How can buyers protect themselves prior to concluding a purchase against possible risks arising subsequent to concluding the purchase? Senior associate Triin Ploomipuu introduces some alternatives.
An entrepreneur makes an investment and acquires a business. The company seems to be a smoothly operating and successful undertaking and all the seller’s assurances seem to support that impression. A while after the acquisition, after a closer look at the company’s day-to-day activities, the buyer finds to his discontent that the company has huge tax arrears, a major supplier cancelled its contract months ago, and on top of all that the company may be liable for huge environmental pollution. It’s obvious that the company does not meet the expectations based on the statements and assurances of the seller. But the seller has no means to compensate for the damage inflicted.
Why are the seller’s statements and assurances important?
In transactions where a shareholding or a company is acquired as an asset, it is customary for the seller to enter into the contract by making material representations regarding the acquired company’s properties and qualities. Usually these assurances concern the legal status of the company, its assets, obligations, substantial contracts, fulfilment of tax liabilities, existing permits and licences, and other relevant aspects. It is also customary to agree that the seller is liable for the validity of the assurances during some specific period (usually up to two years after the transaction) and, should any of them be invalid, the seller is to compensate for damage.
Unfortunately, it may be the case that the seller has no means to compensate, so that earlier assurances and the stipulation of compensation for damage have no actual substance. In that case the buyer could find one of the following measures helpful:
Representation guarantees
In simpler transactions and those involving less scope and value, it is customary to agree upon payment of the purchase price by instalments. In that case the buyer pays the purchase price over an agreed period after the transaction on the basis that the assurances by the seller are valid. The positive side to the instalment system is its simplicity and economy as the parties need no further contracts or extra expenditure. The instalment plan is advantageous because the risk of receiving the purchase price is taken solely by the seller. Should the buyer claim invalidity of assurances, require compensation, and leave some instalments unpaid, the seller has to take measures and invest in receiving the money (file an application with a court or arbitration tribunal). However, in the case of bigger transactions the seller is usually not willing to take that risk.
Using an escrow account is customary with larger and more complicated transactions. The parties agree to the buyer transferring part of the purchase price for some period to an account specifically opened for that purpose and, if the seller has misrepresented the facts, the damage incurred will be recovered from the money on the escrow account. The disadvantage of using an escrow account is that the parties must pay the bank for opening and administering the account and conclude an agreement with the bank. Additionally, the money on the account will be “unusable” during the entire agreed period, which is usually the period of the seller’s liability. At the same time, this scheme should not be feared as the bank’s fee is not very sizeable compared to the transaction value (usually about twenty thousand kroons) and the contract with the bank is quite simple and easily understandable. This scheme minimises the credit risk associated with seller insolvency and the seller will receive the money on expiry of the term (unless the buyer has filed an application with a court or arbitration tribunal) without interference from the buyer.
Recently, a guarantee or surety by the seller’s holding company, usually by the direct or indirect parent company, has come into use. This surety is most usual when the seller becomes an “empty shell“after the sale, with no material assets or profitable business. The advantages of the guarantee and surety provided by a company belonging to the group are simplicity and affordability – they require few additional procedures or expenses. Usually the guarantee is a simple one-page document. The contract of surety is usually longer but also uncomplicated. Generally, the guarantee is realized on the basis of a claim, which means that disputes over actual breach and damage may be resolved after the guarantee sum has been paid to the seller. The case of sureties is more complicated as on top of the claim one needs to prove breach of obligations. However, the buyer should be aware in the case of both guarantee and surety that, if the seller is in financial difficulties, the company providing the guarantee or surety may not be in better shape, which means the credit risk may not be managed.
A relatively commonly used means is the bank guarantee. The advantages of a bank guarantee for the buyer are simplicity of establishment and realization, and greater security as compared to a guarantee by a company in the same group as the seller. In real life, a “demand guarantee” is realized by claiming in accordance with the formalities described in the guarantee without the need to prove breach before payout. On the other hand, the downside for the seller is that the bank in turn often requires a guarantee from the person whose obligations are guaranteed. There have been cases where the bank has demanded transfer of the entire guarantee sum to the bank account. This means the bank guarantee may be too expensive and uncomfortable for the seller.
In the Baltic States, including Estonia, misrepresentation insurance is not yet widely known, although it has been used in the USA, Great Britain, and elsewhere for some time already. Misrepresentation insurance covers damage occurring due to untrue material representations in the sale contract of a company. An insurance agreement may be concluded by the seller or the buyer – the buyer’s insurance will cover damage suffered by the buyer on breach of the seller’s assurances, whereas the seller’s insurance will cover losses incurred on the buyer’s claiming misrepresentation. The advantage of the insurance is that the insurer assumes the risk due to misrepresentation, so that, if any representations are false and the buyer suffers damage, then damages are covered by the insurance and the seller is free from risk of disputes or the need to pay compensation for damage. The buyer receives compensation from the insurer and there are no risks concerning seller solvency or lengthy, expensive court proceedings. The disadvantages of the insurance are its expense (the usual fee is 1-3% of the cover) and more complicated structure as compared to the other guarantees (the insurance contract is quite complex and custom-made for each transaction). Moreover, one should not forget that on the happening of the insured event the insurer may contest the claim so that receiving the sum insured may not be problem-free.
In this connection, it is clear that the individual type of misrepresentation guarantee must be agreed and discussed ahead of the transaction. Risks to be managed are the highest where the buyer has not done thorough pre-purchase research (due diligence) regarding the company to be acquired or conducted an audit. Often, due to time limits, buyers may be justified in opting to not conduct an audit or conducting it in limited scope so that the guarantees required are higher. Additionally, any hints of seller solvency issues should make the buyer suspicious.
Triin Ploomipuu acts as legal counsel in corporate, contract, and commercial law matters. She also assists clients in mergers, divisions, takeovers, and issues related to shareholder agreements.
Buyer’s Protection against Misrepresentation
How can buyers protect themselves prior to concluding a purchase against possible risks arising subsequent to concluding the purchase? Senior associate Triin Ploomipuu introduces some alternatives.
An entrepreneur makes an investment and acquires a business. The company seems to be a smoothly operating and successful undertaking and all the seller’s assurances seem to support that impression. A while after the acquisition, after a closer look at the company’s day-to-day activities, the buyer finds to his discontent that the company has huge tax arrears, a major supplier cancelled its contract months ago, and on top of all that the company may be liable for huge environmental pollution. It’s obvious that the company does not meet the expectations based on the statements and assurances of the seller. But the seller has no means to compensate for the damage inflicted.
Why are the seller’s statements and assurances important?
In transactions where a shareholding or a company is acquired as an asset, it is customary for the seller to enter into the contract by making material representations regarding the acquired company’s properties and qualities. Usually these assurances concern the legal status of the company, its assets, obligations, substantial contracts, fulfilment of tax liabilities, existing permits and licences, and other relevant aspects. It is also customary to agree that the seller is liable for the validity of the assurances during some specific period (usually up to two years after the transaction) and, should any of them be invalid, the seller is to compensate for damage.
Unfortunately, it may be the case that the seller has no means to compensate, so that earlier assurances and the stipulation of compensation for damage have no actual substance. In that case the buyer could find one of the following measures helpful:
Representation guarantees
In simpler transactions and those involving less scope and value, it is customary to agree upon payment of the purchase price by instalments. In that case the buyer pays the purchase price over an agreed period after the transaction on the basis that the assurances by the seller are valid. The positive side to the instalment system is its simplicity and economy as the parties need no further contracts or extra expenditure. The instalment plan is advantageous because the risk of receiving the purchase price is taken solely by the seller. Should the buyer claim invalidity of assurances, require compensation, and leave some instalments unpaid, the seller has to take measures and invest in receiving the money (file an application with a court or arbitration tribunal). However, in the case of bigger transactions the seller is usually not willing to take that risk.
Using an escrow account is customary with larger and more complicated transactions. The parties agree to the buyer transferring part of the purchase price for some period to an account specifically opened for that purpose and, if the seller has misrepresented the facts, the damage incurred will be recovered from the money on the escrow account. The disadvantage of using an escrow account is that the parties must pay the bank for opening and administering the account and conclude an agreement with the bank. Additionally, the money on the account will be “unusable” during the entire agreed period, which is usually the period of the seller’s liability. At the same time, this scheme should not be feared as the bank’s fee is not very sizeable compared to the transaction value (usually about twenty thousand kroons) and the contract with the bank is quite simple and easily understandable. This scheme minimises the credit risk associated with seller insolvency and the seller will receive the money on expiry of the term (unless the buyer has filed an application with a court or arbitration tribunal) without interference from the buyer.
Recently, a guarantee or surety by the seller’s holding company, usually by the direct or indirect parent company, has come into use. This surety is most usual when the seller becomes an “empty shell“after the sale, with no material assets or profitable business. The advantages of the guarantee and surety provided by a company belonging to the group are simplicity and affordability – they require few additional procedures or expenses. Usually the guarantee is a simple one-page document. The contract of surety is usually longer but also uncomplicated. Generally, the guarantee is realized on the basis of a claim, which means that disputes over actual breach and damage may be resolved after the guarantee sum has been paid to the seller. The case of sureties is more complicated as on top of the claim one needs to prove breach of obligations. However, the buyer should be aware in the case of both guarantee and surety that, if the seller is in financial difficulties, the company providing the guarantee or surety may not be in better shape, which means the credit risk may not be managed.
A relatively commonly used means is the bank guarantee. The advantages of a bank guarantee for the buyer are simplicity of establishment and realization, and greater security as compared to a guarantee by a company in the same group as the seller. In real life, a “demand guarantee” is realized by claiming in accordance with the formalities described in the guarantee without the need to prove breach before payout. On the other hand, the downside for the seller is that the bank in turn often requires a guarantee from the person whose obligations are guaranteed. There have been cases where the bank has demanded transfer of the entire guarantee sum to the bank account. This means the bank guarantee may be too expensive and uncomfortable for the seller.
In the Baltic States, including Estonia, misrepresentation insurance is not yet widely known, although it has been used in the USA, Great Britain, and elsewhere for some time already. Misrepresentation insurance covers damage occurring due to untrue material representations in the sale contract of a company. An insurance agreement may be concluded by the seller or the buyer – the buyer’s insurance will cover damage suffered by the buyer on breach of the seller’s assurances, whereas the seller’s insurance will cover losses incurred on the buyer’s claiming misrepresentation. The advantage of the insurance is that the insurer assumes the risk due to misrepresentation, so that, if any representations are false and the buyer suffers damage, then damages are covered by the insurance and the seller is free from risk of disputes or the need to pay compensation for damage. The buyer receives compensation from the insurer and there are no risks concerning seller solvency or lengthy, expensive court proceedings. The disadvantages of the insurance are its expense (the usual fee is 1-3% of the cover) and more complicated structure as compared to the other guarantees (the insurance contract is quite complex and custom-made for each transaction). Moreover, one should not forget that on the happening of the insured event the insurer may contest the claim so that receiving the sum insured may not be problem-free.
In this connection, it is clear that the individual type of misrepresentation guarantee must be agreed and discussed ahead of the transaction. Risks to be managed are the highest where the buyer has not done thorough pre-purchase research (due diligence) regarding the company to be acquired or conducted an audit. Often, due to time limits, buyers may be justified in opting to not conduct an audit or conducting it in limited scope so that the guarantees required are higher. Additionally, any hints of seller solvency issues should make the buyer suspicious.
Triin Ploomipuu acts as legal counsel in corporate, contract, and commercial law matters. She also assists clients in mergers, divisions, takeovers, and issues related to shareholder agreements.