Latest verdict gives important indicators for buyers and sellers
In addition to other undertakings, corporate acquisition agreements often also contain warranties given by the seller concerning the accuracy of the annual financial statements of the business being sold. In practice, however, there are frequent disputes concerning these balance sheet guarantees, as they are known: Under what circumstances is the guarantee considered breached? What are the consequences of a breach of the guarantee?
Even so, courts have to date had relatively few opportunities to reach a position on these questions. A recent judgment handed down by Frankfurt am Main Higher Regional Court (OLG) will, therefore, be of particular interest to sellers and buyers of companies and their lawyers. It deals intensively with the interpretation of balance sheet guarantees and the legal consequences of any breach. Important indicators for the drafting of contracts in M&A processes can be drawn. What exactly does the judgment say, and what can we learn from it?
The judgment of OLG Frankfurt am Main on the interpretation of balance sheet guarantees
In the judgment of 7 May 2015 (ref.: 26 U 35/12) the 26th Civil Chamber of OLG Frankfurt a.M. responsible for enforcement matters ruled as follows: A warranty included in the sale and purchase agreement for the acquisition of a majority of shares in a limited company (GmbH) to the effect that the annual financial statements present a true and fair view of the assets, financial position and results of operations of the company is to be regarded as what is known as a “hard balance sheet guarantee”. Its fulfilment must be assessed solely on the basis of objective criteria and not the subjective horizon of the seller (or the buyer).
The compensable loss of the buyer is derived from the “reduction in value”. This is the difference between the agreed purchase price and the lower purchase price that the buyer would have agreed had he known of the actually less favourable results of operations of the company. It therefore does not consist in the sum of the difference of the individual incorrect balance sheet items (“balance sheet replenishment”).
The case underlying the judgment can be summarized as follows:
The buyer bringing the action had acquired from the seller all shares in a GmbH at a purchase price of €675,000. It had simultaneously undertaken to repay loans up to a maximum amount of €185,000 that the seller had granted to the company. In the notarised share purchase agreement the buyer had submitted to immediate enforcement in respect of both obligations.
The sale and purchase agreement included, among other clauses, the guarantee, typical in M&A practice, that the annual financial statements (in this case for the 2007 financial year) had been prepared “with the due care of a prudent business person in accordance with accepted accounting principles in compliance with statutory provisions, complying with the principle of accounting and valuation consistency“ and presented [on the relevant dates] “a true and fair view of the assets, financial position and results of operations of the company“. According to the contractual provisions on the consequences of a breach of the guarantee, the buyer was to be compensated with cash in order for it or the company to be put in the position they would have been in had the corresponding guarantee been correct and complete.
After paying the bulk of the purchase price, the buyer had the annual financial statements in question examined. The result, which the court found largely to be pertinent, was that the guarantee breached valuation and measurement provisions of commercial law, so that instead of the balance sheet profit of €178,389.96 there had actually been a net loss for the financial year of €29,141.84.
The buyer claimed this difference in net earnings as the minimum loss. It set the amount off against the unsettled claims to payment of the remainder of the purchase price and from the loan granted by the seller. In its action the buyer was defending itself against the enforcement instituted by the seller on the basis of the sale and purchase agreement.
Grounds given by OLG Frankfurt a.M.: Hard balance sheet guarantee breached
The court held that the relevant guarantee was a “hard” balance sheet guarantee. In terms of content the guarantee took into account only whether the annual financial statements objectively provided a correct and comprehensive view. In contrast to a “soft” balance sheet guarantee, therefore, it is not sufficient for the accounts merely to be correct from the accounting point of view. The seller is also liable for unknown liabilities and contingent liabilities. This concerns not only those that come to light in the period for commenting on post-balance sheet events and must therefore be reported in the balance sheet; the liability also applies for liabilities that the seller itself could not have identified in application of the requisite care at the time the financial statements were prepared. The hard balance sheet guarantee is thus not limited by subjective criteria.
This applies not only to the seller’s possibilities of gaining knowledge, but also to those of the buyer. In the view of the court, the clause of section 442 of the German Civil Code (BGB) is not applicable to claims for breach of independent guarantees unless otherwise agreed. According to the findings of OLG Frankfurt a.M. and the court of first instance, the balance sheet guarantee in this case was objectively breached due to the lack of provisions for deferred taxes, warranty obligations and legal and consulting costs as well as the lack of reporting of work in progress. It was immaterial whether the seller against whom the action was brought could have identified these. Thus a claim for compensation existed on the merits.
Amount of the compensation claim
As regards the amount, the view of OLG Frankfurt a.M. was that the compensation claim should not be calculated on the basis of the payment needed to “replenish” the balance sheet in the incorrect items. Rather, leaning on earlier judgments of the German Federal Court of Justice (BGH) on liability for breaches of duty in contract negotiations (known as culpa in contrahendo, or c.i.c.), the court ruled that the difference in value from the (hypothetical) lower purchase price at which the buyer would have concluded the corporate acquisition agreement had it been aware of the true situation is to be payable. Where necessary, this amount must be estimated in accordance with section 287 of the German Code of Civil Procedure (ZPO).
In the case at hand here, the court made it relatively easy for itself, determining the loss at the balance sheet difference calculated by an expert less a discount of 20% (in other words, 80% of the balance sheet replenishment claim). The action against the enforcement was thus allowed to the extent that the guarantee claim could be set off against the loans.
Consequences for practice and recommendations for drafting
The judgment shows how crucial the distinction between “hard” and “soft” balance sheet guarantees can be in a corporate acquisition. The contracting parties and their advisers should take this as an incentive to pay greater attention to the formulation of the corresponding guarantee. If, for instance, only a soft balance sheet guarantee is to be agreed, this must be made clear with unambiguous wording.
The judgment cited here will certainly not be the last word on the legal consequences of a breach of a balance sheet guarantee, particularly as the issue continues to await clarification at the supreme court. Criticism has rightly been expressed in reviews to date, for instance, that in using the hypothetical reduction in price as a basis OLG Frankfurt a.M. only gave the buyer a claim to recompense for what is known as the negative interest, or loss of trust. It thus puts the buyer in the position he would have been in if he had known that the balance sheet was incorrect and so would not have agreed such a contract, even though the parties to the sale and purchase agreement had clearly agreed that the positive interest was to be compensated in the event of a breach of a guarantee. The buyer should therefore, the argument goes, be put in a position as if the balance sheet were correct. This is inconsistent, though, because OLG Frankfurt a.M. itself, as evident from the grounds for its judgment, recognised that the possible knowledge of the buyer is irrelevant for the guarantee to take effect. Even if the buyer had positively known of the errors in the balance sheet, therefore, the guarantee claim would still have existed on the merits. According to the logic of OLG Frankfurt a.M., however, in such a case it would be difficult, as to the extent of the damage incurred, to establish any claim for compensation at all.
It is also unclear whether, in the view of OLG Frankfurt a.M., the claim to compensation of the reduction in value is limited in terms of amount to the claim for replenishment of the balance sheet. After all, in cases in which the balance sheet error is the expression of a permanent reduction in net earnings, the reduction in value could, given the multiples usually applied for the price fixing, easily be a multiple of the missing balance sheet item. Furthermore, according to the BGH case law on c.i.c. to date, there is no restriction of loss of trust to the positive interest.
In particular, it remains open whether a different ruling would have been reached if the claim had from the start been directed not (as in this case) at compensation in cash, but primarily at compensation in kind (known as restitution in kind). In a case brought before Munich OLG in 2011, for instance, the court affirmed a balance sheet replenishment claim in the amount of the incorrectly reported receivable.
Despite these outstanding issues – or precisely because of them – the parties to a sale and purchase agreement should also pay attention to suitable wording in respect of the legal consequences. They should expressly state what claims trigger the breach of a balance sheet guarantee and how exactly the loss is calculated. In particular, it should be absolutely clear from the agreement whether a payment to replenish the balance sheet is to be owed, or only compensation for the lower value of the purchased company. To that end specific clauses relating to the balance sheet guarantee could be included that vary, specify or supplement – depending on what is wanted – the general legal consequences clauses for the “guarantee catalogue” of a corporate acquisition agreement. This is because general references to “compensation in accordance with sections 249 ff. BGB” or the like do not say anything about what loss is actually to be compensated in the individual case according to the intention of the parties.
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The author: Attorney Dr. Thorsten Steinhaus is a partner in the law firm TRACC LEGAL Rechtsanwälte GbR in Munich. The majority of Dr. Steinhaus’ assignments involve business transactions, intellectual property protection and competition law, consultation and contract design in the field of private and commercial law, and the representation of clients in court and arbitration proceedings in the aforementioned areas. He can be contacted for personal consultations on +49-(0)89-95 44 302-85 and by email at steinhaus@tracc-legal.de.