Purchase and Sale of a Business: A Concern of Both Parties
Although wait-and-see moods have prevailed in the Lithuanian market of mergers and acquisitions so far, changes in economy are a good opportunity to consider further business strategy. As a rule, the conditions dictated by the market determine a growth in the number of business sale or merger transactions where involvement of a strategic investor is necessary in order to ensure extra financing, development of new technologies or objective to enter new markets.
Although no one is surprised by notices of company acquisitions any longer and the conception of business as a good becomes more and more frequent, the process of acquisition or sale of business often lacks professional attitude. Thus, the funds saved for a qualified advice later must be spent for resolution of disputes between the purchaser and the seller or simply for acceptance of unforeseen losses.
In the present article we will shortly consider the business assignment methods drawing more attention to the most popular business transfer method, namely purchase-sale of shares, and review the measures allowing management of the risks arising in the course of business transfer, the possible defence in case of violation of the contract and other aspects of purchase-sale of shares.
According to the legal regulation effective in Lithuania, a business may be sold by employing the following several methods: sale of a company as a proprietary complex, sale of separate assets and assignment of property rights; in certain cases, reorganisation of a legal entity; nevertheless, the most popular and common method is assignment of the controlling portfolio of shares. The essential element distinguishing different business assignment forms is the object of the transaction. Pursuant to the contract for purchase-sale of a company as a proprietary complex, the purchaser shall acquire not the right to control the legal entity, but the business belonging to the legal or natural entity and everything related to this, i.e. the proprietary complex (including property rights) used in economic activities. Meanwhile, the object of the business acquisition transaction whereby the controlling portfolio of shares is purchased is shares, i.e. securities entitling to be involved in management of the company and receive a part of the company’s profit, i.e. control over the very legal entity with the economic activities which have been carried out till then is acquired.
However, it is to be noted that the common business acquisition method by issuing the controlling portfolio of shares is impossible in case of assignment of a partnership, sole proprietorship, individual activities, and a farm of a farmer. In the afore-mentioned cases, there prevails purchase-sale of a company or proprietary complex, i.e. carried out economic activities, by acquiring the totality of real property, equipment, intellectual property, trade marks, other property and non-property rights in relation to the carried out activities as well as debts and other liabilities. Nevertheless, the procedure of purchase-sale of a company as a proprietary complex is much more complex than assignment of control over a legal entity by means of sale of the company’s controlling portfolio of shares: before signing the contract for purchase-sale of a company it is necessary to draw up the company’s asset inventory list, draw up the company’s balance sheet, a list of the company’s debts (liabilities), the structure of the company’s assets and price thereof must be evaluated by an independent auditor, the creditors must be notified of the sale of the company and the creditors are entitled to request for additional security of their claims. Furthermore, it should be borne in mind that the contract for purchase-sale of the company must be in a notarised form.
Namely for the afore-mentioned reasons, in practice the more common business assignment form is purchase-sale of the shares granting the right to the company’s management and control. Contrary to the case of purchase-sale of a company as a proprietary complex, in case of acquisition of a business through the controlling portfolio of shares, it is not necessary to carry out a series of actions of the sale of a company as a proprietary complex provided for in the law.
However, the specific nature of shares as the object of civil rights determines that the contract for purchase-sale of shares is a risk contract. The Supreme Court of Lithuania (hereinafter referred to as the “SCL”) has repeatedly noted in several cases that shares are specific assets, since their value is subject to changes depending on different factors, namely, the financial situation of the company the shares of which are being purchased, types of its activities, general economic indicators etc. Thus, in case of purchase of shares, there may arise certain risk that if the value of the shares falls down due to external factors, the purchaser may incur losses or, on the contrary, receive profit if the value of the shares increases. Nevertheless, frequently risk of the reasonableness of the price paid for the shares is related not so much to external factors as to the internal situation of the company and future perspectives namely for which the price is actually paid when purchasing the shares, i.e. the right to be involved in the company’s management and the right to sharing the profit earned by the company. Thus, it is reasonable to consider how to protect own rights if at the moment of purchase of certain controlling portfolio of shares of the company the purchaser was not aware of certain circumstances and where the purchaser would not have purchased the controlling portfolio of shares or would have purchased it for an absolutely different price if he had known such circumstances. And although there is no unambiguous answer to this question, it should be borne in mind that any transaction of purchase-sale of shares is, first of all, subject to the doctrine of caveat emptor (Latin, let the buyer beware), i.e. the seller’s duty to disclose information relevant to conclusion of a contract is outweighed by the purchaser’s duty to take interest in the situation of the company the shares of which are being purchased.
For example, in one of the heard cases the SCL has noted that: “the specific nature of the property being purchased determines the fact that both one party and the other party run risk since, generally, future changes cannot be known in advance. Thus, [...] a prudent and cautious purchaser must analyse the situation, business perspectives, possibilities to earn profit of the company the shares of which are being purchased and other factors in an as detailed and thorough manner, as possible”. In the above case, the court determined that when acquiring the controlling portfolio of the company’s shares the company engaged in investment activities has failed to examine the company’s activities and the financial situation, has failed to analyse its business perspectives and possibilities for profitable operation, when making a decision on entering into the transaction it observed only possible company profitability forecasts. Thus, the court stated that failure to examine the company’s activities by the purchaser meant taking of non-measured risk and, accordingly, in the particular case, certain circumstances concealed by the seller cannot be considered as deception about the essential circumstances of conclusion of the transaction, i.e. as the seller’s bad faith. The fact that in the contract for purchase-sale of shares the parties provided for that the purchaser waived of the right to bring claims for any obligations of the company the shares of which were purchased and the value of shares during the contract validity period, i.e. till implementation thereof, is the circumstance which was as much relevant to the present case.
Of course, we cannot absolutely ignore the seller’s duty to disclose information relevant to conclusion of the contract. Such duty may be perfectly illustrated by another case adjudicated by the SCL. In the case the court determined that during the privatisation period the seller of the company’s shareholding approved false financial statements, thus, misleading the purchaser about the real market value of the shareholding; furthermore, prior to entering into the transaction, accounts were improperly managed in the company being privatised, a shortage of cash in the company’s cash register and bank account was established. Later on, the former chief accountant of the company was found guilty over fraudulent management of the company’s account in accordance with the procedure prescribed in the criminal law. In the light of the afore-mentioned circumstances, the court decided that false information on the company’s financial situation provided by the seller of the shareholding definitely had an impact on the purchaser’s decision on the price of the shares. The court pointed out that the value of the company being privatised has been unreasonably increased by the amount of cash concealed as a result of fraudulent management of accounts (which was not recorded in the financial statements during the company privatisation period) as such unreasonable increase of the company’s value was treated as the losses incurred by the purchaser.
On the other hand, it should be borne in mind that the courts of lower instances have upheld the position that in case of purchase-sale of the controlling portfolio of shares the legal rules governing the rights of the purchaser that purchased a thing of unsatisfactory quality cannot be applied so far. The explanation is rather simple: securities (including shares) are not a thing in legal terms. Thus, if in case of purchase-sale of shares a company “with defects”, the person cannot request for reducing the price of the shares. Therefore, the scope of the seller’s liability for the “defects” of the company is sort of reduced, since even the seller himself may not at all times be aware of any additional liabilities of the company which may arise as a result of possible disputes with contracting parties, tax administrator etc. after the sale of the company. The more especially as the owner of the controlling portfolio of shares is not always actively involved in the activities of the company’s management bodies (certainly, excluding the cases of resolution of the issues attributable to the competence of the General Meeting of Shareholders).
Thus, taking into account possible risks, the purchaser should be first interested in finding out the real situation of the company in which he seeks to gain control and accordingly evaluate possible value of its shares. Therefore, in order to avoid the situation of a pig in a poke, as a rule, the company’s financial, tax and legal audit widely known as due diligence is conducted.
In the due diligence phase the purchaser seeks to collect and evaluate the main relevant information on the company being purchased in order to make a decision on entering into the transaction and reasonableness of its value. In addition to financial and legal audit, there may be conducted a technical, environmental audit or an audit in other areas which have major impact on the business, depending on the specific nature of the company’s activities. As a rule, the analysed data and documents are of limited use; thus, generally the company’s diligence is carried out after signing a letter of intent which, inter alia, sets out the confidentiality obligations.
It is to be noted that during the due diligence process systemic risks are considered. Therefore, in pursuance of avoiding lower potential threats or concealed obligations of the company, as a rule, the contract for purchase-sale of shares describes the seller’s representations and warranties as well as the purchaser’s remedies to be implemented in cases where false representations and warranties of the purchaser become evident in detail. Thus, another risk management measure is the seller’s representations and warranties provided for in the contract a breach of which entitles the purchaser to request for the seller’s liability. Bearing in mind that in cases where the seller’s warranties and representations prove to be true it is rather difficult to assess the adverse effect, it is best to provide for the compensation mechanism and remedies in the very contract.
Certainly, the seller may not at all times be aware of and, the more especially, control all possible risks in relation to the company; therefore, the seller seeks to limit his liability in terms of the value and time. Generally, in order to keep a balance between the parties’ interests, the contract for purchase-sale of shares sets forth the purchaser’s right to request that the seller was liable for not provided liabilities of the company during certain period of time (as a rule, 1-2 years) by certain part of the value of the transaction.
The deferred payment and earn-out conditions allowing the purchaser to control the risks of arising of possible not foreseen liabilities or continuation of business may be attributed to contractual safeguards.
Normally, the deferred payment provision is applied in order to secure performance of possible claims of the purchaser. In the above case, the purchaser undertakes to pay a part of the price which, as a rule, ranges from 5 to 10 per cent only upon expiry of the time limit within which claims for not foreseen liabilities of the company which become evident may be brought. Thus, the purchaser that brings reasonable claims may include them in the payable part of the price.
The earn-out provision which is rather often applied in contracts may also serve as some price adjustment instrument. In pursuance of ensuring continuation of business, parties may agree on a price premium payable in case of meeting the agreed yield, profitability indicators etc. during the established period.
Thus, both the purchaser and the seller have sufficiently measures for securing own interests to find such solutions which would be acceptable to both parties in their arsenals.