Skeletons in the cupboard: warranty and indemnity insurance in corporate real estate transactions

United Kingdom

This article was produced by Nabarro LLP, which joined CMS on 1 May 2017.

Summary and implications

Warranty and indemnity insurance is an increasingly common part of many corporate transactions. Corporate real estate transactions are no exception, although there are some differences to note.

Why use corporate structures in the first place?

Corporate real estate deals typically involve the sale and purchase of shares in a special purpose vehicle (SPV) that holds property, as opposed to a transfer of the target asset itself. There are tax advantages to this method of transfer (SDLT on a sale of shares in an English company is 0.5 per cent), but these are not the only driver.

In a standard corporate sale of a company operating a business, the change of ownership allows the buyer to get on with running the business after completion, and the seller to make a clean break, walking away from the deal without significant, ongoing, contingent liabilities. The same approach is often used in the real estate context.

Warranties and indemnities – the skeletons left in the cupboard

However, the nature of corporate transactions is that the buyer must beware (that's a legal doctrine) of skeletons in the cupboard (that's not). A buyer is highly unlikely to enter into a share purchase agreement (SPA) unless it contains warranties (written statements of fact about the company) from the seller, which give the buyer the right to sue for damages if it discovers, after completion, that the statements were untrue.

In a real estate context, statements about the company's ownership of title to the property, legal encumbrances on the property, adverse possession and occupation, and a range of other issues, may be included as well as those common to any corporate transaction (such as details of the company's share capital, material contracts, capacity, accounts and, of course, potential tax liabilities). However, given that property deals are inherently simpler and less risky, and that the corporate route attempts to replicate via an SPV what happens in a direct property transaction (where land registry searches and such are typically performed by the buyer), warranties are often lighter than in a standard corporate sale.

Nevertheless, the fact that the seller will normally be exposed for some time after the sale to potential claims by a buyer under the SPA warranties means the seller will not normally be able to deposit all potential skeletons with the buyer and walk away following a deal. At the same time, buyers generally need comfort that the seller (which might itself be an SPV that will be liquidated not long after the deal, or a fund that will soon be wound up) can and will pay up in the event of a successful claim.

A possible compromise

Standard compromise solutions include injecting some certainty as to the potential size of any future claim by capping liability under the warranties at an agreed level, using a parent company guarantee, or holding some of the sale proceeds in escrow.

This is less than ideal for the seller and its parent company, who will usually want to distribute the sale proceeds in their entirety, and who under this arrangement retain potentially significant contingent liabilities. The key downside for the buyer is that recovery via warranty claims is risky, particularly where the long term creditworthiness of the seller is weak or uncertain.

Another option – warranty and indemnity insurance

Warranty and indemnity insurance (WI) is an increasingly common and neat solution in corporate real estate transactions. It works broadly like any insurance – the insured party pays a premium (usually through a broker) to an insurer who agrees to cover a defined amount of losses resulting from the occurrence of any of the events listed in the policy: in this case any claims under the warranties or tax indemnity. Parties should consider the WI option early in the process, and where appropriate involve brokers relatively early to give the insurer time to review the SPA, disclosure letter and due diligence reports and agree a price for the policy (which may affect the price of the deal, depending on the commercial position). WI nonetheless takes typically only a couple of weeks to arrange, so it should fit comfortably into most deal timetables.

Which party is insured?

Either party can take out a WI policy. If the seller does so, it will be liable to the buyer for warranty claims up to a cap amount specified in the SPA, and for the excess specified in the policy. The insurer then steps in to satisfy the buyer with the remaining amount. This has the disadvantage of leaving the seller on the hook for claims, albeit for a reduced amount, but also complicates things by leaving the seller in control of the process of claiming against the insurer.

If the buyer effects the policy directly with the insurer, the cap in the SPA is low (the current market standard in the real estate context has become a nominal amount, often £1), and the purchase price for the company may be reduced to account for the premium. Buy-side WI also allows the seller to step away (subject to satisfying any nominal cap in the SPA), and gives the buyer a strong contractual recourse to the insurer in the event that any of the warranties are breached.  In effect this should mean more definitive closure for the seller and greater reassurance for the buyer.

Premiums and coverage

The market rate for premiums in real estate WI policies is probably around one per cent to 1.5 per cent of the limit on the coverage under the policy. The amount of coverage is a commercial point that will vary on a case-by-case basis, and could theoretically stretch to the whole of the purchase price. However, given the relatively lower risk (which means sellers often stand behind fundamental warranties (e.g. title) themselves) and the more limited nature of warranties in an average real estate deal, current market practice seems to be for coverage to extend to between 10 and 20 per cent of the purchase price.

The strategic use of WI

Insurers usually accept a low cap on the seller's liability and do not insist on the buyer claiming against the seller before the right to claim against the insurer is triggered. This means that a buyer in a competitive auction process can potentially offer the seller a better deal in terms of minimizing the seller's contingent liability under any warranty or tax indemnity claims. If pitched at an appropriate level, taking into account the competition, this could be very attractive to sellers, enhancing the buyer's offer relative to other bids where WI has not been considered.

Sell-side WI is also sometimes used where the seller wants to level the playing field (on this point) between different types of bidder who may have different attitudes to risk under the warranties. By taking out a WI policy, the seller can offer all bidders the same cap on its contingent liabilities.

Conclusion

WI is an option that has the potential to allow both parties to a corporate real estate transaction to sleep easier after the deal, knowing that if any skeletons do fall out of the cupboard, the insurer is on hand to step in and give them a proper burial.