REPRESENTATIONS, WARRANTIES AND DUE DILIGENCE IN MERGERS AND ACQUISITIONS

 JANVIER 2012

In this month’s Newsletter article, we will assess the impact of conducting legal due diligence on the responsibilities of the parties for merger and acquisitions. This article shall primarily assess the warranty against defects of a seller arising from a sale and purchase agreement and then the effects of legal due diligence on such liability shall be analyzed.

Indemnification against defects arising from sale and purchase agreements

The main obligation of the seller under a sale and purchase agreement towards the buyer is to transfer the ownership of the goods that are sold to the buyer. The seller assures that the good shall be delivered to the user without any defects, which is a secondary obligation to the obligation to transfer the ownership. The warranty against defects is a statutory obligation and it does not require an express representation of the seller.

Types of Indemnities against defects

A defect is a deficiency on the traded good, arising from the good not possessing the qualities -merchantability and fitness for purpose- mentioned and promised by the seller, or decreasing or abrogating the value or the benefits of the good as per the agreement, which hampers an ordinary buyer’s expectation from the good.

The obligation to indemnify against defects arise in two situations, one lacking in the assured qualities of the goods mentioned and promised at the time of agreement by the seller – representation- and the other lacking in the reasonably expected qualities of the goods -warranty-.

Representation
The seller may make specific representations and give assurance to the buyer about the qualities of the traded goods in the sale and purchase agreement. Quality refers not only to the inherent specifications of the sold good, but also to any material (any adverse quality decreasing or abrogating the value or convenience of the sold good in comparison with the goods of the same type), financial (e.g. past year financial statements of the target company) or legal relationship (e.g. lack of requisite permits for the site of operations of the target company) which may be considered to effect its value. Such declarations may either state that the good possesses a certain quality (affirmative promise) or it lacks certain qualities (adverse promise). Furthermore, even though the seller does not explicitly promise and assure any quality, if an agreement presumes the existence of certain qualities and the seller signs such agreement without any disclaim provision, it shall be deemed to be an implied warranty.

Warranties of expected qualities
Although the seller does not explicitly promise that the traded good possesses a certain quality or lacks deficiencies, the sold good shall possess the qualities necessary for the expected purpose of its sale. The seller shall be responsible reasonably expected qualities even if it is not aware of such deficiencies or it has not mentioned or promised such qualities. Certain conditions must be met in order for the obligation of warranty to arise:

There must be a deficiency, which decreases or abolishes the value or fitness of the goods for particular purpose.

The purpose of allocation and usage of the goods may be determined as the purpose explicitly or implicitly agreed jointly upon by the parties. Failing such agreement of the parties, the purpose of allocation and usage of the goods shall be determined by taking into consideration the established practice at the place of sale, the particularities of the situation, terms and conditions of the agreement and similar aspects. Deficiencies of such qualities may result in material, economic or legal defects, as explained above while assessing the quality of the goods.
The lacking of such quality must materially decrease or completely abolish the value or the fitness of the sold goods.
A material defect shall mean a defect, which would have resulted in the non-execution of an agreement or the decrease of its price if it the parties knew it. The seller shall not be held responsible of nonmaterial defects unless it specifically warrants that such deficiencies are not present or certain qualities are present. Nevertheless, if the seller warrants the existence of a certain quality, the seller may not claim that such defect does not materially decrease the value of the good and shall be held responsible of this nonmaterial defect.

The defect on good must be latent.
Pursuant to article 197 of the Code of Obligations numbered 818 (the “CO”), the buyer shall be presumed to have accepted any defect present on the sold good if it is aware of such defect and nevertheless has purchased the good. The defect shall be classified as detected at first glance if it may be discovered without conducting a thorough inspection, and as evident if it may be detected through conducting an examination. If the buyer has bought the good without previously conducting an examination, the seller shall not be held responsible for defects on the good that may be detected at first glance. Yet, if the buyer has conducted an examination prior to the purchase of the sold good, the seller shall further not be responsible from evident (unhidden) defects which could have been detected had the buyer shown necessary and ordinary attention. However, in such a situation, if the seller expressly provides a warranty that such evident defect is not present, its responsibility from warranty against such defect shall endure.

Defects, which may not be easily detected despite a thorough examination, are hidden -latent- defects. The seller shall be held responsible of such defects which are not revealed even through examination, regardless of such defect being warranted or not.

The deficiency shall be present on the good prior to the transfer of the liability of losses to the buyer.

The seller shall not be held retroactively responsible from defects which arise after the liability of loss on the goods is transferred to the buyer and which do not relate to previously present conditions[i]. This rule shall apply regardless of whether the defect may be detected at first glance, or is evident or hidden. In order for the seller to be held responsible therefrom, the hidden defect shall be present on the good prior to the transfer of the liability of loss to the buyer.

The responsibility of the seller shall not be waived by the agreement.

The parties to the sale and purchase agreement may limit or completely waive the obligation of the seller of warranty against defects. Nevertheless, limitations on warranties shall not be valid if the seller has fraudulently hidden the defect, misrepresented the goods to buyers and induced the buyer to execute the agreement with the terms and conditions that the buyer wishes.

Referring to the provisions governing warranty against defects and requirements of examination and notification

In order for the buyer to hold the seller responsible from warranty against defects, it is required for the buyer to have fulfilled the obligation of conducting an examination. The buyer shall examine the sold good as soon as possible and confirm whether the sold good possess the necessary or promised qualities. The buyer may personally conduct the examination or procure the examination to be done by a third party should it necessitate specific professional knowledge.

The buyer shall conduct the examination as soon as possible. Pursuant to article 25/3 of the Turkish Commercial Code, the examination shall be conducted within eight days following the sale for sale and purchase of commercial commodities. In order for the seller to be held liable of defects, the buyer shall immediately notify the buyer of such defects detected through examination (CO art. 198).

The possibilities of the user resulting from warranty against goods

If the aforementioned conditions for responsibility from warranty against goods are fulfilled, the buyer shall have certain options. The buyer may request either the decrease of the purchase price paid under the sale and purchase agreement, the termination of the agreement or the replacement of the sold good with a good of the same type, if the good is a fungible good (CO art. 202, 203). The buyer shall select its option in line with its benefits. However, under certain circumstances where the parties have not reached a consensus with respect to the chosen option, a lawsuit may be filed where the judge may rule on another option different from the chosen option. For instance, in case of a termination lawsuit, the judge may decide on the purchase price to be decreased instead of termination if it determines that the loss to be incurred by the buyer and seller are clearly disproportional. The parties may further provide in the agreement the option of the buyer to request the seller to repair and eliminate the defect.

Impact of a legal due diligence on warranties

In merger and acquisition of companies, the transferring and acquiring parties execute a share purchase agreement. This agreement is regarding the transfer of a target company or enterprise and such enterprise shall be purchased through transfer of shares or assets. The transfer transaction is a sale and purchase agreement of an asset or share certificates, as a result of which the seller has the obligation of warranty against defects explained above in mergers and acquisitions. In practice, the buyer conducts due diligence on the enterprise in order to confirm that the purchased enterprise possesses the qualities defined in the sale and purchase agreement.

Types of due diligence

The examination conducted on the sold good may be in relation to legal, operational, strategic or financial matters. Financial due diligence comprises of a detailed investigation of the economic and financial situation of the target enterprise Strategic due diligence is an examination on the characteristics and inclinations of the market in which the target operates. Operational due diligence is the investigation of the management, and information and product technologies of the target.

The legal due diligence on the other hand analyses the legal structure (establishment, bodies, permits, employees, facility agreements, distribution, license and similar material agreements, legal disputes, assets, intellectual property rights and similar aspects).

Due diligence is beneficial and of an importance for the buyer in order to determine the risks, liabilities, scope of representations and warranties of the seller and the value of the target enterprise, and for the seller in order to have a possibility to rectify any potential obstacles.

The due diligence may be conducted by the buyer or the seller. The seller shall provide all necessary documentation in relation to the target to the buyer in a virtual or physical environment. The buyer shall have the opportunity to conduct an examination on the target by reviewing such provided documentation.

The seller may also conduct this due diligence (vendor’s due diligence). The seller provides the buyer with the result of the due diligence conducted by independent and specialized persons. The seller may warrant that all information provided is accurate and complete. In such a case the seller is in an advantageous position during negotiations for having had the opportunity to take measures against certain risks which may be faced.

Consequences of conducting a due diligence

Due diligence conducted prior to the execution of the agreement or prior to the transfer of the rights

The buyer may conduct a due diligence prior to the execution of the agreement. The buyer shall purchase the sold good based on the report prepared as a result of this due diligence. If the seller provides all necessary documents for this examination and the buyer purchases the sold good based on the due diligence, the responsibility of the buyer from the warranty against defect of the sale will be limited. This due diligence shall constitute the examination of the sold good by the buyer. The responsibility of the buyer for warranty against evident defects that may be detected as a result of this examination (and defect that may be detected without any need for examination) will cease.

The acceptance by the buyer of the legal due diligence report prepared by the seller shall delimit the responsibility of the seller with respect to warranty against defects to the same extent as the buyer’s due diligence. Nevertheless, such a report may at the same time be considered as a promise of quality in relation to the sale by the seller. Therefore, if a quality specified in the report is not existent, the seller shall be responsible of the declared quality (as explained above).

However, if the seller did not provide the buyer with certain facts and necessary documents, which could have identified the defects of the examined enterprise by grave fault and fraudulent actions, or has not provided such information in its vendor’s due diligence report, its responsibility shall not be limited even if a due diligence has been conducted. Furthermore, the sellers’ responsibilities from hidden defects, which may not be detected through examination, shall endure (CO art. 200).

Due diligence conducted prior to the execution of the agreement or prior to the transfer of the rights

Such a due diligence shall not have an impact on the responsibility of the buyer on warranty against defects. This due diligence shall constitute the examination that the buyer is legally obliged to conduct after the purchase in order to hold the seller liable from the defects.

Consequences of conducting a due diligence

Pursuant to CO article 187, one of the conditions for the seller to be responsible from defects of a sale is that the defect shall be a hidden defect. As mentioned above, any deficiencies, which are or may be detected as a due diligence conducted prior to the purchase, shall no longer constitute hidden defects. The seller shall not be held responsible from (unhidden) defects, which may be detected by the buyer through a due diligence conducted on the sold good with due attention. The responsibility of the seller shall only endure if the seller has fraudulently hidden certain facts and information or in case of a hidden defect.

Therefore, the parties of a share purchase agreement prefer to draft the representations and warranties of the seller in detail. This is done especially given the difficulty of determining which defect shall continue to be a hidden defect after conducting a legal due diligence. Pursuant to CO article 197, the seller shall not be responsible of such hidden defects. Likewise, the representations and warranties have an important role in determining the mentioned and promised qualities.

The seller warrants under the representations and warranties of the share purchase agreement that the purchased enterprise actually possesses the qualities claimed to be possessed by the enterprise. These provisions determine the qualities of the enterprise and therefore the responsibility of the seller; given that any discrepancies between the declared qualities and the qualities present in the enterprise shall constitute a defect. The buyer is requested to assume certain risks by its representations and warranties; frequently the representations and warranties include a provision that all information and documents provided by the seller during the due diligence are accurate and complete and the seller did not refrain from the provision of any information or document.

Conclusion

The seller, whose property is transferred to a buyer under a sale and purchase agreement, is under no obligation to ensure that good does not possess any defects. If the buyer detects that the sold good has defects as a result of conducting an examination thereon and notifies such defect, it may hold the seller responsible from its warranty against defects. In such a case, the buyer may either request a purchase discount, or the termination of the agreement or the replacement of fungible goods. If the buyer purchases the good after conducting an examination, it will be assumed to have accepted the (evident) defects, which may be detected as a result of the examination; and consequently the buyer shall not be held responsible of such defects.

The mergers and acquisitions include the execution of a sale and purchase agreement. The buyer shall examine the sold company or enterprise through conducting a due diligence thereon. Therefore, such a due diligence shall result in the seller not being responsible of defects that are not hidden defects. On the other hand, if the seller knowingly and fraudulently hid certain facts as a result of which certain defects are not identified, the responsibility of the seller with respect to warranty against defects shall continue.

The seller may explicitly warrant that certain evident defects detected through the due diligence are no longer existent. The sellers provide an explicit promise that the purchased company or enterprise bears certain qualities and does not possess certain defects under the representations and warranties in the share purchase agreements. Such promises define the responsibilities of the seller.

Legal due diligence and the representations and warranties drafted based on the results of such due diligence determines the scope of responsibility of the seller of warranty against defects. Therefore conducting a due diligence and drafting of the representations and warranties in the share purchase agreements in detail are of a material im


[i] Pursuant to the CO, unless stipulated otherwise, the liability of loss shall be transferred to the buyer as of the execution of the sale and purchase agreement. The Code of Obligations numbered 6098 which will come into force on July 1, 2012 has amended this rule. Liability of loss of movable goods shall belong to the seller until its delivery, and the responsibility of immovable goods shall belong to the seller until the registration of the purchase.