detail below;

Non-subrogation rights: the policy should include an express waiver of the rights of the policyholder to take any action against the seller (absent fraud) in the event of a claim by the buyer. Even if the terms of the wider policy are less important for a seller in the context of its cap on liability under the SPA, the waiver of subrogation rights is relevant otherwise, without it, the W&I insurance could circumvent the commercially agreed ‘clean-break’;

Exchange and completion: the policy usually takes effect when the warranties are given on exchange. Where exchange and completion are not simultaneous and there is repetition of the warranties at completion, it is likely the insurer will want to see the seller obliged to update its disclosures for the period between exchange and completion. As with the position pre-exchange, matters disclosed before completion will not be covered under the insurance so the SPA will usually need to deal with allocating the risk of something occurring during this interim period; and

Assignment: the right to assign may be limited under the policy but a buyer will want to include the right to assign the benefit of the policy to a group member if a restructuring is anticipated and, likewise, where a finance party is involved, then the policy will need the wording to allow assignment to a lender and may wish to include any subsequent lenders.

COVERAGE

The key features included in a typical policy are outlined above but it is also important to understand what W&I insurance does not cover. Whilst commonplace and highly suitable in the context of real estate investment holding structures, it is not appropriate in every situation and does not solve all problems that arise in the course of a corporate-wrapped transaction.

Accordingly, W&I insurance should not be seen as a product which offers complete protection against the risk of a seller breaching a warranty or a tax covenant claim occurring. In addition to the general exclusions which are not covered as a matter of course, the W&I insurance policy terms also usually excludes issues a buyer will be expected to have known about. The aim of the buyer’s due diligence process should therefore be to flush out these issues so they can be considered and dealt with in advance of signing.

General Exclusions

W&I insurance policies have standard exclusions that are usually not negotiated. In the context of corporate-wrapped real estate transactions, these will likely include environmental liabilities, the condition and structural aspects of the building and its fabric, as well as more general matters which this type of insurance does not cover, such as fraudulent acts of the seller. Certain secondary tax liabilities and transfer pricing tax will also typically be excluded.

Specific Exclusions

With regard to specific warranty exclusions, the starting point is that the policy will cover warranty claims that arise from matters that were unknown at the time the warranties are given. Matters that the buyer knows about or should have known about will likely be excluded from the policy coverage, absent any specific cover for an identified risk. There may be some room for negotiation here but this is often reflected in additional premium costs.

Though a claim under a tax covenant is in principle different to a claim against the seller warranties in the SPA, W&I insurance will still only cover unknown or low-risk tax items (noting that care should be taken with the latter and discussed with advisers at the time). Nevertheless, if a tax liability is known or deemed likely to occur, then the insurance will exclude it in the absence of specific cover.

Identified Risk Insurance

Depending on the nature of the identified issue, if it and the risk can be assessed and the liability quantified, then a separate and/or top-up policy may be available. Such a policy would give the buyer cover for an additional premium, with the pricing usually reflecting the likelihood of the liability crystallising.

THE INSURER(S)

The nature of W&I insurance means that it is not just the buyer who has a vested interest in a detailed due diligence process, because the insurer will assume the liability for claims. As a consequence, the insurer’s underwriting process is focused on understanding the level of review undertaken. As part of this, the underwriters will want to receive copies of the reports prepared in connection with the transaction, in particular, the legal, tax, financial and technical due diligence reports, in each case, on a non-reliance basis (the insurer will instruct its own advisers, if required). The insurer will review the reports to see the approach taken and will usually follow-up with questions to test the conclusions, query any limits to scope or the materiality thresholds applied and get a sense of how forthcoming the seller has been. At the end of this process, the insurer provides its coverage position, including with regard to the general and specific exclusions in the policy.