What are Synthetic Warranties and Tax Deeds, and how do they benefit transactions?

Synthetic warranties
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In merger and acquisition transactions, the warranties provided by the vendor and buyer can be a tense and difficult area to negotiate. While the buyer seeks the comfort of extensive warranties to protect them from potential transactional risks, a vendor usually prefers as few warranties as possible to limit their liability. Should the vendor breach these warranties, claims are often the result.

In merger and acquisition transactions, the warranties provided by the vendor and buyer can be a tense and difficult area to negotiate. While the buyer seeks the comfort of extensive warranties to protect them from potential transactional risks, a vendor usually prefers as few warranties as possible to limit their liability. Should the vendor breach these warranties, claims are often the result.

Warranty and Indemnity Insurance (W&I) mitigates both parties’ risks for their part in the transaction. While this usually serves the purposes of both parties, vendors can refuse to give certain assurances and warranties in an effort to keep their liabilities low.

In particular, if a vendor does not provide any right of recourse through warranties and indemnities or through escrow, this puts the buyer, not to mention their lenders and shareholders, in a vulnerable position.

Even if the vendor takes this position, it is still possible to give the buyer the protection they want through insurance, with a Synthetic Warranty (or Synthetic Tax Deed), which provides them with right of recourse against a contractual party. So-called because they are provided by the insurer and not the vendor, Synthetic Warranties are available if insurers have thorough Due Diligence and vendor disclosure via a well populated data room, and are often presented as a solution if the vendor is in administration or receivership.

Synthetic Deeds and Warranties are a fairly new and innovative addition to the W&I market. We are starting to see them grow in popularity, and we would certainly recommend them if buying from a receiver or administrator.

Synthetic Warranties and Tax Deeds sit outside of the Sale and Purchase Agreement (SPA). For the vendor they also have the benefit of potentially avoiding a price chip being put forward by the buyer as a result of the absence of any warranties or indemnities. At the moment there is no ‘one-size-fits-all’ Synthetic Warranty option, as each one is unique to the transaction. Generally, they are dictated by the following factors:

• Quality and extent of Due Diligence
• Reasons for requiring a synthetic warranty pack
• Type of asset / target company
• Jurisdiction
• Size of transaction

Case study: Synthetic Warranties in practice

The National Asset Management Agency (NAMA) were the appointed asset manager of a Dublin-based real estate asset held in a Jersey vehicle. NAMA were selling the asset for EUR 250,000,000, but were unable to provide any contractual protection to the buyer, either through the warranties themselves or through monetary recourse.

The Warranty & Indemnity (W&I) policy had a limit of EUR 30,000,000 (being c.10% of Enterprise Value [EV]) with an excess of EUR 625,000 (being 0.25% of EV) and a premium of EUR 420,000 (being a rate on line of 1.4%).

Due to NAMA’s limitations on liability, we proposed a synthetic W&I structure, comprising a Synthetic Warranty Deed and a Synthetic Tax Deed. Providing the buyer with the security they required, these sat within the policy as the Sale and Purchase Agreement (SPA) did not contain a warranty pack or tax covenant. Both the synthetic warranty pack and synthetic tax covenant were drafted between the buyer, their legal advisors, Lockton, and the W&I insurers.

In the absence of a full and proper disclosure exercise and an arm’s length negotiated warranty package, the insurer took comfort from the Vendor’s Due Diligence and the Buyer’s Due Diligence. The insurer would only cover those synthetic warranties and tax indemnities that had been appropriately subjected to Due Diligence, stress tested and mitigated where possible.

There could be no disclosure under the transaction documents against these warranties, so only a tax deed was possible as opposed to a tax warranty. The insurer took comfort from their disclosure exclusion under the W&I policy encapsulating the Due Diligence, the Virtual Data Room, the Acquisition Agreement (no disclosure letter) and their knowledge exclusion. The warranties could only be given on an absolute basis, in the absence of a vendor’s knowledge qualification.

We carved back the Transfer Pricing and Secondary Tax Liability exclusions under the policy as these sat as limitations under the tax deed. There were no standard form limitations under the SPA (such as change in law, provisions in the accounts etc.) as there were no warranties for these to apply against, so these were drafted separately and appended to the W&I policy as "additional limitations/exclusions", which on a customary transaction the insurer would typically sit behind. The conduct provisions under the policy would prevail as the buyer would only be bringing a claim under the W&I policy in the absence of any recourse against NAMA.
 

To find out more about how Synthetic Warranties and Tax Deeds could benefit your transaction, contact Harry Blakelock at harry.blakelock@uk.lockton.com.