Warranty and indemnity insurance: risky business

Most lawyers are blessed with (or cursed by) a healthy dose of cynicism, but nowh-ere is it more evident than when discussing the merits of warranty and indemnity insurance (W&II) in the secondary buyout market.
Researching this piece drew an extraordinary split in opinion from partners. Comments ranged from the downright dismissive - ie those lawyers who think that brokers, who provide policies protecting buyers and sellers of a company against a breach of warranty, have a high time dressing up old policies in new clothes and for their efforts make a hell of a lot of money in the process.
On the other side of the fence, some lawyers are emphatic about the importance of insuring against risk. This bunch believes that the very future of the steadily burgeoning secondary buyout market depends on investors (predominantly private equity funds) guarding against liabilities as much as possible.
But is there merit in either of these arguments?
This is an issue at the moment for a number of reasons. First, most lawyers and brokers agree that there has been something of a resurgence in W&II. Indeed, the insurance market is again offering W&II after a sudden (though not unexpected) fall-off in policies following the events of 11 September.
Second, there has been a groundswell in secondary buyouts. It is common knowledge that for private equity houses looking to exit an investment, at the moment the stock market is quite simply not an option.
According to the European Private Equity and Venture Capital Association, European divestments (a fancy name for exiting an investment) were down to e8.1bn (£5.59bn) in 2002 compared with e12.5bn (£8.63bn) the previous year.
Perhaps most tellingly, 29.8 per cent of divestments were made through a trade
sale and a piddling 1.1 per cent was achieved through an initial public offering.
There is scant information about how many secondary buyouts there were in 2002, but it is likely to be a number that is increasing all the time.
The idea that an institution wants to make sure that when it buys or sells a company an unseen liability doesn't suddenly appear six months in and bite it on the backside seems like a good one. But these things are never simple and this is where the split widens.
Sitting on the anti-W&II fence, there are those lawyers
who argue that a company sale from one private equity house to another means that the business would have been, as one chap puts it, "due diligenced to hell".
Bearing in mind that the normal divestment period for a private equity investment is between three and five years, there would have been a huge amount of due diligence undertaken initially and the process would have been repeated at the exit.
Also on a secondary buyout, if the management decides to keep its investment in the company as it is taken over by a new private equity house, this can provide comfort. Surely, if there was something dodgy in its background, or the company wasn't performing, then the management would want to get its assets out - and fast.
While these arguments may qualm buyers' fears, it is fleeting comfort.
First, private equity houses will not give warranties. If that seems slightly ludicrous (and a bit childish) there is method in it.
A private equity house is there to invest money, so the prospect of having a big slug of potential investment tied up for 12 or 24 months - the period that liabilities on warranties are normally limited to - is not exactly thrilling.
Second, due diligence only uncovers so much, so who knows what potential liabilities could be lurking in the background?
Given that, at the end of the day, private equity houses are investing people's pensions, there is a moral duty here to make sure that money is not squandered because of an unforeseen problem.
Also, the very nature of the private equity market has changed since the mid-1990s. One broker says that since 2000 the stake institutions take in companies has grown significantly.
So, for example, a private equity house may hold 90 per cent of a company and the management 10 per cent.
Since it will be the management that will give warranties on the company (because the private equity house won't) the full responsibility is with it should anything go wrong.
Also, the management will commonly provide warranty only on its own investment in the company, which compared with that of the private equity house, is tiny. The buyer may want £50m of warranty protection, but the policy may be capped at only £5m.
This is a huge concern but one that has been remedied somewhat by the introduction of purchasers' W&II, where the buyer can take out a policy above the amount capped by the management.
While it is normal to see a mix of both purchasers' and vendors' (in this case management) W&II, one broker estimates that between 2002 and 2003 around 50 per cent and 60 per cent of warranty policies were vendors', with the remaining number made up of purchasers'. Between 1998 and 2000, 80 per cent and 90 per cent were vendor policies.
Finally, there is the very real issue that although secondary buyouts are helping private equity houses divest, at the end of the day these institutions are still doing business with a rival.
Although there is no suggestion that a competitor may try to stitch up a rival house by keeping potential liabilities hidden just to sell on the group, it could happen.
However, one thing lawyers do agree on is - surprise surprise - money.
Premium rates for vendor W&II are cheaper than purchasers' rates, although with the market rate spanning between 2 and 9 per cent, and with the growing popularity of purchasers' policies, this can end up costing businesses a lot of money.
Why lawyers get so wound up about this isn't clear, since they aren't the ones paying it. Maybe it's the thought of potential legal coffers going into someone else's pockets.
dearbail.jordan@thelawyer.com