Contractual Limitations of Seller's Liability in Business Sales Transactions (M&A)
If the buyer timely prepares agreement terms that are acceptable to him or are in line with the established practice, the seller will have less corrections to make, which will contribute to the effectiveness of the negotiations.
One of the negotiation topics in each business sales process is the seller's liability and its boundaries. This issue is relevant, and not only in the context of the agreement text. In fact, it should be addressed as soon as a decision to start the sales or acquisition process of a company (its shares) is made.
An accurate description of the seller's liability in the agreement text is to some extent beneficial to both parties. Thus, the rules of the game are defined in the event that the seller, for example, fails to fulfil his obligations or provides false representations regarding the company’s position. The agreement text, of course, should be assessed together with what is not expressly stated in the agreement. In fact, what’s not expressly stated in the agreement is sometimes more important than what is stated.
The opposing interests of the seller and the buyer
Many factors determine the rules and progress of the transaction process. For example, the context of the transaction and the main motivation of the parties (i.e. why the seller wants to sell and why the buyer wants to buy), the position the company being sold is in (i.e. whether the sale is a result of financial difficulties or, on the contrary, the company is at its peak in terms of development), who finances the transaction (for example, credit institutions or other investors may impose their own specific terms and conditions), what is the company’s market share and visibility in the respective market, etc.
The seller usually tries to limit his liability by different means. Depending on the positions of the parties during the negotiation process and other factors, the contractual mechanisms limiting seller’s liability may be both balanced, i.e. reasonably taking into consideration the interests of both parties, or imbalanced, i.e. taking more account of the interests of one party (seller’s liability is maximally limited or, on the contrary, the liability is not contractually limited or the limitation is minimal). On average, some compromise in transactions in this regard is reached.
General information regarding contractual terms
In most transactions, the terms discussed with respect to limitation of seller’s liability are the same. There is a whole set of terms that is usually included in the agreement and is not even discussed, as these rules are in line with the established practice in similar transactions.
What matters is which party prepares the first purchase agreement draft, as it sets the initial tone and some focal points for the negotiation process. The seller’s draft usually draws special attention to terms limiting seller’s liability. In turn, the buyer’s draft only touches upon these issues or doesn’t address them at all.
It is not always advisable for the purchase agreement draft prepared by the buyer not to address the limitations of seller’s liability. In very rare instances the seller will opt not to include them in the purchase agreement. If the buyer initially includes terms that are acceptable to him or are in line with the established practice, the seller will have less corrections to make, which will contribute to the effectiveness of the negotiations. However, sometimes it may be strategically correct not to include these terms in the draft agreement. That can also work. In such case, certain limitations are imposed by law (for example, limitation periods, the buyer’s obligation to minimise his losses, etc.).
The issue of seller’s liability should be resolved at the beginning of the process
It is worth thinking about the seller’s liability in time and well in advance of signing the purchase agreement. This is in the interests of both the seller and the buyer.
For example, it may be good for the seller to consider reorganising the sales structure so that both the seller’s liability could be limited (it matters whether the seller is a natural or a legal person) and income could be generated in a more efficient way from a tax standpoint. It is also worth considering some organisational work that could be done in the company to eliminate or solve issues that might be of concern to the buyer. With the help of financial, tax, and legal professionals, the seller can do his business research on his own and timely address issues that the buyer might consider to be risk factors.
The buyer, of course, has opposite interests. Therefore, attention should be paid to who the seller is and how capable of assuming liability the seller might be after the transaction is completed. It is recommended that the information disclosed by the seller is accurately recorded. In this regard, a 'virtual data room', to which all documents provided by the seller are uploaded, can be very useful for research purposes. This solution may also be beneficial to the seller, as it helps to control who has access to a specific document and who has viewed it, as well as when and how the document has been viewed.
Seller’s liability in the context of the transaction chronology
Usually the purchase agreement contains a certain chronological order of actions the parties will perform after signing the agreement and completing the transaction. Likewise, the liability of the seller that may arise out of the transaction should be viewed chronologically. Almost all transactions have at least three main stages.
First: seller’s liability (the parties) in case an earnest money agreement, a preliminary agreement, a letter of intent, or a similar agreement is concluded. As a general rule, the parties agree that the initial document will be legally non-binding, with the exception of certain clauses. For example, if the parties agree that the potential buyer shall be granted exclusivity for a certain period of time, the buyer could reasonably expect to be compensated for any transaction-related costs (including company research, document preparation costs, etc.) in case of breach of the exclusivity clause. Therefore, at this stage it is recommended to agree that the liability of the seller (parties) is limited by the direct costs of each party or agree on a specific amount that can be forecasted as potential costs at the moment of signing the agreement.
Second: seller’s liability in case an agreement is signed but is not performed. This issue is particularly important in cases when one of the prerequisites for completing the transaction is not fulfilled, which may or may not be in the parties’ control. For example, it might be in the seller’s control to fix unresolved issues in the company before the transaction is completed (agreements with creditors, new employment agreements, issues related to the transfer of intellectual property, termination of agreements with related parties, etc.). In turn, a decision by the Competition Council to allow or disallow a merger, or allow a merger under terms that are unacceptable to one of the parties, is beyond the parties’ control.
Third: seller’s liability after the completion of the transaction. The liability that may arise after the completion of the transaction is what the purchase agreement will mostly focus on. A number of terms could be included in the agreement with respect to this aspect. Some of them are discussed below.
Contractual mechanisms used to limit seller’s liability
The agreement usually defines what exactly the seller may be liable for. As a minimum, the seller is liable for non-performance of its contractual obligations or violation of the seller’s representations. If the parties agree that the seller also assumes full liability for a certain risk or problem after the completion of the transaction, the agreement shall stipulate that the seller will compensate any amount the company or the buyer will have to pay in case of any such risk or problem in the future. In other words, there is no need to prove the losses – only the existence of the respective costs and a link to the risk or problem described in the agreement must be proved.
The seller will usually attempt to limit its representations with information that has been disclosed or is otherwise known to the buyer. Typically, the parties try to make sure the agreement clearly defines what information that has been disclosed or is otherwise known to the buyer means. For example, with respect to information disclosed to the buyer the agreement may be accompanied by all (or the essential) documents (printed copies or copies in an electronic data carrier) that have been presented to the buyer. Likewise, any other information that has been provided to the buyer in a verifiable manner may be regarded as information that has been disclosed to the buyer.
Attention must be paid to ensuring that the buyer understands and has verified all of the representations contained in the agreement. Theoretically, it may happen that the seller (owner of the company) is not aware of the information that is known to the management of the company (board). Therefore, it is always recommended to coordinate the final list of representations with the management, accounting department, and other departments of the company. Alternatively, a different approach may be used, i.e. certain representations can be limited by the information known to the seller, and in such case the buyer would have to prove that the seller knew about the risk or problem, if it arises.
The most heated discussions usually concern the maximum liability of the seller, if the seller chooses to specify it in the agreement. With certain exceptions, typically the limitation ranges between 10% and 40%. For example, for certain material infringements, it is reasonable to set the maximum liability limit at 100% of the transaction amount (plus buyer’s costs related to bringing an action and litigation costs). A limit in the amount of the purchase price is typically set with respect to the risk of replevin (seller’s statement of ownership and the right to sell without restriction), the absence of encumbrances, the absence of off-balance-sheet commitments, etc.
Typically, another important issue is the minimum claim amount the buyer can turn to the seller for. The agreement may contain the so-called ‘basket principle’. It determines what the minimum total amount of all claims and what the minimum amount of each individual claim should be.
The limitation periods set out in the agreement is another important issue. Namely, how long after the completion of the transaction the buyer can bring actions against the seller. It is in the seller’s interests that these periods be as short as possible. Usually the limitation periods are no shorter than six months and no longer than five years. If the parties are unable to agree on the length of the limitation period, in some cases several different periods may be established. For example, when it comes to tax issues, what is taken into account is the time period a tax audit can be carried out and a surcharge can be made for, and the limitation period for claims related to tax issues is adjusted accordingly. Other company-specific issues can be addressed in a similar way.
In addition to the statutes of limitations, other procedural rules that govern claims are usually included in the agreement. For example, it is stipulated how soon after discovering information that might result in a claim against the seller the buyer has to inform the seller about it. It is also recommended to stipulate that in the event the buyer makes a claim, the parties must settle the matter or the buyer must bring an action before court in due time (otherwise the buyer loses its right of action).
Third party claims are usually addressed in a separate section of the agreement. For example, the seller has represented that the company has no outstanding obligations with respect to its creditors, but a creditor shows up with a claim after the transaction has been completed. In such situations, it is in the interests of the seller to be informed of such claim as soon as possible so that the buyer and the respective creditor don’t settle the dispute without the seller’s consent and the seller, if he so wishes, can deal with the issue himself.
It is also advisable to include issues the seller is not liable for in the agreement. Usually such clauses stipulate that the seller is not liable for any business forecasts, changes in the laws or the interpretation of existing laws, actions taken with the buyer’s consent, etc.
A few closing words
The list of suggestions and issues addressed in this article should not be considered exhaustive. There are other contractual and non-contractual mechanisms that can be used to directly or indirectly take care of the seller’s liability. It should also be noted that the proposed recommendations will not protect the seller from liability if the transaction has significant shortcomings that may allow to challenge it (for example, if the buyer has been lured into a fraudulent transaction or has been misled).
A purchase agreement in a business sales process is not just a tedious formality. In fact, its preparation is a rather creative activity and it can have a significant impact on what type of liability the seller may be faced with after the performance of the agreement. In very rare instances the seller is able to dictate and achieve agreement terms that are only favourable to him. In most cases the right balance for each transaction is found by applying the contractual mechanisms that are available.
Publication in magazine Bilances Juridiskie Padomi / No. 5 (71), May 2019
Author: Vairis Dmitrijevs, LL.M. (University of Cambridge), Assistant Attorney at Law. Over 9 years of experience in business acquisitions and sales and various other types of commercial transactions. Head of the business acquisitions and sales (M&A) practice group at VILGERTS.