The scope of W&I Insurance

Summary

W&I policies are designed to insure against breaches of representations and warranties in contracts for the sale of businesses. They are not designed to compensate a purchaser simply because a deal turns out to have been a bad one. Nor are they intended to respond simply because the value of the target company drops or does not increase as expected post acquisition.

In a decision that will have provided reassurance to W&I insurers, these core principles were upheld in Finsbury Foods Group Plc v Axis Corporate Capital UK Ltd and others.

The judgment contains other useful guidance on various standard clauses in W&I policies.

Background

The claim related to the purchase by the Finsbury Food Group (the Insured) of a specialist, family-owned baked goods business called Ultrapharm (the Target). The Target made gluten-free baked goods for Marks and Spencer Plc, which were sold under M&S's own brand. The sale was concluded for a purchase price of £20m. The Insured subsequently alleged breaches of representations and warranties in the sale and purchase agreement (SPA), and claimed £3.19m from Insurers.

The Insured had purchased a buyer-side warranty and indemnity (W&I) policy. The insuring clause stated that the Policy would indemnify the Insured for any covered Loss, defined as "the amount of monies which [the Insured] is legally entitled to claim against the Sellers and/or Warrantor pursuant to the Transaction Documents [including the SPA] for a Breach...". "Breach" was defined as including breach of the warranties in the SPA.

The Decision

The Court concluded that none of the representations and warranties In the SPA were breached. Absent breach, there was no covered event. The warranties in the SPA covered changes in the business after a specified Accounts Date. Two sets of breaches were alleged.

1. Alleged breach of "trading conditions warranty"

This warranted that there had been:

"no material adverse change in the trading position of [the Target] or their financial position, prospects or turnover and [the Target had not]... had its business, profitability or prospects adversely affected by the loss of any customer representing more than 20% of the total sales of [the Target] or by any factor not affecting similar businesses to a like extent... and so far as the Warrantor is aware, there are no circumstances which are likely to give rise to any such effects..."

This was found to provide two separate warranties, being (i) that there had been no material adverse change in the trading position of the Target or in its turnover; and (ii) that there had been no loss of a customer representing more than 20% of the Target's total sales.  Amongst other things, the court concluded that:

• "Material adverse change" meant something that was substantial or significant as opposed to merely a de minimis change. This was construed to mean a loss of more than 10% of the Target's total sales since the account date. The reference to a loss of customer representing more than 20% of the Target's total sales was a separate warranty albeit contained in the same clause.

• A recipe change agreed between the Target and M&S had not breached this warranty, as alleged. The change had been agreed before the Accounts Date. It did not result in a 10% reduction in turnover of the Target, but at most reduced the profitability of two specific products. Recipe changes were considered part of the ordinary course of the Target's business, and would not, without more, breach the trading conditions warranty.

• Price reductions agreed by the Target did not, in principle, result in a breach of the trading warranty. In the absence of a specific warranty, price reductions could arguably be brought within the trading conditions warranty, but here they had been catered for in a specific price reduction warranty (see below) that took them outside the scope of the more generic material adverse change warranty.

2. Alleged breach of "price reduction warranty".

This provided that the Target would not offer or agree to offer ongoing price reductions or discounts or allowances that would result in an aggregate reduction in turnover of more than £100,000, or would otherwise reasonably be expected to materially affect the Target's profitability. The Court held that this warranty covered offering or agreeing to offer price reductions after the Accounts Date. It did not cover the situation in this case, where price reductions were offered before the Accounts Date but took effect after it.

The fundamental problem for the Insured was that it could not demonstrate any breach of the SPA, in order to trigger cover under the W&I Policy. The fact that the Policy was a buyer's side policy, rather than a seller's side liability policy, did not change the basic requirement that there had to have been a breach of an applicable representation or warranty to trigger cover in the first place.

Although not strictly necessary given the finding that there was no policy trigger, the Court also considered the following points.

Knowledge Exclusions

The SPA excluded warranty claims to the extent the Insured had actual knowledge both of the circumstances that give rise to the warranty claim and of the fact that such circumstances would reasonably be likely to give rise to a warranty claim. In turn, the Policy excluded liability for loss to the extent that it arose out of any breach of the SPA of which any transaction team member had actual knowledge.

On the evidence, the court concluded that one of the transaction team (R) was aware of the price reductions, and rejected R's evidence that he was unaware of the terms of the SPA. The Court accepted that actual knowledge included deliberately ignoring something to avoid knowing that information (commonly called "Nelsonian blindness"). In this instance, R had sufficient information available to him for the knowledge exclusion in the SPA to apply.

Loss

On the evidence, the Insured was clearly desperate to conclude the deal, and had agreed the price at £20m irrespective of any changes in the circumstances of the Target in the lead up to completion of the deal. This was the price required to persuade the seller to sell. As a result, even if there had been a breach of an applicable representation or warranty and the prior knowledge point did not apply, the Insured had not suffered any loss as a result since it would have paid the same price for the Target in any event.

Quantum

To value a breach of warranty claim it is necessary to calculate the difference between the "as warranted" value of the target and the actual value. There was little need to analyse the quantum given the conclusions reached above. But the Judge did state that:

• he preferred to use the EBIDTA and multiplier values reviewed by the parties at the time of the deal, rather than those produced by the experts after the event, as the basis on which to calculate the Target's value;

• the actual valuation of the Target at the time was in line with the theoretical valuations any way; and

• if, despite everything said above, there had been a breach of warranty that caused loss, the quantum of the Insured's claim would have been calculated as the reduction in sales caused by the change in the matters warranted. This was because the purchase calculation was "clearly agreed at 1x sales". Therefore the "loss" would be assessed on that loss of sales basis.

Comment

This decision is as a useful reminder of the purpose and scope of cover provided by W&I policies. W&I insurance serves to protect buyers and sellers against the consequences of inaccurate representations and warranties in SPAs. It also helps to facilitate the conclusion of deals and provides reassurance for those entering M&A deals that they have appropriately protected their own and other stakeholder interests. But these policies do not, and are not intended or designed to, protect parties simply against  the consequences of making a bad bargain. To extrapolate the Judge's comment on the SPA, "[W&I Insurance] is not intended to be a panacea to resolve any unforeseen consequences of Finsbury's admittedly light touch approach to due diligence...". Nor is it intended to replace business as usual insurance such as cyber insurance, PI insurance or general liability insurance.

It is also significant that the knowledge exclusions applied. Insurers are not expected to cover issues known to the relevant people prior to the deal being concluded. It will be for the insurer to prove, on the balance of probabilities, that the knowledge exclusion applies. But the relevant team members cannot simply ignore, or "turn a blind eye" to pivotal information in order to ring fence themselves from potentially troublesome knowledge in the future.  In this case, the knowledge exclusion required knowledge of two elements. It was not just knowledge of the circumstances. It was also knowledge of the fact that those circumstances would be reasonably likely to give rise to a claim for breach of warranty under the SPA.

This is different from a standard knowledge clause that applies to knowledge of circumstances that are likely to give rise to a claim. In this latter case, knowledge of the circumstance is required but not knowledge of the fact that it is likely to give rise to a claim (that being an objective question). Under the SPA in this case, insurers were required to show that R had knowledge that the matters in question were reasonably likely to give rise to an SPA claim. However, an Insured cannot simply say that the relevant person ignored or did not read the SPA and automatically rely on that as a defence, if this amounts to a wilfully refusal to review material provided or available. In this case, the Court considered that the relevant knowledge threshold had been met.

Furthermore, if a deal was always going to conclude at the price agreed, irrespective of the accuracy of a particular representation or warranty, it is highly unlikely that any claim based on a factual breach of that representation or warranty down the line will ever be successful. The Insured has, in that case, suffered no loss. And loss remains a pre-requisite of any indemnity policy.