Know your W&I policy options

In his second article on corporate real estate, Paul Chases teams up with Will Arrenberg and Sarah McNally to look at the market position in relation to warranty and indemnity insurance The first article in this series looked at how the corporate real estate transactions market has developed. In this second article, the market position in relation to seven key areas of warranty and indemnity (W&I) insurance are explored. They are: a buyer or seller W&I policy; W&I policy interaction with the sale and purchase agreement (SPA); exclusions; tax liabilities; application of the Insurance Act 2015 (IA); claims; and timeline. W&I insurance has become an important tool in the UK corporate real estate market and is commonly used as part of transactions for the acquisition or disposal of companies, partnerships and unit trusts holding property assets. W&I insurance works broadly like any insurance – a premium is payable (usually via a broker) to an insurer who agrees to cover certain losses resulting from the events listed in the W&I policy. In the case of W&I insurance this will usually be: warranty and indemnity claims arising under the SPA; and claims arising under the tax deed (to the extent the tax deed, or tax covenant, is not included in the SPA, which is sometimes the case). Such cover is provided subject to policy limitations and certain exclusions listed in the policy. Buyer or seller W&I policy? The policy can be structured to cover: losses arising to the buyer due to a breach of seller warranty or a tax covenant claim against the seller (a buyer insurance policy – written in the name of the buyer); or losses arising to the seller due to a seller warranty breach or tax covenant claim by the buyer against the seller (a seller insurance policy – written in the name of the seller). In the current W&I insurance market the vast majority of W&I policies underwritten are buyer insurance policies – it is rare to see a seller insurance policy. However, very often the seller initiates the W&I insurance process and then hands this over to the buyer as shown in the seller-to-buyer timeline. How a W&I policy interacts with the SPA Generally, W&I insurance transfers liability for warranty breaches (general and tax) and any claims under the tax covenant from the seller to the insurer (subject to the limitations and exclusions in the W&I policy). One of the key W&I insurance points to check is to ensure that the W&I policy operates consistently with the SPA so that there are no provisions within the W&I policy that would cut across or otherwise prevent full recovery under the W&I policy. For example, if the SPA includes a £1 cap on all warranty claims and shorter time periods than the W&I policy within which general or tax warranty claims may be brought, then it will be necessary to make specific provision in the W&I policy to ensure the buyer can claim within the (longer) time limits it is anticipating. Of course, any recovery under the W&I policy will be subject to general or deal-specific exclusions. If the seller has limited its liability to £1 then the buyer will have no recourse against any entity for these excluded matters – hence why there may need to be a carve out from the £1 SPA cap in respect of some or all of those matters, which will be excluded by the W&I insurance. Position on policy exclusions The following tend to be W&I policy exclusions (although some of these may be negotiable): known issues that have been disclosed or are within the actual knowledge of the buyer’s deal team will not be covered. It is standard for the buyer’s deal team to sign a “no claims declaration” to confirm they are not aware of any such matters which may give rise to a claim under the policy; construction defects; pension underfunding; transfer pricing, secondary tax liabilities and protection of “priced in” tax assets; pollution; anti-bribery and corruption; forward-looking warranties; fines and penalties; seller breach of pre-closing conduct provisions; and fraud and deliberate non-disclosure. Tax liabilities In many ways, tax liabilities are covered in much the same way as any other liability under a W&I policy. However, there are a few specific comments that can be made in relation to tax protections. Tax time limits The usual market position is to seek protection under the W&I policy for seven years (essentially mirroring the most likely period in which HMRC have an opportunity to raise queries). Knowledge exclusion Under a non-W&I deal, whilst the warranties will generally be subject to disclosure (and so essentially a knowledge-based limitation) the same is not true of the tax covenant. Therefore the standard knowledge exclusion detailed above acts to limit claims under the tax covenant in a way that is fundamentally different to that seen on a non-W&I deal. This is ultimately a feature of W&I insurance, but a downside that buyer clients need to be aware of. Other limitations Whilst certain tax-related exclusions (as described above) are “normal”, care is still needed to ensure that the drafting in the policy is not overly wide; frequently these clauses are the subject of extensive negotiation to ensure that they are sufficiently targeted, with the first drafts presented by insurers sometimes going beyond the normal “market” version of such exclusions. Historically, we have seen insurers seeking to add additional “house” tax-related exemptions not based on disclosures of identified risks, but based instead on internal policy (such as trading or residence risks). However, this has become more unusual, in large part driven by the increasing competition in the market, alongside the increased transparency and focus on the scope of exclusions at the competitive underwriting stage. A well-advised client will now have a good picture of the scope of exclusions that may apply to the W&I policy before signing up with a given insurer. How to benefit from the Insurance Act 2015 The IA updates the law relating to: the duty to make a fair presentation of the risk; warranties; and the effect of breach of terms and conditions in insurance policies. Most of these changes are helpful to insureds, but it is possible to be caught out by the changes. All material facts still need to be disclosed but the IA provides clearer guidance on whose knowledge is relevant and what searches need to be completed, as well as imposing a duty to present the risk in a “clear and accessible” way. It also changes the law on what remedies are available to insurers if the insured breaches the duty, such that avoidance is not an absolute right and a host of remedies may be available. W&I policies have historically been a fairly sophisticated class of policy. But insureds should be alert to matters such as the following: ■ general “restatements” of the IA with small modifications that could have significant effects; ■ whether bespoke clauses that historically protected against inadvertent or innocent breaches remain fit for purpose post-IA; and ■ insureds may want to consider narrowing the suite of remedies now available to insurers. While warranties are rare in the W&I policies we see, insureds should be mindful of any increased use of conditions precedent, breach of which can have very serious effects on coverage. W&I insurance claims Two key points here: W&I policies will contain a range of obligations (such as notification and claims conduct), and if insureds do not comply with them they may be giving up rights; and if the seller and insurer both have exposures then there may be a need for the buyer to pursue a “dual track” if a full recovery is to be made. Prompt and careful strategic planning at an early stage is likely to pay dividends. Paul Chases is a partner and head of corporate real estate, Will Arrenberg is a tax partner and Sarah McNally is a litigation partner at Herbert Smith Freehills Part 1: CRE: acquisitions and disposals Part 3: “What is market” in 50:50 real estate developments JVs