A recent judgment of the German Court of Appeal (Oberlandesgericht) of Frankfurt am Main (“Court”) (26 U 35/12, BB 2016, pages 721 et seq.) had to deal with the question of how balance sheet guarantees are to be construed under German law in connection with M&A sale and purchase agreements.

The judgment has confirmed the currently existing M&A market practice of working with hard balance sheet guarantees in order to give the purchaser (i) a sound basis for the purchase price calculation and (ii) an enforceable and reliable tool in case of misrepresentation, so that the seller should be aware of potential liability risks in this respect.

In terms of damage compensation, the judgment underscores the necessity of agreeing on a clear and precise damage compensation concept in case of a breach to avoid surprises. Beyond this background, it is recommended from a legal perspective to document explicitly the valuation method as well as the specific elements that result in the overall purchase price. Otherwise, the parties run the risk that a German court will estimate the damages in its sole discretion.

Based on the judgment of the Court, it is not possible to state (as some legal authors do) that German courts would not recognize the concept of balance sheet replenishment (Bilanzauffüllung) in case of a misrepresentation of a hard balance sheet guarantee since the damage needs to be assessed on a case-by-case basis.

I. Underlying Facts of the Judgment

In the legal dispute, the major facts of the case can be briefly summarized as follows:

A purchaser acquired shares of a German company with limited liability (“Company”) by way of a notarized share purchase agreement (“SPA”). The SPA, among other things, contained an independent performance guarantee without fault (verschuldensunabhängige Garantieerklärung, the German equivalent of a representation and warranty) according to which the annual financial statement of the Company was to be (i) prepared with the due care of a prudent business person and (ii) in compliance with the statutory provisions so that such financial statement presented a true and fair view of the financial position and performance of the enterprise of the Company.

In case of a misrepresentation, the SPA contained a provision according to which the seller had to compensate the purchaser in cash in order to put the purchaser in the same position it would be in if the guarantee had been correct and complete. Other remedies (irrespective of nature or legal basis) were explicitly excluded in the SPA.

II. Major Grounds of the Judgment

The major grounds of the judgment are the following:

The Court held that the independent performance guarantee was (by way of construction) to be considered as a “hard balance sheet guarantee” according to which the seller declared that the Company had certain financial key numbers at a specific point in time on which the purchaser could rely. While the wording of the hard balance sheet guarantee in the case at hand appears to be rather short, the Court nonetheless held that it was the intention of the parties to the SPA that any and all assets and debt positions (including adequate provisions (Rückstellungen)) had to be disclosed in the financial statement to give a true and fair view for the purchaser. Given the fact that certain provisions were not made and certain risks materialized post-closing, the Court came to the conclusion that the seller was liable due to a misrepresentation of the hard balance sheet guarantee.

The Court furthermore concluded that the purchaser was not prevented from making this claim due to section 442 German Civil Code given the exclusive liability concept agreed in the SPA (without explicitly waiving section 442 German Civil Code).

In terms of legal consequences due to the misrepresentation, the Court held that the seller was not obliged to replenish the balance sheet of the Company. Instead, the Court concluded in its judgment that the right legal remedy would be a purchase price reduction by assuming that the purchaser would have been in a position to reduce the purchase price accordingly. The difference between the actually agreed purchase price and the reduced purchase price was to be determined by taking into account all circumstances of the individual case and by giving due consideration to the interests of both parties by way of construction. Due to existing doubts, the amount of the damage was estimated by the Court.

III. Assessment of the Judgment

A. “Soft” vs. “Hard” Balance Sheet Guarantees and Their Construction

The first important statement in the judgment is the conclusion of the Court that the agreed wording qualifies as a “hard” balance sheet guarantee (whereas such construction was—from our point of view—not as clear as set out in the judgment).

A “hard” balance sheet guarantee can be defined as a guarantee statement according to which the annual financial statement comprehensively and correctly discloses any and all (current or contingent) assets and liabilities and the profit and loss of the company in an objective way in compliance with the statutory provisions as of a certain point in time. If this point in time corresponds to the effective date, the hard balance sheet guarantee results in a liability obligation of the seller even if the statutory provisions were complied with at the point in time when the annual financial statement was drawn up. This liability exists irrespective of (potential) knowledge or fault of the guarantor and it gives the beneficiary of the guarantee a strong protection.

In comparison, a “soft” balance sheet guarantee is subject to the actual knowledge of the management that the annual financial statement is (subjectively) correct and in compliance with statutory provisions as of the date on which the annual financial statement was signed.

Given the major differences between the two balance sheet guarantees, it is critical for the parties to have legal certainty whether they have agreed on a “hard” or a “soft” balance sheet guarantee. The judgment of the Court shows that an unspecific wording in this respect can potentially result in surprises on the side of the seller/guarantor.

B. General Exclusion of Section 442 German Civil Code in Case of an Individually Agreed Liability Concept of Independent Guarantees?

In the judgment, the Court makes a very brief statement according to which the share purchase agreement is to be construed in a sense that section 442 German Civil Code is (implicitly) fully waived.

According to section 442 para. 1, sentence 1 of the German Civil Code, potential remedies of a purchaser are excluded if and to the extent that the purchaser had actual knowledge of the defect at the time the contract was entered into.

This construction of the Court appears to be rather purchaser-friendly. Based on German M&A market practice, it is entirely standard to explicitly exclude (or amend) section 442 German Civil Code and to introduce a specifically agreed disclosure concept (e.g., by using disclosure schedules, by making reference to the contents of the data room, etc.).

In the light of the foregoing and as the safest course for a purchaser, we would strongly recommend sticking to the currently existing concept in order to avoid potential risks in connection with section 442 German Civil Code whose applicability could have severe consequences on the purchaser.

C. Legal Consequences in Case of the Breach of the “Hard” Balance Sheet Guarantee

1. Negative Interest (Vertrauensschaden) vs. Positive Interest (Erfüllungsschaden/positives Interesse)

The judgment of the Court has stirred some confusion whether the negative or the positive interest is to be compensated. This is due to the fact that the Judgment makes reference to a judgment from 1977 rendered by the Federal Supreme Court (“1977 Judgment”, BGH NJW 1977, 1536 et seq.) while the underlying facts leading to the damage claim are different.

The 1977 Judgment dealt with a case of so-called culpa in contrahendo which enables the damaged party to walk away from the contract and to get reimbursed for frustrated expenses. Under German law, this case law is called “disappointed trust” (enttäuschtes Vertrauen) and grants the damaged party the right to claim the negative interest (Negatives Interesse/Vertrauensschaden), i.e., the damaged party is put into the position in which it would have been if the contract had not been concluded.

However, this 1977 Judgment was a special case in which the damaged party wanted to uphold the contract. In such a case, it is acknowledged by German consistent case-law that the damaged party is entitled to claim the so-called “positive interest” (Positives Interesse/Erfüllungsschaden), i.e., the damaged party can request to be put into the position that would exist if the contract were performed without the breach of contract. In the 1977 Judgment, the German Federal Supreme Court rendered that the damaged party would have been in a position to reduce the purchase price.

The judgment of the Court is not based on culpa in contrahendo but on direct breach independent performance guarantee without fault. In case of a breach of a guarantee, the positive interest has to be compensated by either putting the guarantee beneficiary into the position which would exist if (i) the damage had not occurred or (ii) the guarantee were correct. This was clarified by the German Federal Supreme Court in a judgment in 2006 (BGH NZG 2006, 590 et seq.) according to which all assets and liabilities need to be compared (i.e., the situation of the actual development of all assets and liabilities vs. the development in case of performance of the contract).

In the end, the judgment of the Court is not impacted since in both cases the positive interest is compensated.

2. Compensation of the Positive Interest (Erfüllungsschaden/positives Interesse)

The crucial question is how this translates into the actual damages to be compensated. In both judgments, the courts denied damages according to which the annual financial statements would have to be replenished due to the misrepresentation (Bilanzauffüllungschaden). Based on these judgments, several legal authors have asserted that it is generally right to principally exclude damages by way of a replenishment of the balance sheet.

However, a closer look at the judgments shows that a more differentiated approach is required. Both cases give clear guidelines on the damage calculation. The key to the right solution is the construction of the agreed terms of the share purchase agreement itself. In other words, it needs to be assessed and determined what the parties have actually agreed on a case-by-case basis and what would have been the impact on the purchase price in case of a breach of the hard balance sheet guarantee. Most essential for this question is the determination of the purchase price concept (e.g., net asset value, discounted cash flow, or multiplier method). Depending on the applicable concept, the same accounting error can have different consequences—varying within a huge range.

In order to minimize uncertainties about the consequences of a violation of a hard balance sheet guarantee, it is therefore recommended that the seller and purchaser document jointly how the purchase price was determined (whereas in practice, the purchaser might not be inclined to disclose the full mechanics of such calculation).

3. Criteria for the Determination of the Purchase Price Adjustment in Case of a Breach of a Hard Balance Sheet Guarantee

The impact of misleading financial information on the purchase price depends upon various factors. Most important are (i) the interdependence between the financial information and the purchase price, and (ii) the kind of misleading information. The outcome can vary within a broad range. This is demonstrated in the table below for three different purchase price concepts:

  1. Under the “net asset value method,” the purchase price generally is derived from the value of the company’s assets reduced by its liabilities/accruals at a certain point in time. Expenses and earnings are not relevant.
  2. The “discounted cash-flow method” derives the purchase price as the present value of the company’s cash-flows/earnings. Historical financial information is used as the basis for the prediction of future profits/cash-flows only, and generally does not have a direct impact on the evaluation.
  3. Under the “multiplier method,” the company’s value is determined as a multiple of certain key figures derived from the company’s profit and loss statement.

In the table below it is assumed that the misleading financial information is caused, respectively, either (i) by the omission to build an accrual for specified operational risk, or (ii) by showing in the notes a too optimistic outlook of the company’s profitability for the future.

Purchase price concept

Misleading financial information

(i) Accrual for a specified operational risk has not been built

(ii) Too optimistic outlook of the company’s profitability in the notes

a.) net asset value method

Purchase price should be (x)reduced by the accrual and (y)increased by tax savings from making the aforementioned accrual.

Generally this should not be relevant, since the net asset value method is not influenced by future events.

This might be different only if the subsequent event has an impact with retroactive effect (e.g., on the evaluation of certain assets/liabilities/accruals).

b.) Discounted cash flow method

The impact on the purchase price might be zero/small if the missing accrual relates to discontinued operations.

Could be significant if the missing accrual puts into question the drivers for the company’s profitability expected by the purchaser.

The misleading information could result in a reduction of the purchase price if it led to an over budgeting of future earnings/cash flows in purchaser’s business plans.

c.) Multiplier method

The impact on the purchase price is zero if the relevant base figure (e.g., net sales) is not influenced by the misleading financial information.

If the missing accrual has an impact on the relevant base figure (e.g., EBITDA, net profit), the purchase price has to be re-calculated by using the adjusted base figure multiplied by the agreed multiplier.

Generally this should not affect the purchase price, since the purchase price is derived from historic data.

This might be different if the misleading information has an impact with retroactive effect (e.g., impacts the relevant historic base figure like net profit).

Different purchase price concepts can be combined, in particular if the purchase price for the shares consists of several components. A portion of the purchase price often reflects the company’s expected profitability in subsequent years (measured, for example, by the discounted cash flow model) and another purchase price component is used to consider the value of certain balance sheet items at closing (determined by the net asset value method).

For example, a purchase price component calculated on a net-debt/cash-free basis will be reduced if and to the extent that the closing financial statement shows (i) a claim which is not recoverable in full or in part, (ii) cash positions which are not existent, or (iii) debt or debt-like items which are not considered in the closing balance sheet.

A further layer of complexity is, of course the limitation/qualification of liability in case of a breach which is customary in German M&A contracts by—for example—excluding multiplier damages as consequential damage. Also these implications should be borne in mind when negotiating an M&A transaction with balance sheet guarantees.