APRA calls time on M&A indemnities for customer remediation

As major financial institutions work through the backlog of divestments of their “non-core” assets following the fall-out from the banking Royal Commission, APRA’s latest guidance on M&A indemnities has raised significant questions on the risk allocation between buyers and sellers for historic conduct and customer remediation liabilities – with impacts on both live and completed deals.

APRA has come out this week to say:

“While indemnities are not a new feature of merger and acquisition activity, their scope and nature appears to be shifting in focus, particularly as entities manage matters of conduct and customer redress. Without appropriate controls, these indemnities can expose ADIs [Authorised Deposit Taking Institutions] to potentially significant liabilities.”

Whilst significant deals in this space all have bespoke structuring around the allocation of the risk that the business (be it insurance, superannuation, wealth management, underperforming or sub scale loan portfolios) will need to compensate consumers in the future for historic conduct, compliance or regulatory breaches, a common theme is that the seller provides a robust (often uncapped) indemnity to the buyer to cover those liabilities.

In some cases, the conduct and remediation liabilities are transferred out of the sale vehicle and back to the seller as part of a pre-completion restructure (and the seller provides an uncapped restructure indemnity to the buyer), and in other cases the seller provides a classic specific indemnity to cover the buyer for these liabilities (over and above any existing balance sheet provisioning). Such specific indemnities have, in a number of recent transactions, been uncapped as to quantum but they are usually limited by time, extending only to issues that are discovered by the buyer in the several years after completion of the transaction occurs.

Warranty and indemnity (W&I) insurance has a role to play in limiting the exposure of participants to these transactions, but there are some limitations. W&I insurers are approaching financial institutions deals with caution, conscious of the potential quantum of claims linked to remediation and conduct liabilities. In addition to standard limitations in W&I policies (such as for any known issues), W&I insurers are adopting a conservative approach to such issues, so its’ utility in smoothing risk allocation debates between buyers and sellers is limited to very specific circumstances only.

The practical implications of APRA’s guidance for M&A deals are:

• Remediation indemnities need to be capped by quantum as well as limited by time – in contrast to a number of recent transactions that included uncapped remediation indemnities;
• Remediation indemnities need to be more specific – rather than the seller providing blanket coverage for regulatory issues, the indemnities need to drill down into the specific source of the exposure (e.g. a breach of licence conditions or a breach of responsible lending practices) and have bespoke limitations attached to them that reflect the potential exposure under each risk;
• Bespoke provisioning will be required by the seller for the exposure under the indemnity, not just for the known issues that already have balance sheet provisioning, which will pose a complex actuarial challenge. APRA have flagged that they are looking at relevant deals with uncapped broad remediation indemnities to assess whether the seller needs to hold additional operational risk capital;
• Internal procedures for deal teams negotiating these remediation indemnities may need to be bolstered by independent expert advice as to the likelihood and eventual amount of any claims under the indemnity, including by reference to the experience of peer organisations in equivalent litigation.

These practical implications have financial institutions’ M&A teams scrambling to assess the value impact of their exposure to having to hold additional regulatory capital, and looking closely at the scope of indemnities on deals signed off months ago. The APRA guidance will also have a value impact for both live and completed deals that will need to be carefully assessed.