With COVID-19 causing significant market volatility around the world, M&A deals have slowed to a trickle as companies focus on maintaining cash flow and keeping their employees and business safe. Fewer than half as many transactions were completed in March 2020 than in March 2019, and April 2020 saw the first week since September 2004 in which no deal larger than $1 billion was announced. (1) Further we are beginning to see COVID-19 rethinks of deals. For example, US based payments-based company WEX Inc has announced that it wants to back out of the $1.7 billion acquisition of virtual travel payments providers eNett and Optal, citing that the conditions arising from COVID-19 have had a material adverse effect on both businesses. (2)
However this situation will not last forever and as the world begins to emerge into a post lockdown world, companies will be looking to take advantage of the crisis and to take advantage of distressed or lower valuations assets. In fact, after the global financial crisis, companies that increased M&A spending saw the highest total shareholder returns. (3) As the rise in insolvencies continues, voluntary administrators and liquidators will be looking to sell off assets or restructure companies in order to maximise creditor returns.
In Asia, Warranty and Indemnity (W&I) insurance has continued to play an increasing role in M&A deals, with Marsh JLT Specialty reporting that policies written have seen a 40%-65% year on year increase since 2015. (4) In the current financial climate W&I is likely to be used by deal makers in transferring and managing risk in upcoming deals. The use of W&I insurance by insolvency professionals is likely to accelerate and become more established as an important tool to increase the attractiveness of the sale of distressed assets by providing certainty and protection to sellers in situations where the seller would have no capacity to satisfy future claims.
The global effect of COVID-19 will provide unique opportunities for the W&I market. The global reach of the crisis is likely to see larger multi-jurisdictional insolvencies and therefore deals with targets having conducted business in many different jurisdictions. This demands complex underwriting, due diligence and premium rating capability. Across a multi-jurisdictional region such as APAC this will require the use of local fronting insurer arrangements and in turn is likely to further promote the use and facilitate the continued growth of the class.
The current climate will also provide significant challenges to both underwriters and claim managers. We consider some areas that are likely to provide particular concern and offer some practical tips to our insurer clients.
In light of the impact of COVID-19 on businesses and M&A transactions, W&I underwriters should look closely at the valuation of businesses, such as the price multiple in the context of the revenue outlook and particularly where the valuation has been conducted on a discounted cash flow basis. Consideration of the target company's insurance program will also be prudent, as W&I underwriters should take into account any other insurance coverage which may respond to a claim (e.g. business interruption policies that are not subject to epidemic/pandemic exclusions).
The current broad wording used for many warranties would likely pick up COVID-19 related issues, such as under financial condition warranties, compliance with the law warranties and disclosure warranties.
W&I underwriters should be mindful of warranty claims that may be pursued under the transaction documents in relation to actual or alleged non-disclosures, or warranty breaches caused by third party claims based on the target company's COVID-19 related liabilities. Any such potential exposures and liabilities should be identified in the transaction due diligence and then addressed in the underlying transaction documents through appropriate exclusions or apportionment.
Given the rapidly evolving nature of the COVID-19 pandemic, W&I underwriters should carefully consider the terms for offering cover for breaches of warranties which first occur between signing and completion and are discovered by the buyer, as this may present a material risk for the period between signing and completion. The drafting of any "Material Adverse Effect" (MAE) carve-outs as they apply to this extension of coverage will become increasingly important for W&I underwriters, as buyers in the COVID-19 environment are likely to seek inclusion of such MAE conditions to provide them with an exit from the transaction if the target company's business deteriorates between signing and completion of the transaction.
In addition, W&I underwriters should consider further protections in the underlying transaction documents to limit their exposure, by mirroring such protections in the W&I policy wording, such as through the incorporation of the following types of provisions:
Regardless of the above, it would be prudent for W&I underwriters to also include appropriately crafted insurance exclusions in the W&I policy wording to exclude coverage for specific risks presented by COVID-19. This may arise where W&I underwriters are conducting additional underwriting specifically for COVID-19 and are unable to get comfort in relation to the impact of the pandemic on warranties, especially those warranties furnished at completion.
In considering COVID-19 is likely to place on claims, there are likely to be 3 main areas of concern:
Marsh confirmed, in their recent report on W&I claims in Asia, that 83% of coverage denials have been due to prior known circumstances exclusions, on behalf of buyers. (5) This trend is likely to continue and given that the impacts of COVID-19 are likely to be present for months or even years after the end of the lockdown period, establishing whether prior known circumstances exclusion apply it will be critical for claims managers in adjusting future W&I claims. It will be important to document an accurate timeline of what information the buyers had and when they acquired or should have acquired knowledge, as a matter of general principle insurers carry the burden of proof when seeking to rely on an exclusion clause.
The unpredictability caused by COVID-19 in determining when businesses can resume to the 'new normal', and what this may look like, will present challenges for vendors in settling the accounts. This includes challenges in ensuring that financial and profit forecasts present a true and fair view given the uncertainty on future income and expenses.
Under the accounts warranties in a purchase agreement, vendors generally warrant that the audited and / or management accounts of the business provide a fair and true view of the company's account. They may also warrant that they have been truthfully, fairly and accurately prepared.
In considering if there has been a breach, there is a presumption that the accounts present a fair and true view where they comply with accounting standards. That presumption may be displaced where the accounts do not contain all of the information that they would reasonably be expected to include.
The presumption may also be displaced where there are material omissions from the accounts (including where the omission has a significant effect on the finances). However, an omission of a fact that is unknown to both parties at the purchase date is unlikely to result in a breach of the warranties. (6)
Damages for a breach of the accounts warranties are assessed as the difference between the 'warranted value' of the business against its 'actual value' (assessed at the purchase date).
While simple in principle, the 'warranted value' is not necessarily the purchase price of the business. For example, if the business has been purchased below its true market value, the 'warranted value' may be higher than the purchase price. (7) This issue may arise in circumstances where assets are sold in a "fire-sale" in a fast paced sale with less due diligence and at a significant discount.
Calculating the 'actual value' of the business is not as simple as calculating the real value of the business at the purchase date had the accounts been correctly stated. Courts will have regard to all of the information available to them at the time that they assess damages for W&I claims. This includes any subsequent events (provided they are not from an independent intervening source) to the purchase date that affects the value of the business where they arise from the nature or use of the business. (8)
These challenges will present issues for insurers in assessing W&I claims. For example, legal and accounting issues may arise when considering whether accounts warranties have been breached, including the degree to which the unpredictability caused by COVID-19 is an unknown factor. The assessment of damages may also be complicated, including where the impact of COVID-19 results in the 'warranted value' of the business being lower than the purchase price.
The volatility generated by the COVID-19 pandemic will continue to provide challenges to the W&I market in the short to medium term, however, the crisis also will provide opportunities to increase the use of the product as a way of successfully managing the sale of businesses where the seller cannot be relied upon to satisfy future claims for breach of warranty.
If you wish to discuss this article or W&I underwriting or claims issues, please contact Clyde &Co Partner, Dean Carrigan (Sydney).
(1) Kane Wu, Corona Virus takes its toll on global M&A as $1billion deals disappear, Reuters, April 20, 2020
(2) Krystal Hu, David French, Payment processor WEX threatens to abandon $1.7 billion deal for eNett and Optal, Reuters, May 8, 2020
(3) Boston Consulting "Advantage Beyond the Crisis' www.bcg.com/en-sea/publications/202/building-business-advantage-beyond-covid-19-crisi.aspx
(4) Marsh JLT Specialty, Insights into W&I Insurance Claims in Asia: What half a decade of data tells us, April 2020, p1
(5) Ibid, p6
(6) Macquarie Internationale Investments Ltd v Glencore UK Ltd  EWCA Civ 697; Bairstow v Queens Moat Houses (unreported, 23 July, 1999).
(7) 116 Cardamon Ltd v MacAlister & Anor  EWHC 1200 (Comm).
(8) Kizbeau Pty Ltd v W G & B Pty Ltd (1995) 184 CLR 281.