[author: Alasdair Austin]*

Despite the effects of the global pandemic, life sciences deal making proved to be resilient across U.S. and European markets in 2020. According to EY, the total value for life sciences M&A in 2020 was US$159 billion. In light of this performance, and given the strong potential for further growth in 2021, deal teams across the industry should take note of the latest development in the warranty and indemnity (W&I) insurance market: synthetic warranty coverage and its possible application in the transaction process.

What are ‘synthetic warranties’ in the context of W&I insurance?

Traditional W&I insurance is used by the parties to a transaction to cover the risk of breach of those warranties given by the seller to the buyer under the relevant sale contract (SPA). In the case of the more commonly used ‘buy-side’ W&I policy, in case of a breach of warranty the seller will pay an initial amount to the buyer (the policy excess), after which the buyer will recover any additional loss from the insurer, rather than the seller, up to the policy limit. This insurance provides a ‘clean break’ for the seller and the security of a well-capitalised insurer to give the buyer comfort that it will recover its losses in case of warranty breach.

A W&I policy covering ‘synthetic’ warranties covers breach of warranties that are not contained in the SPA negotiated between the buyer and seller, but are instead contained only in the W&I policy itself. Consequently, negotiations as to the scope and limitations applicable to the insured warranties are in effect moved from buyer and seller, to the buyer and the insurer (assuming a buy-side policy is used). Importantly, the warranties will be made on a deemed basis and so are treated for the purposes of the policy as if they were made by the seller to the buyer, although the seller will have no involvement or liability in case of breach of an insured synthetic warranty.

Synthetic warranties can be found both accompanying traditional W&I policies and in standalone fully synthetic policies. These fully synthetic policies have gradually evolved from ‘enhancements’, which provide synthetics additions to a traditional W&I policy covering the SPA warranties, to offering policy coverage that is purely synthetic in nature and relates entirely to warranties that are not the SPA. Synthetic W&I insurance can be more suitable in situations where sellers are unable or unwilling to provide warranties, such as an administrators in distressed asset deals or trustees. A bidder might also elect to use a fully synthetic W&I policy in order to offer a faster timeframe for the transaction by removing the negotiation with the seller over warranties, and thereby provide a more competitive bid.

Synthetic Warranty Enhancements vs. Full Synthetic Insurance Policies

Parties will have to give thought and consideration as to whether a full synthetic policy could be beneficial to the transaction process, or whether certain synthetic enhancements may be sufficient to resolve any warranty-related disagreements between the parties.

Synthetic warranty enhancements can be used to cover particular risks, which the seller might refuse to provide a warranty for, having most commonly been used for tax warranties whereby the seller’s exposure is often capped at £1. These enhancements can have several effects, including effectively removing qualifiers with respect to knowledge or materiality, or extending the limitation periods for claims.

Fully synthetic policies go further than enhancements and will stand entirely, or almost entirely, in the place of SPA warranties. These may expedite negotiations by reducing the negotiations between buyer and seller in respect of disclosure and warranties, and the negotiations between the buyer and insurer, to one set of negotiations between buyer and insurer. Moreover, the risk of transaction failure may be minimised as a result of removing another potential point of impasse for negotiations between buyer and seller.

A synthetic W&I policy theoretically poses an increased risk to the W&I insurer. When underwriting a traditional W&I policy, the insurer will in part rely on the seller’s negotiation of the insured warranty package and a thorough disclosure process (motivated by the seller’s residual liability for the policy excess) to mitigate the risk of a successful claim under the W&I policy. As these processes are not involved in placing a synthetic policy, the premium payable for a purely synthetic policy may be higher and the scope of the warranties covered more narrow than would be the case under a traditional W&I policy.

The buyer due diligence process will need to be as comprehensive as possible, as this will be all that the insurer will have to rely on in order to prepare the policy, given the lack of protection from a disclosure letter or schedule. The quality and scope of the diligence conducted, together with the underlying assets and the relevant jurisdictions will each help to determine the terms of the policy the insurer is able to offer.

Practical Points

Should the buyer determine that a fully synthetic policy will be placed, it should seek to approach insurers as soon as possible so as to pre-empt any possible transaction delays. In particular:

• Delays may be experienced should the insurer require that they carry out their own due diligence;
• Seller and management engagement will still be required and any delays in this respect could impact the policy;
• Further delays may also have to be factored in given the relative unfamiliarity of parties with synthetic policies in the industry at present (though this will decrease as the policies become more common);
• Moreover, further time may be required to be dedicated towards discussions about how to quantify damages in the event of claims under the policy, especially in the case of more complex distressed asset deals.

Conclusion

Just as the market for traditional W&I insurance has expanded exponentially over the past decade, so too can we expect significant growth in the market for synthetic W&I insurance products. Given the prevalence of the life sciences industry, it is inevitable that this innovation in W&I insurance will become more common place in life sciences M&A as deal teams familiarise themselves with synthetic policies and the opportunities they provide.

*Trainee Solicitor