Dealing with product liability risks in M&A transactions

Product liability risks can become a significant financial burden in M&A transactions. A comprehensive understanding of these risks and an appropriate risk assessment are essential. This post examines how to deal with product liability risks within the framework of M&A transactions.

1. What are the risks under the Product Liability Directive?

1.1 Draft Product Liability Directive

On 28 September 2022, the European Commission published a proposal for a new product liability directive (Product Liability Directive). The proposal foresees stricter rules for manufacturers, quasi-manufacturers, importers, authorised representatives, fulfilment providers, retailers, and operators of online marketplaces in the EEA. You can find a detailed introduction to the Directive in a post by André Depping and Katharina Pöhls.

1.2 Wider scope

The new Directive will extend the personal and material scope of the current Directive and apply the thumbscrews much more tightly for entrepreneurs.

Under the current Directive, only manufacturers, quasi-manufacturers, and importers active in the EEA are strictly liable for defective products. The new draft extends the potential defendants to include authorised representatives of the manufacturer, fulfilment providers, retailers, and, under certain conditions, even operators of online marketplaces. Companies that substantially modify a product will also be liable when the modified product is defective and causes damage. In this case, the statute of limitations will restart.

The proposal expands the scope of products covered by the Directive to include software and digital production files, such as data for 3D printers. It will also include products integrated into another product (such as navigation systems).

1.3 Defectiveness and digital components

In addition, products will be considered defective when they fall short of the safety standards the public expects. That is why product safety law standards will be taken into account when determining whether a product is defective. Increasingly, the focus is on cybersecurity. As a result, software may need updating where possible.

1.4 Start of the Statue of Limitations

The proposal also changes the start of the statute of limitations under product liability law. In the future, placing the product on the market will not alone be decisive; the possibility to control the product after it is placed on the market will also be considered. This meshes with the relevant monitoring and maintenance obligations. The M&A process must give special consideration to this change to the statute of limitations particularly when performing due diligence.

1.5 Relaxing the burden of proof and discovery

Further, the burden of proof is extended to help claimants with presumptions when there is an obvious defect in the product under normal use. In addition, there is an obligation to provide any evidence the claimant needs to assert their claims, such as construction documents or documentation about the monitoring of the product placed on the market.

1.6 Extension of the type of compensatable damage

Further, an important aspect of the draft is the expanded definition of damage, which now includes the loss and corruption of data and removes the thresholds for maximum liability and excess. Liability for digital products will continue to apply where the software was defective when it was placed on the market and can later be remedied by a software update.

2. Which protective instruments are there?

Product liability can play a significant role, especially in the automotive, food, and consumer goods industries due to the high level of damages and the effect on the company’s reputation. The risk is extremely industry-specific and depends on both product and location. The increasing impact of the Product Liability Directive on the digital sector should not be underestimated either.

The following outlines the options available in M&A transactions to protect against claims under product liability law.

2.1 Provisions in the sale and purchase agreement (or share purchase agreement)

The vendor’s representations and warranties (“guarantees”) are a central element of the sale and purchase agreement and are often the focus of negotiations. The interests here are essentially clear: while the vendor would prefer to provide as few guarantees as possible, the purchaser has an interest in obtaining as many guarantees for as many aspects as possible from the vendor so that the purchaser can turn to the vendor for any undisclosed risks.

As product liability can present a significant risk for companies – depending on the sector –vendors normally provide guarantees for claims under product liability law in the contract. However, guarantees usually protect against unknown risks, while specific indemnities distribute known risks. Any circumstances relevant to the guarantees the vendor discloses to the purchaser prior to the conclusion of the contract are typically excluded from the warranty.

A far-reaching product liability guarantee, which ensures the economic risks for all products produced and distributed up to closing remain with the vendor, would protect the vendor against such risks under product liability law.

Variations are also conceivable, where the vendor only guarantees that there are no further product liability cases other than those known and disclosed. In so doing, the risk of dormant product liability claims would transfer to the purchaser. This is then a variation of a limited product liability guarantee.

To the extent that the parties negotiate a product liability guarantee, it is advisable to agree to a longer limitation period for product liability because such cases generally only arise after a delay.

The target company’s reserves for product liability cases must also be considered. The amount of any reserves influences more than the purchase price; where the built-up reserves are appropriate, the vendor may not assume a guarantee in product liability cases.

Where specific indemnities are provided, the question is to what extent they cover product liability claims. Specific indemnities generally only release the vendor where the parties are aware of all the risks of the target company, but there are uncertainties concerning the claims arising and the amount of any claims. Normally, the vendor will indemnify the purchaser against all tax claims and environmental damage. In contrast, such indemnification rarely – in fact, almost never – applies to product liability.

Finally, a due diligence assessment of the target company can help identify existing or imminent product liability risks. The results of the assessment form the basis of product liability representations and warranties and/or indemnities in the sale and purchase agreement. While it is not always possible to predict the extent of product liability from the technical assessment of the products produced or placed on the market, legal due diligence of customer agreements can help better assess the product liability risks. Primarily, the assessor identifies the contracts with the most important customers and analyses the relevant contractual clauses. The following aspects are of particular importance:

  • Is the description of the product or service sufficiently specific to avoid uncertainty in cases of breach of contract?
  • Do customer contracts contain a limitation of liability?
  • Have any clauses limiting liability been effectively agreed and would they withstand judicial scrutiny in the case of dispute?
  • Has the target company assumed strict liability product guarantees and, if so, for what period?
  • Does the contract cover serial damage?
  • Special attention should be paid to the general terms and conditions of the target company, as their effectiveness is subject to strict legal requirements. If the target company has concluded numerous consumer contracts, the hurdles for any limitations of liability in the general terms and conditions to be effective are particularly high.

  • With respect to the extension of the scope of personal use, the Product Liability Directive will also need to be assessed to see whether any significant adverse differences between the risks of liability borne by the target company and possible third-party claims exist.

2.2 Minimisation of liabilty through an asset deal

If the due diligence assessment reveals significant product liability risks facing the target company, an asset deal could be an alternative way to transfer the company. In this case, not the shares but the assets of the target company are transferred (e.g., the ownership in immovable and moveable property of the fixed and current assets). The contractual relationships do not automatically transfer. This can be an advantage where there are potentially serious risks under product liability law for the purchaser.

2.3 Product liability insurance

If the vendor is not willing to provide any guarantees, the purchaser can take over the product liability insurance of the target company or conclude new product liability insurance to ensure sufficient protection.

To minimise claims for product liability, companies can take out appropriate insurance policies to cover product liability and the costs of product recalls. The product liability model provides insurance protection for damage, caused in particular by products manufactured or supplied by the policyholder. This covers claims under the product liability law and damages for manufacturer liability under tort law.

Product liability insurance is an extension of business liability insurance and has been available since 1970. It is constantly adapted to market circumstances (1987, 2000, 2002, and 2008). These adjustments were necessary to account for developments in jurisprudence related to product liability and the modernisation of tort law. It remains to be seen whether product liability insurance will be adjusted again to account for the changes introduced by the Product Liability Directive.

Product liability insurance builds on the Insurance Contract Act (§ 102 of the VVG) and covers both damages to persons and property and consequential loss (unechte Vermögensschäden). The product liability model is just a separate insurance model, which is why the general conditions of third-party liability insurance (AHB) might apply where there are insurance law issues. Accordingly, in addition to the special provisions for product liability insurance, the special rules on exclusions in the AHB should be considered as they could affect product liability insurance.

The production programmes and activities covered by insurance protection should be recorded in as much detail as possible in the insurance policy. This helps both the policyholder and the insurer because it will be clear which production risks the insurer assumes. The detailed description should leave enough room for developments in the operational activities of the policyholder.

As regards guarantees and insurance, it is important to ensure an existing warranty does not diminish the purchaser’s interest in sufficient insurance protection for the target company. However, the guarantee in the sale and purchase agreement is subsidiary to existing insurance protection.

As a rule, the vendor normally provides a guarantee for the existence of the insurance policy disclosed during the due diligence investigation. It is therefore customary to list policies in detail in an annexe to the sale and purchase agreement. In addition, the vendor should guarantee the policies offer the level of protection customary in the sector, the premiums have been paid, there are no (unobserved) conditions which could jeopardise the insurance protection, and no other conditions which could cause the insurance protection to lapse.

In the case of group structures, the target company will generally not be insured directly but under an umbrella insurance policy that applies to various companies within the group. Where this is the case, the purchaser should pay special attention to whether the group insurance (subject to short transitional periods) ends with closing and ensure appropriate follow-on insurance is concluded.

2.4 W&W insurance

2.4.1 What is warranty and indemnity insurance?

In certain circumstances, W&I Insurances (Warranty and Indemnity) can provide a remedy in the case of claims under product liability law in M&A transactions. This insurance provides cover for the parties involved in the transaction for unknown risks because of the past activities of the target company.

In an M&A transaction, the vendor will provide certain guarantees with respect to the target company. These guarantees give the purchaser information about the status of the company and the possible liability risks. To secure both parties and accelerate the M&A process, it can make sense to conclude W&I insurance. The purchaser profits from the additional protection and having a solvent opposing party, while the vendor may be able to obtain a higher sale price for the target without assuming liability.

Generally, the W&I insurance policy is adjusted to suit the transaction. The premium will depend on the size and complexity of the deal. So-called purchaser insurance is now popular.

For the purchaser, guarantees should cover major risks. As W&I insurance works on the basis of the balance sheet on the effective date, forward-looking warranties (such as specific target turnover) are exempted. In addition, liability in the case of purchaser knowledge of disclosed circumstances, penalties and fines, pension obligations, environmental damage, and tax matters are excluded as a standard. In practice, most W&I insurance also excludes damages from product liability on a “deal-specific” basis (considering the specifics of the sector and product).

Take particular note of the definition of “product liability” in the insurance policy. Often, insurers will define “product liability case” as broadly as possible to exclude their liability in such cases. The definitions of product and product liability in the new Directive reflect such a dynamic definition, which is also used as a basis for insurance policies. This can sometimes disadvantage the policyholder if they are not vigilant.

2.4.2. W&I insurance and product liability

As explained above, W&I insurance often does not cover product liability. This is due to the nature of W&I insurance and the fact that purchasers often perform no or insufficient technical due diligence. A strategic investor will carry out such an assessment to conclude an appropriate, tailored W&I policy with the insurer in their own interests, based on the information gained.

Nonetheless, W&I insurance can offer an additional safeguard against product liability law claims. One possibility lies in taking out “top-up cover” as part of the W&I insurance. In this case, the top-up cover will be connected to an existing product liability insurance and increase the sum insured under that basis insurance. This will account for a possible breach of warranty resulting in an insurance claim under product liability insurance with damage exceeding the sum insured under the product liability insurance. W&I insurance will cover that amount of the claim which exceeds the sum insured under product liability insurance.

2.4.3 Litigation buyout insurance

Another way to insure against product liability risks in an M&A transaction is litigation buyout insurance. This allows the parties to distribute risks from potential or ongoing legal disputes. The risks can relate to the outcome of a dispute or the sum of damages and compensation awarded, and to known legal disputes or a “package” of possible legal disputes or demands. Legal costs, including lawyers’ fees, can also be insured. It is also possible to take up appeal hedges, which allow the policy-holding purchaser to insure the advantages of a favourable judgment against the possible annulment on appeal when, at the time of the deal, the judgment has only been rendered at first instance.

3. Summary

The risks of a claim under product liability law will significantly increase with the implementation of the new Product Liability Directive. There are various ways to protect against such risks in an M&A process. In addition to thorough legal and technical due diligence, which should form the basis for a transaction with a high-risk target company, the purchaser can also ask for guarantees or take out product liability insurance. W&I insurance, with top-up cover or litigation buyout insurance, can be a sensible addition to the insurance suite.

Tassilo Klesen
Olga Prokopyeva


Produkthaftung Produkthaftungs-RL Due Diligence

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Tassilo Klesen T   +49 30 26471-351 E
Olga Prokopyeva T   +49 30 26471-351 E