Most of us don’t realise how complex legal work can be when it comes to purchasing commercial real estate. Lawyers spend long hours working on due diligence, presenting issues to the client, drafting and negotiating contracts, obtaining consents and approvals – and we do many other things of greater or lesser interest and importance. When parties finally reach an agreement and the transaction is signed, the champagne corks fly and everyone relaxes. But that does not mean the transaction is completed once for all. Sometimes discussions have to reopen.
As in every transaction, not only in real estate, there may be some post completion discussions, or even disputes, between the parties. Most often, the purchaser raises claims against the seller, stating that some contractual warranties were not true, or there were other issues which popped up after the transaction closed. In the old days the seller would have ensured that one of its parent entities would provide proper guarantees securing such claims. In recent years, however, the market has deviated from that and corporate guarantees have been successively replaced by transaction insurances such as title insurance or warranties and indemnities insurance (W&I insurance).
But what exactly is transaction insurance and why would you need to use it? In a nutshell, transaction insurance is a contract between the insurer and the purchaser under which the insurer effectively takes over certain post-closing liabilities of the seller. Such insurance allows the seller to exit from the investment with a “clean” account, with no residual risks, while the purchaser believes it is protected at least as well, as if the seller remained part of the deal.
A closer look
In real estate transactions there are usually three different transaction insurance products: title insurance with respect to the property, title insurance with respect to shares in the property owning vehicle, and W&I insurance. In some cases there is only title insurance, in other cases, it is a bit of both: title and W&I insurance. Title insurance is in fact an abstract guarantee stating that in case the title holder loses the title (either to the property or to the shares in the property-owning company), the insurer would compensate the loss. It is a guarantee quite general in nature and will (or at least should) work regardless of the seller’s contractual liability. The W&I insurance works differently, as it mirrors the seller’s liability under the purchase contract. So in case the seller is guaranteeing that certain warranties relating to the property are true, the W&I insurer assumes the seller’s liability in the same shape (again – legally W&I insurance is a third party guarantee contract and not a defined insurance policy).
These days, a fair amount of transactions are designed to be based on insurance. The sellers want to have a quick and clean exit and not spend time and money discussing the post closing liability regime. This I can understand, and indeed such transactions are usually slightly faster as the lawyers do not spend time on warranties and liability related provisions, knowing that “it will go under insurance anyway.” The lenders are also happy to see the title or W&I insurance instead of either seller’s guarantee or the seller resolving issues. Transaction insurance has become an institutional grade transaction product. But does it actually deserve to be?
From my perspective as a transaction lawyer, I have a feeling that we sometimes give up important things too quickly, with that notorious statement “we are getting insurance anyway,” in mind. People believe that everything can be insured and that whatever risk is identified, they can just call the insurer and try to cover this with the title policy. But this should not (always) be the case. In some instances, lawyers should not agree too quickly on insurance and should rather expect certain issues to be resolved by the seller before the transaction is completed. And the seller needs to accept that. In the end, the client wants to buy real estate that operates, and not real estate that has issues which can be insured. I don’t think anyone has heard about a situation in which a transaction insurer would have to pay out full compensation. We need to remember that the real estate transaction is predominantly carried out between two parties; the seller and the purchaser. Introducing a third party such as an insurer may of course be beneficial but should be a “last resort” rather than a “first call.” Otherwise, neither the seller nor the purchaser will feel fully responsible for the transaction and the risks which it may create.