Synthetic warranties in W&I - a natural progression?

Synthetic warranties in W&I - a natural progression?

Business Interruption Insurance and COVID-19

The use of warranty and indemnity (W&I) insurance in M&A deals has grown in popularity in recent years, particularly in private equity exits. However, COVID-19 could be the catalyst to spark the growth of more innovative W&I products, such as the use of synthetic warranties.

When a business is sold, W&I insurance is often put in place to provide cover for losses arising from a breach of the warranties contained in the sale and purchase agreement. In the event of a warranty claim which is covered by the policy, typically the seller (although in some cases, the buyer) would be liable for the excess under the policy, with the policy then stepping in to cover the buyer’s losses up to the insured amount. Leaving the seller with some “skin in the game”, in terms of its exposure to the policy excess, has generally been considered appropriate to help ensure a more thorough and robust seller disclosure process for the benefit of the buyer and the W&I insurer.

However, as an alternative to this structure, synthetic warranties – which are not provided by the seller under the share purchase agreement but are negotiated and agreed directly between the purchaser and the W&I insurer – are increasingly being offered by W&I insurers to help facilitate deals happening where the seller is unwilling or unable to provide any direct warranty cover to the buyer.

Where the insurer agrees to include synthetic warranties, the warranties are contained in a schedule to the insurance policy rather than in the sale and purchase agreement and, in the event of a breach of warranty, the buyer pursues the claim directly against the insurer. This can arguably lead to a disconnect during due diligence between the seller’s interest in selling the business for the best price (in the knowledge that it is not exposed to traditional warranty claims) and the insurer’s interest in uncovering any issues which could affect coverage under the policy.

Synthetic warranties are not a new concept, but have previously been offered by insurers in very limited circumstances. With the landscape changing as COVID-19 shockwaves continue to reverberate through the global markets, the rise in the sale of distressed businesses by insolvency practitioners may well change the status quo. Insolvency practitioners may be unwilling to provide any warranties at all, even on a nominal or nil recourse basis. In addition, even if the target does have an experienced management team, they are unlikely to give any warranties if their equity interests in the business are “under water” and therefore worthless. In these scenarios, synthetic warranties could be an attractive option to both the buyer and the seller.

The area where synthetic cover is more commonly seen at the moment is in respect of tax issues. It is standard in M&A transactions in the UK for a seller to indemnify the buyer, on a £1 for £1 basis, for tax liabilities of the target that relate to the period up to completion. Purely synthetic tax deeds (i.e. protection negotiated directly between the buyer and W&I insurer) have been seen in the private equity M&A market for some time. This is an alternative to a party seeking insurance cover in respect of a conventional tax deed which is entered into directly between buyer and seller (where often the seller’s exposure is capped at £1). There are practical differences between the cover offered under the two alternatives, and parties also need to consider the tax treatment of insurance proceeds. For example, the buyer is likely to be provided with the insurer’s preferred draft synthetic deed, and may have limited ability to negotiate a better position, whereas the buyer usually has the “first serve” in terms of drafting its preferred form of tax indemnity if negotiating directly with the seller. Also, if the seller is only subject to a maximum liability of £1 it may be less inclined to negotiate hard on the extent of tax coverage. If the market sees more distressed sales as a result of COVID-19, parties will need to weigh up relative risks/benefits of going “synthetic” versus a seller-negotiated deed.

The buyer should carefully consider a number of factors when assessing the suitability of a synthetic policy on a transaction, including:

  • Premium, de minimis and retention – the insurance policy may be more expensive than a traditional W&I policy (relative to coverage) and the higher risk accepted by the insurer may come at the cost of a higher de minimis and an increased policy excess.
  • Due diligence – an insolvency practitioner is unlikely to provide meaningful disclosure given their limited knowledge of the business, so the insurer will expect to see evidence of a particularly robust buyer due diligence exercise. The insurer may even carry out its own extensive due diligence on the target, potentially impacting the deal timeline.
  • Scope of warranties – an insurer would generally provide a narrower set of warranties than one would see in a typical M&A sale and purchase agreement, so scope for recourse against the insurer is likely to be more limited.
  • Moral hazard – in a nominal or nil recourse structure (i.e. where the seller provides warranties but its liability is nil or £1) the insurer could still pursue the seller under their subrogation right in the event of fraud. However, a claim against the seller in the event of fraud may not be available under a synthetic warranty structure.
  • Quantifying loss – agreeing on how to quantify any loss for the purposes of assessing damages following a warranty claim under a synthetic warranty policy, particularly in a corporate insolvency transaction, is likely to be more complex and will be key to unlocking the real value of such a policy.

Synthetic warranties could become a disruptive innovation in the long-term, transforming the way in which due diligence is carried out and changing how W&I dovetails with the sale and purchase agreement on M&A transactions. Whether there is increased appetite in the W&I market to provide this sort of coverage remains to be seen, but it may be that disrupted market conditions coming out of the COVID-19 pandemic provide the catalyst to launch the synthetic warranties concept more into the mainstream of M&A.

Please do get in touch with Krishna Patel, Melanie Shone or your usual Stevens & Bolton contact if you have any questions.

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