Oleg de Lousanoff February 6 2002 Representations and Warranties in M&A Agreements Hengeler Mueller | Corporate Finance/M&A - Germany Oleg de Lousanoff Corporate Finance/M&A On January 1 2002 a new law took effect, fundamentally changing the second book of the German Civil Code - the Law of Obligations. This new law was not welcomed by legal practitioners. While the Civil Code (which came into force on January 1 1900), and in particular the Law of Obligations, was not devoid of inconsistencies, legal practitioners had over the years found ways - supported by case law and legal writing - to deal with such inconsistencies. The new law has eliminated this legal certainty. The provisions on prescription periods (contained in the first book of the Civil Code), the general part of the Law of Obligations and the specific parts dealing with purchase agreements have been entirely revised. This will have an impact on typical M&A transactions, since share or asset (business) purchase agreements are subject to the provisions on purchase agreements set out in the Law of Obligations - just as is the purchase of a car or a loaf of bread. Fortunately, many of the (old and new) provisions of the Law of Obligations can be, and normally are, excluded or altered in share or asset purchase agreements. It has thus been possible to develop concepts which, by widely excluding important parts of the Law of Obligations, accurately reflect the conditions that exist in typical M&A transactions.One provision of the new law, Section 444 of the Civil Code, has caused considerable anxiety among M&A lawyers, as it could substantially alter one of these concepts: the well-balanced system of representations and warranties, and the consequences of their breach. In accordance with international standards, German M&A agreements usually contain a number of guarantees (representations and warranties) on the sold business, together with detailed provisions on the consequences of a breach of such guarantees. In addition, they usually provide for an exclusion of all other rights which the buyer might have under statutory law - including a right to rescind the contract, a right to reduce the purchase price or a right to request full indemnification. The new Section 444 of the Civil Code seems to preclude the exclusion of these statutory rights (which are clearly inappropriate in many cases). The relevant part of Section 444 reads as follows: "The seller may not rely on an agreement by which the [statutory] rights of the buyer in view of a fault are excluded or restricted if the seller has...assumed a guarantee for the quality of the sold goods."At first glance, it seems that this provision prevents the parties from limiting the statutory consequences of a breach of a guarantee. If this construction is correct, the parties to a purchase agreement can (if the seller has assumed guarantees for a certain quality of the sold business) no longer limit the consequences of a breach of such guarantee, for example by providing for caps and baskets, for shorter limitation periods than the statutory limitation periods, for sliding scales or for other well-known remedies. Commentators' proposals on how to circumvent Section 444 are no less drastic than the consequences attributed to it: agreements should be subject to the German law in force on December 31 2001 or else German law should be completely evaded. However, these suggestions have their limits: it is unclear whether, under the German Private International Law, Section 444 of the Civil Code will be regarded as mandatory so that, for contracts localized in Germany, it cannot be evaded by excluding the application of German law or by providing for the application of an old version of German law.Nonetheless, the prevailing view is that Section 444 may fit into the system of representations and warranties with greater ease than its wording suggests. On the one hand, the provision clearly prevents a seller from guaranteeing a certain quality of the sold goods and then providing for a general exclusion of liability should the sold goods not have the guaranteed quality. This result is self-evident. On the other hand, however, the provision, construed in a well-balanced way, will not prevent a seller from defining the scope of a guarantee that he is willing to give. This would mean that a seller retains the flexibility to guarantee a certain quality of the sold goods, and to define what he is willing to do or to pay if the sold goods are not of the guaranteed quality. If this widely accepted interpretation - which is also supported by legislative history and the official motives behind the bill - is correct, the anxiety of German M&A lawyers may be unfounded; Section 444 will not preclude utilization of the well-known concepts of representations and warranties, with which all M&A players are accustomed. The question of whether this interpretation is correct may only be answered by the Federal Supreme Court. Until it decides on this issue, the uncertainty will remain.For further information on this topic please contact Oleg de Lousanoff at Hengeler Mueller by telephone (+49 69 17 09 50) or by fax (+49 69 72 57 73) or by email ([email protected]).