In transactions, representations and warranties refer to factual statements and assurances provided by the parties involved. In the context of mergers and acquisitions (‘M&A’) transactions, sellers provide warranties on legal authority to enter into the agreement, ownership and title over the shares along with more comprehensive warranties concerning the business operations and other assets involved. At the same time, buyers represent and warrant their authority and capacity to enter into the transaction as well as their financial ability to complete the deal.
In the current M&A atmosphere, Warranty and Indemnity (‘W&I’) insurance is finding more relevance in transactions. W&I insurance is used in M&A to protect either the buyer or the seller from financial losses arising from a breach of warranties structured around negotiated warranties contained in the transaction documents. In essence, W&I insurance transfers the risk of such breaches away from the contracting parties and places it with the insurer.
Under W&I Insurance coverage, the insurer undertakes to compensate the insured party, whether the buyer or the seller, for any loss resulting from warranty breaches under the transaction documents. This W&I mechanism allows flexibility for both parties to proceed, as the potential financial impact of unforeseen warranty claims is borne by the insurer rather than the transacting entities themselves. W&I Insurances have developed to meet the specific requirements of both buyers and sellers, and offer two main policies which are the buy-side and sell-side coverage policies. In a buy-side W&I insurance, losses arising from a breach of the warranties provided by the seller in the transaction documents are covered by the policy. Hence, the buyer recovers the losses directly from the insurer rather than pursuing a claim against the seller. Typically, the cost of a buy-side W&I insurance is shifted on to the sellers through adjustments to purchase consideration. On the other hand, a sell-side W&I Insurance is a type of coverage taken out by the seller in a transaction to protect itself against any potential financial losses that could arise if the buyer makes a claim for a breach of warranties or misrepresentations made under the transaction documents.
In this article we also aim to explore another kind of policy that is taking shape called the ‘synthetic W&I policy’. Synthetic W&I insurance is an alternative to standard buy-side or sell-side W&I insurances. Unlike a traditional W&I policy, which relies on warranties negotiated between the buyer and the seller, a synthetic W&I is determined by the warranties negotiated between the policy holder and the insurer. These synthetic warranties are determined without any input from the seller and are not included in the transaction documents. Hence, synthetic W&I insurance is particularly well-suited to distressed deals. Additionally, in recent times, synthetic W&I insurance have gained recognition in deals where the transaction documents specify that the seller has no liability for breaching warranties, and where, in order to provide a competitive bid, a buyer will forgo seeking certain warranties from the seller and later incorporate them synthetically.
Nevertheless, synthetic W&I insurance policies are not without their limitations. Firstly, it is likely for insurers to restrict the suite of synthetic warranties to warranties that are relatively standard in that particular type of deal, resulting in a limited scope than a traditional W&I insurance. Secondly, synthetic W&I policies are heavily reliant on customary due diligence of legal, technical, financial, and tax matters, due to the absence of disclosures by the seller against the warranties. Thus, the scope of the policy mirrors the scope of the due diligence. These limitations, however, are less pronounced in partial synthetic policies, where synthetic warranties are included to supplement the seller warranties in the transaction documents.
In incorporating a synthetic W&I insurance policy into a deal, two key aspects need to be considered are determination of loss and subrogation. While a traditional W&I policy would rely on the transaction documents to establish the basis on which loss is determined, a synthetic W&I policy would have to set this out in the policy since the claim has no contractual basis in the transactional documents. Moreover, a traditional W&I insurance would enable the insurer to subrogate the claim after paying the insured. In a synthetic W&I insurance, however, no inherent right of subrogation exists, and even when specifically contracted, is usually limited to fraud. This right of subrogation against the seller for fraud is typically included in both the insurance policy and the transaction documents.
Despite the growing presence of synthetic W&I insurance in Western jurisdictions, its uptake in India remains limited due to the heightened risk to insurers and inherent policy constraints. Synthetic W&I insurance acts as an enabling tool for transactions by mitigating the buyer’s risk while also being favourable to the seller. Nonetheless, its effective use requires attention to considerations such as its scope, basis for determining loss, and the subrogation rights of the insurer.
[The authors are Senior Associate and Associate Partner, respectively, in Corporate and M&A Team at Lakshmikumaran & Sridharan Attorneys, Hyderabad]
