Warranty and indemnity (W&I) insurance has by now been fully embedded in the M&A transaction process, but the coverage provided by the insurance policy is based on the warranty package in a share purchase agreement (SPA). This may change with more insurers being asked to cover synthetic warranties.
Here are five points that a deal team should know about synthetic W&I insurance:
The synthetic warranty package
While synthetic elements to a W&I policy and especially tax policies are nothing new, traditional W&I insurance policies cover the warranties contained in the underlying SPA, and the insurer relies, at least in theory, on the parties to the SPA to rigorously negotiate the warranties as if there was no insurance in place.
For synthetic W&I insurance, the warranties are not given by the seller and instead a synthetic set of warranties is attached to the policy. The wording of the warranties is therefore not dependent on negotiations between the buyer and the seller, but, assuming that it is a buy-side policy, between the buyer and the insurer. In reality, however, it seems unlikely that a buyer will be able to attach its entire “shopping list” of warranties and instead the warranties will in all likelihood be relatively standard. This approach is understandable given that neither the buyer nor the insurer know the business like the sellers do.
Unlike traditional W&I policies where certain warranties are amended or there is a knowledge scrape for the purposes of the policy, the synthetic warranty package will contain the final warranty wording.
Is a due diligence still required?
Not only will a due diligence exercise by the buyer and its advisors still be required, but it will be more important in the synthetic-context given the absence of disclosure by the seller by way of a disclosure letter or schedule – with the insurer instead having to ultimately rely on the due diligence materials in disclosing potential issues.
This may also potentially mean that European insurers may be less likely to offer US-style enhancements, such as the removal of general disclosure of buyer due diligence or the data room.
While traditional W&I policies incorporate the SPA definition of loss (with certain amendments for purposes of the policy), the absence of a contractual claim means the basis on which loss is determined must be set out in the policy.
Calculating loss will likely differ in various jurisdictions. The policy could, for example, specify that the loss will be determined by reference to a contractual measure of loss, such as the actual loss which the target could have avoided if the synthetic warranty had been correct.
Subrogation: Can the insurer still pursue the seller for fraud?
Under traditional indemnity insurance, the insurer, once it has paid the insured, is entitled to subrogate to any claims that the insured may have in respect of the subject matter of the insurance. In the case of traditional W&I insurance, those are typically claims against the seller and the due diligence service providers. The corresponding policy, however, usually limits the insurer’s subrogation rights to claims against the seller for fraud.
While the SPA would not contain any warranties covering the same subject matter as the synthetic warranties, the buyer may in certain jurisdictions still have claims for fraud against the seller.
For example, as a matter of German law, the buyer may have a claim for fraud against the seller if the seller failed to disclose to the buyer essential facts regarding the target.
To the extent that the fraud does concern the same issues that are addressed by the synthetic warranties, the insurer would be subrogated into the buyer’s corresponding claim against the seller and/or any third parties responsible for the fraud under contract or statute, subject to the customary limitations applicable to subrogation.
Subrogation, therefore, does not necessarily fall away.
Synthetic W&I insurance and the M&A deal
In principle synthetic W&I insurance should not affect the transaction timeline more than traditional W&I insurance; however deal teams will benefit from contacting and working with the W&I insurer from early on in the M&A process, especially because each insurer will have its own unique process in dealing with synthetic coverage.
We anticipate that this type of synthetic W&I policy may be more expensive than traditional W&I insurance policies. However, the potentially increased cost may be off-set with its advantages, such as its attractiveness for a seller wanting to exit a transaction with no liability for breach of warranty, and buyers wanting to make their bid more attractive to seller.
The economic downturn caused by COVID-19 may also result in a number of distressed deals for which synthetic W&I insurance is a good fit.