The use of synthetic W&I insurance solutions in sell-side M&A

The use of W&I insurance in the context of company acquisitions has become standard procedure. Through the targeted use of synthetic elements in the W&I policy, the parties can optimally cover the needs of both sides and create a coverage position that ensures maximum exclusion of liability for the sellers on the one hand and comprehensive coverage for the buyers on the other. From the seller’s point of view, it is advisable to plan W&I insurance and especially the use of synthetic solutions into the process at an early stage.

1. Introduction

After the use of W&I insurances and other M&A insurance solutions has become a common, naturally used and frequently assumed tool in larger transactions in recent years, more recent developments show the increased use of synthetic solutions. In the following, “synthetic solutions” are understood to be all arrangements that provide for a liability in the relationship between the insurer and the policyholder with regard to guarantees or indemnities that is not inherent in the purchase contract - i.e. between the seller and the policyholder. This includes both certain so-called “enhancements” of agreed guarantees as well as the completely independent coverage of certain risks, for example through a purely synthetic tax indemnity. It can be seen that the targeted use of synthetic elements not only provides further liability relief for the seller, but also brings attractive advantages for the buyer in a transaction designed around the use of an M&A insurance policy. The following article presents the targeted use of synthetic elements in the context of a typical sales process and at the same time shows that such arrangements can also be used sensibly in mid-cap transactions.

2. Integration into the M&A process

The integration of a W&I insurance policy into the sales process should take place as early as possible in order to be able to approach a broad number of providers, to close any gaps in the due diligence that is fundamental to the W&I insurance policy and thus ultimately to achieve an optimal coverage position.

Depending on the details of the sales process, the procedure is somewhat different: In a 1:1 situation, it may well be expedient for the buyer or even the parties to jointly engage a broker to find a suitable provider. Here, the cover position is based on a pre-negotiated, possibly already signed purchase agreement and an attempt is made to achieve the greatest possible cover for this negotiated position.

However, the focus of this article will be on the sale of a company within the framework of a structured auction process. In such a process, too, a purchase agreement was traditionally negotiated first, which was then placed on the market via a broker. If it was not possible to obtain coverage for certain points, either the scope of the guarantees was adjusted or, under certain circumstances, the seller’s liability was agreed.

Recently, however, a different procedure has become established, at least for larger transactions (upper mid-cap and large-cap), which among other things allows the targeted use of synthetic elements. Here, the seller first drafts a purchase agreement with a realistically expected final set of guarantees and has a broker conduct a market approach before negotiations begin. Instead of only presenting a draft of the purchase agreement to be negotiated in the bidding process, the seller then gives the bidders access to the broker’s NBI report (Non-binding indications - an overview of the offers of the approached providers of W&I policies). The bidders then negotiate a W&I policy with the preferred provider before submitting their final offer and on the basis of their final, regularly pre-negotiated mark-up. The cover position agreed there is used as a basis for the final offer, so that further discussions about cover are regularly no longer necessary – or no longer to any relevant extent – after the offer has been submitted and the policy can be concluded quickly. This then includes, in particular, agreeing on synthetic aspects with the selected insurer in order to arrive at a coverage of risks that is sufficient for the bidder.

3. Drafting the purchase contract

The same transaction structure is increasingly found in smaller mid-cap transactions. However, as some bidders in these structures regularly have less experience with W&I insurance, closer guidance from the investment bank managing the transaction and the advising lawyers is necessary in this respect. This should already be taken into account when drafting the first seller’s agreement. In practice, it has become apparent that the use of synthetic structures is increasingly assumed and that the seller’s drafts have once again become much more seller- friendly. In order to avoid frictions, especially in smaller transactions, it is not only advisable to make explicit references to the possibilities of synthetic cover to less experienced bidders, but it should also be clear from the draft SPA and the NBI report which synthetic elements are associated with which additional costs in order to avoid later discussions on the bearing of costs.

4. Warranties

When drafting the first seller’s draft of the purchase agreement, different aspects have to be considered with regard to the catalogue of warranties in order to arrive at an optimal cover position for the bidder with minimal liability risks for the seller, also by using synthetic elements. In the following, some of the most important structures will be presented:

4.1. Categories: Fundamental Warranties vs. Business Warranties

Within the set of warranties, a distinction is regularly made between fundamental warranties on the one hand and business warranties on the other. In essence, the fundamental warranties deal with the existence of the target company and the unencumbered shares; whether the usual guarantee on the absence of insolvency grounds falls under this is handled inconsistently. The business warranties cover all other warranties, in particular all operational issues.

In the context of purchase agreements using W&I insurance, the sellers are regularly liable for the correctness of the fundamental warranties in addition to the insurance, but exclude liability for the business warranties completely (EUR 1). Anglo-Saxon financial investors in particular sometimes limit themselves entirely to issuing fundamental warranties and expect the management involved to grant the business warranties. Such arrangements can lead to quasi-synthetic arrangements if the managers do not have a stake in the company and therefore cannot issue warranties as sellers. In this case, a separate management deed can be used to agree on a catalogue of warranties that are declared by the managers, but for which the insurer is exclusively liable.

4.2. Time: Signing / Closing

Especially in constellations where a longer period between signing and closing is to be expected, the question arises whether the warranties given at the signing of the transaction are also given as of the time of closing and to what extent a W&I insurance provides cover in this respect. The ideal position for the parties to the purchase agreement would be that the seller only provides warranties at signing, but the buyer can also assert claims (under the insurance) in the event of breaches at closing.

The underlying problem is that W&I insurances generally only cover issues for which thorough due diligence has taken place. This is obviously not possible at the signing of the transaction with regard to the warranties given as of closing. The solution is for the policyholder to submit a bring-down declaration to the insurer at closing, stating whether and, if so, which breaches of warranties occurred in the period between signing and closing. For these, cover under the W&I policy is then excluded, unless something else has been expressly agreed at extra cost (so-called “new breach cover”). The bring-down concept, on the other hand, is only meaningful if the policyholder receives corresponding information from the seller. Accordingly, purchase agreements regularly provide for the obligation to issue corresponding bring-down declarations by the seller to the buyer and policyholder. The seller has to ask his own management about this again immediately before closing. However, the seller’s liability arising from the submission of the bring-down declaration is regularly expressly excluded.

4.3. Seller’s knowledge

An essential element for limiting liability is for the seller not to give all or certain guarantees objectively, but only subject to its own knowledge. This is because in this case, in particular, it is much more difficult to substantiate the accusation that statements were made into the blue (Angaben ins Blaue), with the potential consequence of unlimited liability due to intentional misrepresentation, so that the seller can rely to a much greater extent on the exclusion of liability established by the purchase contract and the W&I policy.

Whether this is limited to positive knowledge - as is still predominantly the case - or whether the seller must also accept grossly negligent ignorance is a matter for the individual case. From the seller’s point of view, however, a limitation to positive knowledge is the far superior means of limiting liability. The corresponding discussion is being conducted in parallel in the context of W&I insurance, because a different definition of knowledge is sometimes used for the purposes of W&I policies - in the German market it has so far been regularly rejected to extend liability to grossly negligent lack of knowledge, even though increased discussions on this issue have recently become apparent. This is relevant not only for those warranties that are already subject to knowledge in the purchase contract, but also for those for which it is assumed in the warranty spreadsheet within the scope of the W&I policy that they were given with qualified knowledge.

On the opposite, it is an essential element of synthetic cover to waive knowledge qualifications provided for in the purchase contract by means of so-called “knowledge scrapes”. In these cases, it is assumed for the purposes of the W&I policy for certain – regularly numerous – guarantees that the knowledge qualification provided for is not applicable and that the guarantee is accordingly covered by the insurance as an objectively correct statement. As a result, the ideal result can be achieved for both parties, because for the seller the remaining risk of subjectively correct but objectively false statements is eliminated, but the buyer can rely on the objective correctness of the warranties backed by a corresponding liability. This form of bridging the gap ideally shows the possibilities of taking into account the wishes and requirements of both parties through synthetic arrangements.

For the advice to sellers and the drafting of the purchase contract, it remains to be noted that the possibility of a knowledge scrape must always be considered. By using knowledge qualifications, it should be possible for the seller to offer further guarantees and accordingly to obtain more attractive offers from the bidders. The draft should indicate that a waiver of the knowledge qualification is only acceptable in the context of the W&I policy and not in the context of the purchase contract.

4.4. Materiality scrape

In a very similar form, there are increasing requests in the market following the US model to agree on additional materiality scrapes in line with knowledge scrapes, i.e. to assume in the context of the W&I policy that materiality reservations contained in the guarantees are deemed to have been deleted. This form of synthetic extensions is now widespread in M&A insurance policies in the US M&A market, also against the background of the specific disclosure customary there, but is still the exception in Europe and especially Germany. Whether it will become more widespread is likely to be largely dependent on the link to due diligence: as long as the threshold used in the due diligence is reflected in the M&A policy, further materiality reservations are generally not necessary from the insurer’s point of view and a materiality scrape is conceivable in principle. In practice, however, materiality reservations are regularly found in areas where a material (vendor) due diligence was not possible. This will likely also make it difficult to obtain a corresponding cover position from the W&I insurance.

5. Legal consequences

When drafting the purchase contract, two further aspects in particular need to be considered in the context of the legal consequences of breaches of warranty. On the one hand, it is possible that the definition of damage in the purchase contract differs from that under the W&I policy. In particular, there is currently renewed discussion here as to whether and under what circumstances insurance companies are prepared to allow a damage calculation by multiple or at least not to expressly exclude it. The latter is now regularly agreed in W&I policies even if the purchase contract itself is silent on the matter. Furthermore, (very) short limitation periods for the warranties and indemnities covered by the W&I policy are increasingly found in the purchase contracts, as it is entirely common to synthetically agree to significantly longer periods in this respect than those provided for in the specific purchase contract and also generally common in the market in uninsured transactions. This aspect should also be explicitly pointed out in the first draft of the purchase agreement and the NBI report.

6. Tax

Especially in the context of insuring tax aspects, synthetic cover has become very common. Here, it has not only become common to extend existing guarantees and indemnities through the steps outlined above, but also to regularly agree on entirely synthetic tax indemnities without the actual purchase contract even providing for them. The basis for this is, in particular, a thorough due diligence, which the seller can prepare accordingly by means of a vendor due diligence report or at least a comprehensive tax fact book and thus create the conditions for completely excluding its own liability. The same applies to the tax warranties themselves, which are sometimes also agreed purely synthetically.

7. IP

A recent development in the field of synthetic cover is that – so far mainly in the London market – similar to insurance solutions for known tax problems, policies are also being offered that cover known, but in practice unlikely, risks with the IP rights of the target company. This development can offer highly interesting opportunities, especially for IP-heavy companies, e.g. in the tech or healthcare sector.

8. Conclusion

The synthetic extension of the scope of coverage of M&A insurances compared to the actual purchase contract is becoming increasingly important. For sellers, this offers the possibility of limiting or excluding their own liability with even greater legal certainty. For bidders in competitive processes, this results in more extensive coverage without having to limit the quality of their own bids. With the help of these instruments, they can submit a lean mark-up that focuses on purely commercial aspects and a reasonable extension of business warranties in order to stand out. In addition, bidders have the advantage that if the quality of claims under the W&I policy is better than under the purchase contract, there is no reason to assert claims against the seller at all, and thus a uniform and stringent pursuit of warranty claims is ensured.

Due to the increased effort involved both in the examination by the insurer and in the due diligence – a vendor due diligence is regularly offered – more extensive synthetic elements have so far been found mainly in the upper mid-cap and large-cap segment. However, identical arrangements are also possible for smaller transactions if the parties are willing to invest the effort involved and the additional premiums that regularly have to be paid for the synthetic elements.