In many transactions, the target company’s financial statements either play an important or even a crucial role for the determination of the purchase price. As a result, a financial statements warranty is of utmost importance in most share purchase agreements. This article analyzes the consequences of a breach of the financial statements warranty under German law: how can the purchaser calculate its damages?
At the outset of the analysis stands Section 249 German Civil Code (“BGB”). It contains a principle which is common to most laws on damages: The purchaser has to be put into the position, it would have been in if it had not been for the breach. Section 249 BGB calls for a hypothetical analysis of the so-called “but-for world”, i.e. the world without the breach.
The first question, therefore is: “What is the breach?” or “What was warranted under the share purchase agreement”? An example for a typical financial statements warranty reads:
The audited financial statements of the seller as of 31 December 2014, which are attached for evidence purposes as Exhibit X
(i) have received an unqualified auditor’s opinion,
(ii) have been prepared in accordance with the generally accepted accounting principles as applied in Germany,
(iii) applied in all material respects on a consistent basis,
(iv) and give, to seller’s Knowledge, in all material respects, a true and fair view of the assets, financial condition and results of the operations of seller.
The possible ways to calculate the damages for a breach of the warranty can be best illustrated by way of examples:
Example 1: The purchaser realizes after closing that the sellers failed to recognize a liability in an amount of EUR 1 million towards a supplier in the financial statements.
Example 2: The purchaser realizes after closing that one of three plants is defective (and cannot be repaired). This jeopardizes the ability of the target to reach the production goals within the next five years. The defect was not disclosed to the purchaser during the due diligence. On the contrary, the financial statements indicated that all three plants are flawless because all three were shown under non-current assets. Each plant was valued at EUR 1 million.
1. Option 1: The pure damage on the balance sheet “Bilanzauffüllungsschaden”
One way to calculate the damages would be to request the seller to pay an amount of money which equals the exact difference between the “correct balance sheet” and the “incorrect balance sheet”. In both examples, the purchaser could demand damages in an amount of EUR 1 million because in both cases the impact of the breach on the balance sheet was exactly EUR 1 million. In the first example, the “correct” current liabilities were EUR 1 million higher than represented in the financial statements. In the second example, the “correct” non-current assets were EUR 1 million lower than represented in the financial statements.
The damage on the balance sheet (“Bilanzauffüllungsschaden”) does generally not reflect the damage to the purchaser. The “real” damage to the purchaser might be different – it can be higher or lower. In Example 2, the “real” damage to the purchaser is higher than the damage on the balance sheet: When the purchaser calculated the value of the target company, the purchaser has of course attributed a value to each plant which exceeded the nominal value of EUR 1 million.
Summary of the case Higher Regional Court of Munich, decision dated 30 March 2011, 7 U 4226/10
The Higher Regional Court of Munich held in a dispute arising from a share purchase agreement that the purchaser is entitled to claiming the damage on the balance sheet. Whether the decision was merely a decision in an individual case remains to be seen.
The facts of that case were as follows: The sole shareholder of a limited liability company sold its shares to the two plaintiffs. The purchase agreement contained a financial statements warranty. After the closing, it turned out that the financial statements prepared by the seller were incorrect. The balance sheet contained outstanding claims although these claims had already been settled. Therefore, the plaintiffs claimed damages.
The Higher Regional Court held that the purchasers can and must ask for specific performance as a first step. Accordingly, the seller has to put the purchasers in the position, they would have been in if the balance sheet had been correct, namely if the alleged outstanding claims had not already been settled. This meant that the seller had to pay the amount of the alleged outstanding claims to the purchasers and thereby remedy the effect of the breach on the balance sheet.
2. Option 2: The difference in the enterprise value of the Target company
Another way to calculate the damages would be a comparison of the enterprise value of the Target company in the “real world” and in the “but-for world”.
The enterprise value of the Target company is often determined on the basis of a DCF valuation, i.e. the purchaser takes into consideration which future cash flows it can generate by purchasing the target company. If the future cash flows are not affected by the seller’s misrepresentation, the purchaser does not suffer a sustainable damage regarding the enterprise value.
In Example 1, there is no sustainable damage on the enterprise value of the company. If the seller reimburses EUR 1 million which the company expended to pay off the supplier, the purchaser is fully compensated for the loss resulting from the breach of the Warranty.
In Example 2, the breach has a sustainable effect on the company and the enterprise value of the company. The defective plant leads to a reduction of future cash flows – unless the plant could be easily exchanged by a new plant. If one were to assume that the seller expected to generate revenues of EUR 10 million and a profit of EUR 2 million with each plant, the impact on the enterprise value will be EUR 2 million for each year that the plant is not running (discounted to the present value) plus EUR 1 million for the construction of a new plant. A valuation expert would have to assess the exact impact.
For the purchaser, the advantage of calculating the damage by way of an enterprise valuation is that sustainable effects on the earnings capability of the company can be reflected in the amount of damages. The damage claim could thus be higher than under Option 1. The disadvantage for the purchaser is that the calculation is very complex and might call for the involvement of a valuation expert.
Summary of the case Federal Court of Justice, decision dated 15 March 2006, VIII ZR 120/ 04, NJW-RR 2006, 1185-1188
In a decision dated 15 March 2006, the German Federal Court of Justice held that this way of damage calculation would be the default method under German law.
The facts of the underlying case were in essence as follows: The seller warranted in the share purchase agreement that (i) there had been no material changes to the financial situation of the target company as presented in the financial statements 1989; (ii) the earnings situation of the target company was positive.
The Higher Regional Court, i.e. the instance below the Federal Court of Justice, found that the seller violated the above mentioned warranty. A court appointed expert demonstrated to the Higher Regional Court’s satisfaction that there was a material change to the financial situation and a severe impact on the earnings situation. (The reported decision of the Federal Court of Justice does unfortunately not give any details as to the adverse changes.) The Higher Regional Court on that basis argued that the damage to the purchaser was at least 500,000 Deutsche Mark because the purchaser would have reduced the purchase price by at least 500,000 Deutsche Mark if he had known at the time of the conclusion of the contract of the real financial situation of the target company.
The Federal Court of Justice did not follow this reasoning. The Court held that the Higher Regional Court’s assessment regarding the damage calculation was insufficient.
a) The Federal Court of Justice differentiated between a damage claim for the positive interest and a damage claim for the negative interest. Latter can – according to the Court – only be obtained in cases of culpa in contrahendo, i.e. in cases of misrepresentations during the contract negotiations. The negative interest has to be calculated by way of comparison between the price actually paid and the price the purchaser would have paid if the financial statements warranty had been correct (= but-for scenario). One has to add that a claim for (negligent) culpa in contrahendo is very frequently excluded in Share Purchase Agreements governed by German law.
b) Regarding the positive interest the Federal Court of Justice held that the purchaser’s damage has to be calculated by way of comparison between the actual value of the company and the value of the company if the financial statements warranty was fulfilled, i.e. if there had been no material change to the financial situation of the damaged party.
The Federal Court of Justice held that the lower Court mixed up the basis for the damage claim and the damage calculation. The lower Court assumed that the purchaser had a claim for the positive interest but calculated the negative interest. The Federal Court of Justice referred the case back for a renewed decision: either the purchaser also had a claim for the negative interest (culpa in contrahendo) or the lower Court would have to calculate the damages differently. Unfortunately, the follow-up decision of the Higher Regional Court is not published.
In sum, the German Federal Court of Justice calculated the damage for a breach of a financial statements warranty by way of comparison of the actual value of the company and the value of the company if the warranty had been fulfilled. Only in the exceptional case of a claim for culpa in contrahendo, the purchaser can claim the difference in the actual price paid and the price paid if the financial statements had been correct.
3. Option 3: The difference in the actual price paid and the price paid if the financial statements had been correct
The third way to calculate the damages has already been mentioned in the above paragraph 2.a). A purchaser might argue that it would have paid a much lower purchase price if it had known that the financial statements had been incorrect. Accordingly, a third way to calculate the damage would be to compare the actual price paid and the price the purchaser would have paid in knowledge of the real financial statements.
If a purchaser calculated the purchase price by way of an EBITDA multiple – which is very often the case –, the purchaser might be able to argue in Example 1 that the purchaser would have paid a significant lower purchaser price if the liability to the supplier had been correctly reflected in the financial statements. The purchaser could argue that it used an EBITDA multiple of 5.0 and that therefore its damage amounts to EUR 5 million. In response, the seller might argue that the multiple might not be applied because the failure to book certain accounts payable has only a one-time impact on the earnings situation of the target company.
In Example 2, the purchaser will even be more likely to argue that it would have reduced the purchase price by EUR 5 million (EUR 1 million x the EBITDA multiple of 5.0) because in Example 2 it will be more difficult for the seller to argue that the EBITDA impact is non-recurring.
The third way to calculate the damages resulting from a breach of a financial statements warranty has been applied in at least two published decisions.
Summary of the case Federal Court of Justice, decision dated 25 May 1977, VIII ZR 186/75, NJW 1977, 1536
The first decision stems from 1977 and was rendered by the German Federal Court of Justice. The facts underlying its decision of 25 May 1977 were as follows: The seller provided the purchaser – the claimant in the proceedings – with incorrect financial statements during the purchase price negotiations. No separate warranty was given that the financial statements were correct. Therefore, the purchaser had to base its damage claim on German statutory law. The purchaser raised a so-called claim for culpa in contrahendo, i.e. a claim for misrepresentations during the contract negotiations. The purchaser argued that the seller knew that the purchaser would calculate the purchase price based on the financial statements. The seller, therefore, also knew that a misrepresentation with regard to the financial statements would lead the purchaser to overpay for the target company. The German Federal Court of Justice held that the purchaser had indeed a claim for damages and had to be treated as if it had concluded the purchase agreement for a lower price in the but-for world, i.e. in a scenario where the financial statements had been correct.
As mentioned above, it needs to be added that most share purchase agreements which are subject to German law exclude the applicability of the statutory damage claim for culpa in contrahendo.
Summary of the case Higher Regional Court of Frankfurt, decision dated 7 May 2015, 26 U 35/12
Very recently, also the Higher Regional Court of Frankfurt has applied a very similar damage calculation rationale. Contrary to the decision by the German Federal Court of Justice, the decision by the Frankfurt Court dealt with a standard contractual financial statements warranty, and not with a claim under statutory law. The purchaser had to realize after closing that the target company in the prior fiscal year made a net loss of EUR 30,000 instead of a profit of EUR 180,000 as represented in the financial statements produced by the sellers during the negotiations. The Higher Regional Court held as follows:
“Taking into account that the financial statements warranty shall ultimately define the relevant factors for the determination of the purchase price in a binding way, the purchaser – in case of a breach of the financial statements warranty – has to be put in the position as if he – with the knowledge of the true facts – had achieved to conclude the share purchase agreement at a lower purchase price […]. Thus, the depreciation is considered to be the damage, i.e. the value discrepancy compared to the hypothetically achieved lower purchase price, but the damage is not – as it was assumed by the District Court – the sum of the differences with respect to individual incorrect balance sheet items, particularly as those possibly have a neutral impact on the financial situation of the company”
That means, the Higher Regional Court applied the same rationale that the Federal Court of Justice had applied for a damage claim resulting from misrepresentations during the negotiations. On first glance, the decision contradicts the decision of the Federal Court of Justice dated 15 March 2006. The different result might, however, also be due to the different phrasing of the financial statements warrant. While the seller in the Federal Court of Justice case guaranteed that there had been no material change to the financial situation of the company, the seller in the Higher Regional Court of Justice case guaranteed that the financial statements had been prepared in accordance with GAAP.
4. Conclusion: uncertainty as to the proper way to calculate
Unfortunately, uncertainty as to the proper way to calculate the damages remains. The recent decision of the Higher Regional Court of Frankfurt was also not appealed to the German Federal Court of Justice who could have clarified whether its case law dealing with the statutory claim for culpa in contrahendo is also applicable to contractual claims. The resulting uncertainty is unfortunate considering that the financial statements warranty is one of the most relevant warranties for the purchaser.
Since most disputes resulting from share purchase agreements are subject to an arbitration agreement, it remains to be seen when the German courts get the next opportunity to clarify which option shall be applied in order to calculate the damages resulting from a breach of a financial statements warranty.