We’ve been working through a series on M&A issues. Such a series would be incomplete without an entry on international M&A and the use of reps and warranties insurance. My colleague Emily Maier is at the forefront of these types of transactions. In the post below, she describes one of the very creative M&A insurance solutions—Synthetic Indemnity Cover—that the market can provide for US/UK M&A transactions.—Priya Huskins
Despite Brexit, the purchase of UK entities by American companies is still going strong. As in all M&A transactions, both parties typically make representation and warranties to each other, which form the basis of certain liability and sets the conditions for closing. However, a common problem in these transactions is that business is “done differently” over there.
The gap in expectations as to what representations and warranties are appropriate between a UK seller and a US buyer can feel like a chasm. New developments in Reps and warranties insurance, a specialized M&A insurance product, can bridge that gap.
UK versus US: Similar words, different language.
So what is the difference in expectations when it comes to representations and warranties between a UK seller and a US buyer? Three predictable areas of contention include:
- Consequential losses. In the UK consequential losses are often excluded in a standard English law stock purchase agreement (SPA). US buyers, by contrast, typically expect to be able to recover these indirect losses. Thus, the UK seller’s expectation is for (potentially significantly) less recovery by the buyer than the US buyer might have for a US deal.
- Remedy for a breach of warranty claim. In the UK a breach of warranty gives rise to a claim for damages based on the reduction of share value resulting from the breach. Whilst there is an expectation of reasonable costs and expenses to be included in that loss, this remedy yields less than the dollar-for-dollar compensation enjoyed in the US.
- Scope of the Representation. In the UK the whole data room is considered disclosed (even if there is a disclosure letter with specific disclosures given). In US transactions, the entire data room is not considered to be part of the deal disclosure. Instead the Seller provides a specific (and often exhaustive) list of disclosures against each individual warranty given, as appropriate.
The gaps in expectation can lead to a break-down in negotiations when American companies want the type of recovery they normally get in US deals. On the other hand, UK sellers may be unwilling to undergo the extensive exercise of line by line disclosures that are standard in US deals and may feel unduly exposed when asked to take on the broader US-concept of loss.
Until recently the only way to get US-style coverage for English law deals was for American buyers to negotiate extremely hard (or, perhaps, overpay) to get the UK seller to agree to their demands. Sellers, unsurprisingly, are very unwilling to concede.
Historically, reps and warranties insurance underwriters were unwilling to bridge this gap. In a sign of the robustness of the reps and warranties Insurance market, however, insurance underwriters have become more flexible.
Reps & Warranties Market Today: Creative Solutions—Synthetic Indemnity Cover
As the reps and warranties market continues to be flooded with more capacity every month, we have found certain underwriters willing to get more creative. They are abandoning their previously hard stance of only providing coverage in line with what the seller themselves is willing to provide vis-à-vis remedies and consequential loss.
These carriers are instead offering English law insurance policies with US-style coverage – even if a seller is not providing equivalent protection to a buyer under the UK Stock Purchase Agreement – coverage known as “Synthetic Indemnity Cover.”
Synthetic Indemnity Cover can be done on an “all or nothing” basis or on an à la carte basis to address these common mismatches in expectation.
Starting in reverse order, for mismatch #3 on disclosure, most underwriters will offer coverage for such a breach for UK deals as long as the seller is willing to prepare a US-style disclosure schedule and the parties agree to this in the SPA.
However, we have recently seen one underwriter prepared to offer a policy where they still required that the seller prepare US-style disclosures but did not require the second hurdle of referencing these disclosures in the SPA. Where one Underwriter goes, others will often follow.
Moving on to mismatch #2, Synthetic Indemnity Cover can provide cover for a breach of warranty claim on an indemnity basis, as opposed to the typical damage analysis per English law. The difference can be substantial.
Under English law, damages for breach of warranty are calculated as the reduction in value of the target’s shares resulting from the breach. The aim is to put the buyer in the position they would have been had the warranty been true. As a result it’s necessary to demonstrate that the circumstances that produced the breach negatively impacted the value of the shares. That reduction in value caps the amount of loss.
In contrast, under the market standard for US deals, warranties are given on an indemnity basis. This means the buyer can recover dollar-for-dollar the cost to fix the problem. There is no need to prove the event affected the value of the company.
Relevantly, under English law the buyer has a duty to mitigate his or her loss for a damages claim, whereas there may be no such duty to mitigate in the context of an indemnity. However, insurers will almost always require any claim whether an indemnity or damages claim to be mitigated under the policy.
Practically however, whilst there is benefit in having cover for warranties on an indemnity basis because it can make proving loss easier, it may not always make sense given the duty to mitigate and recovery available under the typical English damages model. Where such coverage may be most valuable is in combination with coverage for consequential loss.
Addressing mismatch #1, without paying additional premium, it is easy to have the consequential loss exclusion removed from a UK reps and warranties policy. However, when asking for cover on an indemnity basis (mismatch #2), having this same consequential loss exclusion deleted is likely to attract an additional premium. Whether the extra cost is worth it is a conversation to be had with counsel and your broker.
In Conclusion: The Value-Add
As with all things insurance related, the proof of value of US-style enhancements is only equal to the claims history. There hasn’t been enough activity related to Synthetic Indemnity Cover to be able to quantify the exact value of these enhancements. Perhaps the non-disclosure of the data room is the most useful of the enhancements; but, as it requires cooperation from the seller, it may not be as easy to obtain as the other enhancements discussed.
Regardless, my expectation is that insurance carriers will treat claims activity for Synthetic Indemnity Policies the way they have been treating most reps and warranties claims: eager to make payments when releasing new products in order to affirmatively demonstrate the value of these products.
The emergence of Synthetic Indemnity Cover demonstrates that reps and warranties Insurance is still an evolving product. Recent competition is allowing us to move the market once more and make this solution even more viable for all involved in M&A. If you are purchasing a UK company, there has never been a better time to explore—and perhaps even purchase—Synthetic Indemnity Cover.
None of the comments in this article constitute legal advice.