Seller’s Liability for Defects in Company Acquisitions
Dr. Zahide Altunbaş Sancak
The Ph.D. dissertation titled “Seller’s Liability for Defects in Company Acquisitions – Specific to Joint Stock Corporations” was written under the supervision of Prof. Dr. iur. Dr. h.c. Yeşim M. Atamer in the Private Law Doctoral Program at the Institute of Social Sciences, Istanbul Bilgi University was unanimously approved by the committee. It was then compiled into a book by On İki Levha Publishing. The study aims to shed light on the question of what extent the provisions of the Turkish Code of Obligations (TCO) regulating the seller’s liability for defects can be applied in share deals of a joint stock corporation; concluding that the answer is a “yes” for acquisitions where the control of the target company passes from the seller to the buyer. The study also clarifies the term ‘defect’ in company acquisitions and the legal nature of seller’s representations and warranties, which are the most debated clauses of a share purchase agreement (SPA), scrutinizes the legal conditions for defect liability in share deals, and discusses the buyer’s optional rights and potential claims in the case of defect liability. The key points that are covered in-depth in the book and are regarded as critical for share deals in practice are outlined in this blog post.
Applicability of the TCO’s Defect Liability Provisions in Share Deals
The German Federal Court (BGH) and German doctrine have long recognized that the seller’s liability for defects applies in transactions where all or almost all shares of the target are transferred. According to BGH, if the buyer reaches the dominant position (beherrschende Stellung) in the company by acquiring shares, the seller should be liable for the target’s defects. There is no consensus on the meaning of the phrase “almost all”; in the opinion of BGH, the ratio should be minimum 75% as it grants the authority to change the scope of activity in the articles of association (see e.g., BGH v. 2.6.1980 – VIII ZR 64/79 (KG), NJW 1980, 2408).
This topic is not as crystal clear in Swiss-Turkish doctrines and court decisions as it is in German law. The established case-law of the Swiss Federal Court (BGE) stipulates that the seller can be held liable for the defects of the target, only if the agreement includes warranties of quality (Zusicherungen, see e.g., BGE 107 II 419). The Swiss doctrine, on the other hand, holds that if the share sale leads to the transfer of control, the seller should be legally liable not only for the defects of the shares but also for the company’s defects even in the absence of warranties in the agreement. Although it is contentious, the general approach in Turkish doctrine is to apply defect liability provisions in transactions where there is a control transition. The Court of Cassation, on the contrary, has a penchant for close interpretation, yet also has rulings resembling BGE’s approach and even a decision that approved the application of defect liability.
The study concludes that the seller will also be liable for the company’s defects in acquisitions where the target’s control is transferred through share deal because the seller’s performance obligation is to hand on the target company as a whole in such a manner it fully operates. The essence in determining whether the defect liability applies is the transfer of control from the seller to the buyer, not the percentage of transferred shares. Thus, each transaction must be evaluated in light of all relevant economic and legal considerations. The definitions established in the capital market and competition laws, as well as the Turkish Code of Commercial provisions applicable to groups of companies, should be the guidelines in determining the control’s content.
Legal Nature of Representations and Warranties in SPA
The most critical clauses of an SPA, namely, the representations and warranties (R&W) of the seller, are subject to long negotiations between the parties, as they serve the purpose of risk sharing. While R&W catalogue’s content varies depending on the target company’s operations and assets, it generally covers the sale shares, the seller’s capacity as well as target-specific matters, such as its legal status, capital, permits, licenses, legal disputes, and financial statements. It is still contentious whether the legal nature of these clauses is either a “warranty of quality” as defined by TCO Art. 219 or a “guarantee undertaking” under the general provisions.
According to the study, a R&W can be drafted as a guarantee undertaking or a warranty of quality. The legal nature of a R&W is related to the interpretation of the contract, and its determination requires examination of each clause in the concrete case. As such, the retroactive commitments under the seller’s control, often made as of the contract’s signing, are, in principle, a warranty of quality and will lead to defect liability in case of breach. Contrarily, undertaking perils that cannot be ascribed to the company’s qualifications and condition at the time of the passing of risk (i.e., at closing) would suggest the presence of a guarantee commitment.
Effect of Due Diligence on Seller’s Defect Liability
Unlike other types of sales, in company acquisitions, the buyer examines all relevant information and documents of the target before signing the agreement. Such review is mostly carried out on corporate documents, permits, licenses, property rights and other assets, financial statements, pending and potential lawsuits, as well as agreements of the target. This review, known as “due diligence” in practice, has been inspired by Anglo-American legal system, where the buyer bears the risk as per the caveat emptor principle.
Such investigation carried out by the buyer has a significant impact on the seller’s defect liability. Pursuant to TCO Art. 222, the seller will not be held liable for those defects that the buyer knew or should have known. However, for this, the defect must be clearly evident or could have been discovered with sufficient inspection––the seller should remain liable for hidden defects. Additionally, pursuant to TCO Art. 222 para. 2, the seller cannot claim that the buyer should have known about the defect if the agreement contains a warranty of quality, that is a R&W on the matter.
Limitation on Seller’s Defect Liability by SPA
Parties are free to determine the precise scope of seller’s defect liability, due to the subsidiary nature of the TCO’s respective provisions. They can agree on expanding, limiting, or even eliminating such liability. Nevertheless, TCO Art. 221 intervenes in such arrangements: seller’s defect liability cannot be waived or limited in case of intent or gross negligence.
Clauses limiting seller’s liability are commonly seen in SPAs. The disclosure letter, in which the seller enumerates the matters for which they are not liable, as well as the de-minimis and basket clauses, which relieve the seller from the burden of dealing with claims concerning trivial amounts, are foremost among them. The parties may also agree that the seller is only liable for some of their undertakings “to the best of knowledge” or that the seller can only be held liable if the deviation is “material”. All these clauses restraining the seller’s liability are subject to TCO Art. 221: If the seller has deliberately or with gross negligence transferred the target with defects, clauses limiting seller’s liability are at risk of invalidity. It can be argued that there is intent or gross negligence, in case of violation of the seller’s obligation to inform the buyer arising from the law, contract, or the rule of good faith.
In the dissertation, it is argued that in company acquisitions, seller’s liability for defects should also be applicable for defects of the company, in addition to those of the sale shares, where the control of the target is transferred as a result of the sale of the respective shares. The basis of this argument is arising from the opinion adopted in German law that the seller should be liable for the company defects if all or almost all of the shares are subject to the transfer. Majority of the scholarly opinion in Swiss-Turkish doctrine has been developed in the same direction.
It has been observed in practice that share transfer agreements are drafted with no regard to this debate, which has been ongoing in German and Swiss legal circles for years. The reason for this is most likely due to the fact that the company acqusition transactions and accordingly, the content of the share purchase agreements, have been developed under the influence of the Anglo-American legal system. Yet, in Turkish law where laws of sales and within this framework, obligations of the parties are regulated in detail, such agreements should be drafted by taking into account the applicable provisions of the TCO. As regards the seller’s defect liability, legal nature of the most critical clauses of share purchase agreements, i.e., representations and warranties, impact of due diligence carried out by purchaser on the seller’s liability as per TCO Art. 222, enforceability of the clauses limiting seller’s liability pursuant to TCO Art. 221, and in general, contractual clauses on seller’s liability for the sale shares and the target should be negotiated and drafted in accordance with the TCO provisions on seller’s liability for defects.
Keywords: Mergers and acquisitions, Share deal, Share purchase agreement, Liability for defect, Representations and warranties
 Partner, Güleryüz Partners