Impact of the Ukraine war on the coverage of liability risks in the context of M&A transactions by W&I insurances

A. Initial situation

Since 24 February 2022, Russia has been attacking targets throughout the territory of Ukraine without a formal declaration of war. After the Russian armed forces failed at the beginning of the war to permanently occupy the capital Kyiv and parts of Ukraine further west, the fighting is currently concentrated in eastern Ukraine. It is unclear what Russia’s current war aims are based on the course of hostilities to date, as these have been associated with significant losses for the Russian armed forces and the original goals have not been achieved. In view of the course of negotiations to end the war so far, it is likely that hostilities will continue for some time.

In response to the war of aggression, which Russia continues to describe as a “special military operation”, the Western community of states has initiated massive economic sanctions in addition to arms deliveries, and sanctions up to and including a far-reaching embargo on raw materials are in the offing.

The sanctions and public pressure in the West have led to a massive exodus of Western companies from Russia, which is not limited to sanctioned sectors. Production in Ukraine is currently substantially affected by the hostilities and a further collapse of production is to be feared. In addition, there has been a massive exodus from Ukraine, which also has an impact on local production capacities. At the same time, the war is causing restrictions on air and sea travel. As a result, global supply chains, which were already strained by the effects of the Covid-19 pandemic, have once again come under severe pressure.

The war in Ukraine is hitting a market environment that is increasingly characterised by inflationary tendencies and an associated turnaround in interest rates. At the same time, the market for corporate transactions is relatively stable and remains characterised by investment pressure on the buyer side and the resulting high company valuations and seller-friendly contractual arrangements. In this market environment, a far-reaching shift of liability risks from the warranty and indemnity regime of the transaction documentation from the seller to W&I insurers has been taking place for some time.

As a result, the extent to which the effects of the Ukraine war can be covered using W&I insurance solutions is relevant if these risks are assigned to the seller within the warranty catalogue and corresponding warranties are to be the subject of an insurance solution.

B. Impact of the Ukraine war on M&A transactions in general

The warranty regime of the transaction documentation leads to an allocation of risks to the seller to the extent of the seller’s representations unless exclusions of liability under the respective warranty regime apply. The representations are made as of a specific date – usually the date of signing and the date of execution of the transaction documentation – and are subject to certain exclusions of liability.

The impact of the Ukraine war on individual M&A transactions is therefore first influenced by the progress of the transaction, i.e. whether signing and/or execution had already taken place at the start of the hostilities. In addition, the nature of the effects is of paramount importance for assessing whether the risks are generally covered by a standard market warranty regime and whether the seller can exempt itself from liability in this respect under the contractual warranty regime.

C. Transaction progress as a starting point for the analysis of warranty-related risks and response options

Insofar as transactions were signed and completed before the start of the Ukraine war, effects under the warranty promises are rather unlikely, as the time reference points of the assurances are before the start of the hostilities.

If transactions had already been signed at the start of the hostilities but not yet completed, the situation is more complex. If, on the other hand, the parties want to stick to the transaction, the question for the seller is whether he is liable for the effects of the Ukraine war under the warranties relating to the date of completion and how he can exclude such liability as far as possible within the fixed contractual framework. Frequently, however, buyers will probably not want to stick to the transaction due to the changed environment and will try to get out of the transaction. In this respect, the circumstances of the individual case will be decisive, but it does not seem impossible – especially if a MAC / MAE mechanism is agreed as part of the transaction documentation – that the buyer will be able to terminate (or at least adjust) the transaction documentation.

The impact of the Ukraine war is fully felt if the transaction has neither been signed nor completed. In such a case, however, the parties have the option of addressing the relevant effects through the warranty regime and the due diligence process.

D. Differentiation into direct and indirect effects of the war in Ukraine

The manifold effects of the Ukraine war on the legal and factual circumstances of target entities are not always likely to be fully grasped and are, by their nature, rather dynamic. Nevertheless, a general distinction can be made between direct and indirect effects, whereby the boundaries are often likely to be blurred. However, the identification of specific effects of the Ukraine crisis within the warranty regime is likely to be easier the more directly the connection to the acts of war and the reactions to them is.

This distinction is relevant above all because a sufficiently clear description of the concrete effects and risks forms the basis for proper treatment within the framework of transaction documentation and the transaction process.

Diffuse general risks, for example, can by their nature only be covered to a limited extent by contractual provisions at the level of the warranty regime and the disclosure and due diligence process, while clearly defined risks are in principle amenable to regulation by the parties within the warranty regime (and potentially to an exemption for known risks). In addition, this concerns in particular the disclosure of warranty-relevant facts with a correlating disclaimer, which presupposes that the relevant circumstances of a disclosure are accessible in accordance with the disclosure standard of the transaction documentation, i.e. in any case not merely identifiable in a completely abstract manner.

E. Scope and limits of coverage for possible risks within the scope of W&I insurance

These statements are at the same time relevant to the scope of insurability, as the coverage exclusions of W&I insurance typically only cover the immediate effects of the Ukraine war.

I. Limits of insurability from general exclusions of cover

Limits to the insurability of risks related to Russia and Ukraine are regularly discussed if target companies have subsidiaries there or have substantial sales in these countries.

Even before the Ukraine war, W&I insurers were reluctant to underwrite risks in or related to Russia. This was mainly due to concerns about existing sanctions. Nevertheless, in individual cases it was possible to structure insurance solutions for transactions involving Russia.

With regard to Ukraine, there were also many concerns about insurance coverage, which, however, had their origin primarily in reservations about local business practices. However, insurance coverage was regularly possible in individual cases if certain requirements for the transaction were met.

Since the start of the Ukraine war, various coverage exclusions have now gained relevance, the content of which largely relates to the direct effects of the Ukraine war and excludes certain losses from insurance coverage.

1. Coverage exclusion for disclosed facts

The W&I insurance only covers unknown and undisclosed matters, which is reflected in the coverage exclusion for disclosed matters. However, this coverage exclusion is likely to be relevant mainly for direct impacts of the Ukraine war, as indirect impacts are not sufficiently ascertainable to be disclosed under current fair disclosure concepts. This may change as developments progress and the concrete implications of the war in Ukraine are increasingly understood, but currently there is massive uncertainty in many respects combined with strong dynamics of the situation, which cannot (yet) be satisfactorily addressed by a disclosure process.

2. Territorial coverage exclusions

Ever since the annexation of Crimea by Russia in violation of international law, W&I insurance policies have contained exclusions of cover for circumstances relating to the annexed territories in Crimea and the areas in eastern Ukraine affected by fighting by pro-Russian separatists. These coverage exclusions have been applied in a modified and extended form since the beginning of the Ukraine war. As a result of this exclusion of cover, there is no insurance coverage for damage with a geographical reference to the areas covered. However, due to the requirement of a reference to the conflict area, the exclusion of liability is basically limited to direct (local) consequences of the Ukraine war.

3. Coverage exclusions for armed conflicts

Most W&I insurance policies provide for an exclusion of cover for losses in connection with war or armed conflict. This is certainly the case for Lloyds Syndicates. The wording and the scope of application of the coverage exclusions are currently being adjusted in many cases on the occasion of the Ukraine war, but essentially concern direct effects of hostilities.

4. Sanctions

All insurance policies contain provisions on compliance with existing sanctions, although the scope of possible insurance coverage varies. While some W&I insurers explicitly exclude sanction-related warranties from coverage, other W&I insurers are generally open to the insurance of sanction-related warranties but link the obligation to indemnify to the payment to a beneficiary not affected by sanctions. Compliance with existing sanctions on the part of a target company is thus not consistently excluded from possible insurance coverage.

5. State expropriations

The possibility of state expropriation of foreign assets within Russia has been raised in various contexts. The corresponding risks have led some insurers to include a general exclusion of cover for expropriation transactions. These partly go beyond Russia and also affect Belarus and Ukraine.

6. Special case: Insurance cover in case of theoretical possibility of contract termination

In previous insurance practice, the occurrence of a contractually defined Material Adverse Change / Material Adverse Event is not a reason for termination of the W&I insurance, but the obligation to indemnify is regularly excluded - with reference to obligations to mitigate loss. This means that the W&I insurance can be continued despite the occurrence of MAC / MAE, but the insured warranties cannot compensate for the effects of MAC / MAE. This must be taken into account when drafting the contract by suitably tailoring or waiving the corresponding mechanisms. For without a corresponding provision, a limitation of cover under the W&I insurance is hardly a possibility.

II. Hedging of relevant effects of the Ukraine war under a standard market warranty catalogue

As a general rule, effects of the Ukraine war are insurable under the warranty regime and the general coverage decisions of the W&I insurer.

In view of the dynamics described the insurance cover for indirect effects – especially under general clause-like warranties – can be quite extensive, while cover for direct effects will often be subject to one of the coverage exclusions described.

In the following, without claiming to be exhaustive, some of the risks that will usually be covered by the insurance coverage will be examined in more detail:

a) Fundamental warranties

The focus of the usual fundamental warranties is on the assurance of the seller’s legal capacity and authority to enter into and complete the transaction, the enforceability of the transaction documentation, the absence of conflicts between the transaction documentation and the seller’s legally binding obligations, and the seller’s unencumbered ownership of the object of purchase.

With regard to the assurances regarding the seller, the enforceability of the transaction documentation and the absence of a breach of legally binding obligations of the seller, a breach of warranty in transactions related to Ukraine and/or Russia seems conceivable in particular as a consequence of new sanctions that directly prohibit the intended transaction or at least indirectly make it impossible (in particular also with regard to the settlement at the level of the purchase price payment, which may become impossible due to sanctions). In such a case, depending on the existence and design of a coverage exclusion for sanctions, claims against the W&I insurance are likely to be possible.

If the subject of the transaction are shares in Ukrainian and/or Russian companies (and no sanctions intervene), there is a risk of expropriation. Unless this risk is addressed by an explicit exclusion from cover, a formal expropriation (including a forced sale below market value) may result in an insured loss. This is particularly true if relevant facts arise after the signing date and the transaction documentation does not include a bring-down to the closing date and a MAC clause.

In these cases, the buyer will regularly be able to claim the positive interest, or at least the costs of the failed transaction.

b) Real estate

The liability of the W&I insurance for property-related warranties is generally excluded if the properties are located in Ukraine or Russia, as area-related coverage exclusions are likely to apply in this respect. In contrast, in the case of direct and indirect acquisition of domestic real estate from a Russian or Ukrainian seller outside the scope of sanctions, a customary warranty regime should be insurable without restriction, so that the risk of enforcement of warranty claims in Russia or Ukraine can be avoided here using W&I insurance.

c) Financial statements

The material accuracy of financial statements as of 31 December 2021 will not be affected by the Ukraine war in principle, as it did not begin until after the balance sheet date. In contrast, the development in the 2022 financial year will certainly lead to challenges in the preparation and audit of the annual financial statements, depending on the sector, especially in areas of accounting that require prognostic assessments and estimates based on preliminary information. Overall, the uncertainties are not likely to be limited to the currently predominantly affected areas of the energy sector and the food industry but are also likely to affect other sectors due to the manifold effects of the war. In particular, the aforementioned uncertainty factors condense within the framework of the management report, whereby this (to the extent that it exists) is in many cases not likely to be part of the definition of the insured financial statements because of these very risks. In contrast, a coverage exclusion for forward-looking statements and forecasts (if any) will regularly not intervene due to its design, as the forecast elements are not explicitly part of the wording of the warranty itself.

d) Material contracts

The most probable effects of the Ukraine war in the context of customary warranty regimes are likely to concern the warranties on material contracts of the target entities, especially since these do not presuppose a direct context to the war. At the same time, the indirect effects of the Ukraine war – especially price increases and disruptions of supply chains – tend not to be covered by the exclusions of cover provided so far. Thus, in addition to the direct effects of sanctions on the existence and enforceability of material contracts, which – depending on the insurer – may well qualify as an insured loss, there is above all insurance coverage for (undisclosed) indirect effects. This concerns statements on the absence of disruptions in the supply chain, the availability of alternative suppliers for input products at comparable conditions, termination rights due to a significant change in the market environment, as well as statements on the absence of circumstances that are likely to cause a breach of contract or otherwise give rise to disputes between the parties.

Whether and to what extent disruptions of performance are used by the contracting parties to withdraw from essential contracts or to enforce claims for damages is questionable due to the general effects. In this respect, the effects of force majeure clauses in the respective contracts must also be considered in individual cases, which are currently the subject of extensive discussions. In general, it can be assumed that force majeure clauses only take effect if an unexpected event occurs. Particularly in the case of material contracts that were only concluded after the start of the war, recourse to such clauses is questionable.

e) Ordinary Course of Business

With regard to the statements on an orderly course of business since the last balance sheet date, which are common especially for transactions with locked-box purchase price models, the situation is also complex. Business models are likely to be affected differently by the Ukraine war, while indirect effects influence a large number of business models. In this respect, insured breaches of warranty come into consideration if the corresponding risks have affected the course of business. Thus, disclosure and examination in the course of legal and financial due diligence are likely to capture relevant risks rather difficultly due to the only preliminary information basis and the very diffuse effects. In this respect, the situation is comparable to the dynamics in the early stage of the Covid-19 pandemic. Here, relevant risks were often generally excluded from the scope of the warranties because proper disclosure was not possible. It remains to be seen whether this will also happen in a similar way with regard to the Ukraine war.

f) Litigation

The risk of legal disputes is substantially increased, in particular, by possible performance disruptions in the area of material contracts. In addition, the predictability of possible disputed circumstances is greatly impaired by the complexity of the effects of the Ukraine war. Insurers will therefore be increasingly reluctant to insure warranties on the absence of circumstances that may give rise to litigation without appropriate restrictions.

g) Compliance

In the area of compliance, the unpredictable introduction of sanctions and compliance with sanctions by the target entities are particularly relevant. Depending on the approach of the insurance, a breach of sanctions by the target company can lead to an insured event if cover has been obtained for the relevant compliance warranties and only prohibits a payout to subjects affected by sanctions, but cover is not excluded entirely.

h) IT / Cyber

The Ukraine war is increasingly also being fought in cyberspace through hacker attacks. Insofar as the target companies have taken out cyber insurance prior to the Ukraine war, it may therefore make sense to use W&I insurance as a top-up to cyber insurance. However, at least sector- and jurisdiction-specific restrictions on insurance coverage must be assumed, since warranties on the adequacy of IT infrastructure and IT security, as well as the absence of incidents in the area of IT security, involve massive risks that make insurance claims likely within the scope of the hitherto customary coverage as an extension of existing cyber risk policies.

i) Insurances

As a rule, the existence of insurance policies is not directly affected by the war in Ukraine. It should be noted, however, that property insurance policies of the target companies contain extensive exclusions for wars and armed conflicts. This may well lead to insured events under the W&I insurance if the warranty regime contains statements on the coverage of corresponding losses. At the same time, the possibility for the W&I insurer to refer the buyer to the existing property insurances within the framework of the basic subsidiarity of the W&I insurance is severely limited as a result of this state of affairs.

F. Summary

The effects of the war in Ukraine are complex and affect various aspects of standard market warranty regimes. Many of the direct effects are excluded from possible insurance coverage under W&I insurance by specific exclusions. However, there remains a wide range of risks resulting from indirect effects of the Ukraine war that remain accessible to insurance coverage and are of high practical relevance. The W&I insurance is thus a suitable tool to cover unknown risks and intangible effects of the Ukraine war – this, incidentally, corresponds to its essence.