Global | Publication | August 2022
The statutory regimes dealing with obligations and contract law in Luxembourg – as in many other countries – provide the buyer of a company’s shares with a certain degree of protection. However, the default protective measures available can be difficult to apply in some cases and might often be insufficient considering the commercial value of large transactions and the inherent risks and uncertainties.
For this reason, tailored and deal-specific “warranty clauses” have taken root as an accepted practice in the context of share purchase agreements. Their aim is to protect each party to the agreement against the risk that their reasonable expectations related to the transaction are not fulfilled as promised.
Warranty clauses cover both representations and warranties (herein referred to collectively as “statements”) and indemnification for breach of warranties (it being understood that a warranty is breached if the statements are untrue and/or inaccurate in any way). As far as Luxembourg law is concerned, referring to representations and warranties as “statements” is more appropriate. However, the terms ‘representations and warranties’ are typical in common law governed legal systems.
The content and wording of the statements will depend on, among other factors, whether the transaction at hand takes the form of a share deal or an asset deal. The main vehicles commonly relied on in Luxembourg for acquisition purposes (S.à r.l., société anonyme, SCS, SCSp) are often used to structure the sale or purchase of shares or units respectively (“share deal”) or for the purpose of sale or purchase of an asset such as NPLs, real estate, or domestic or foreign companies directly (“asset deal”). The choice for a share deal rather than an asset deal or vice versa may be driven by various factors. One could be the tax treatment of the buyer or seller, and whether the buyer wishes to purchase all of the assets and liabilities (share deal) or to “cherry-pick” specific assets and liabilities (resulting in a different level of due diligence and risk).
In this publication, we will focus on share deals.
The central purpose of the seller’s statements is to set out the situation of the target company and its constituent parts at a given time. In this respect, they split into the two categories of (i) fundamental or core statements (such as those relating to share ownership or the absence of encumbrances on shares and legal capacity) and (ii) business, operational or non-core statements (such as those relating to information on material contracts, employees, taxes or accounts).
Furthermore, the seller’s statements describe its situation to the extent, if relevant, of the (potential) guarantor of its obligations. All this reflects the buyer’s reasonable objective of obtaining an accurate picture of the target company in terms of its legal position (i.e., claims, encumbrances), finances, assets (i.e., IP, real estate or other), business operations, employment, structure of the group, and more.
The core purposes of this “screening” procedure described above are twofold: preventive and remedial.
The preventive aspect operates through encouraging the seller to analyse its own company’s assets and financial position in detail and to inform the buyer accordingly. Thus, it facilitates risk management on the part of the seller and promotes diligent fact-finding. In turn, it helps to put the buyer in a position where it can make an informed decision on whether to accept the risk without reservations, or alternatively demand an adjustment or even abandon the deal.
On the other hand, the remedial aspect operates through the triggering of an obligation to compensate the buyer if the statement in question is inaccurate, incomplete or misleading, depending on the wording used in the relevant sale document.
The specific content of the statements in a given transaction is largely determined by the seller’s branch of business activity. Thus, the statements made by a pharmaceutical company will differ from those of a telecommunications company. An exemplary and non-exhaustive list of statements could consist of declarations concerning:
The buyer might expect the seller to expand on each of the above points with differing degrees of detail. A split into “core” and “operational” statements is well suited for implementing this.
Most statements are given at the date of signing the agreement and are expected to be repeated at closing by means of a bring-down clause (in case of a time lapse between signing and closing) in line with applicable Luxembourg market practice. One exception to this, is statements in respect of accounts, which are granted as of the “accounts date” (as such term is defined in the relevant sale document).
Statements can be – and very often are – qualified by the party providing them, by means of various limitations, among which “disclosures” play a central role. Broadly, two types of disclosures can be distinguished, namely (i) the definition of a statement’s scope and, (ii) the communication of facts and circumstances contradicting and thereby qualifying the disclosure a statement. An example of the former is a statement that a certain schedule contains all the royalty payment agreements concluded by the target. An example of the latter is a declaration that the shares of the target are free of any pledges. We will discuss the distinction between general and specific disclosures in more detail in a separate, dedicated publication on the topic of disclosure letters.
Another type of limitation is the inclusion of a “knowledge”-qualifier i.e., of the consequences of the seller’s and/or the buyer’s respective knowledge of the issues underlying the statements. Structuring the impact of seller’s knowledge carries with it a number of important choices. Firstly, either the actual or the deemed knowledge on the part of the seller can be referenced. Secondly, there are several alternatives as to whose knowledge is relevant, e.g. that of the target’s or the seller’s management board. To note, the seller’s lack of knowledge should limit the respective statements only under the condition and to the extent that the information in question is unusually difficult to collect, such as contractual breaches or IP infringements committed by a third party. Otherwise, the impact of this limitation could easily get out of hand. Dilemmas along the same lines arise when trying to stipulate how the buyer’s knowledge should bear on the scope of the statements.
Furthermore, statements can be limited by materiality thresholds, absolute compensation ceilings and deductibles. Whilst the former two notions are rather self-explanatory, deductibles might consist of, for example, compensation payments made by a third-party insurer to the aggrieved party. Additionally, calling on the seller’s representations and warranties can be tied with strict formalities, which reduces their accessibility to the buyer in practice. Finally, the seller can resort to a measure as simple as keeping the scope and content of his warranties to the barest minimum.
In order to incentivise the seller to provide accurate and complete statements and to provide the buyer with recourse measures, a breach, i.e. an inaccuracy of statements, is sanctioned using the pre-defined method contained within the contractual documentation. At this point, we turn to the notion of “indemnification” which reflects the remedial aspect of the representations and warranties, and gives effect to it. This protective measure benefitting the party who relies on the statement is sometimes incorrectly referred to as “damages” for a purported “breach of warranties”. Instead, indemnification should be understood as a numerical adjustment (usually a cash adjustment) to the advantage of the party relying on the statement and at the expense of the party providing it. The most straightforward and frequently seen type of indemnification is a reduction of the purchase price by the amount reflecting the detriment suffered by the affected party (resulting in a decreased value of the target company’s shares).
The procedure and extent of buyer indemnification should be outlined in the share purchase agreement or the schedules to it.
Indemnities can also be of a specific nature. In case of a specific indemnity, the specific adjustment amount due is set out directly in the share purchase agreement or schedule. A specific indemnity clause would typically provide that a predefined amount is to be paid in the event of a particular inaccuracy. For example, in a scenario where an employee of the target is awarded damages by a court in respect of a known ongoing dispute; the seller assumed in its respective statement that the target company’s case was stronger so that it would prevail before the court but was unsuccessful.
W&I insurance frequently plays a key role in the negotiations. The buyer might insist on the seller taking out such an insurance especially where the seller puts forth assurances of inadequate value, or where no third-party guarantor is available to back the seller’s obligations in the case of inaccuracy of the seller’s statements. Under a common W&I insurance, the insurer would often, in transactions involving Luxembourg entities, step in essentially “in full”. This means that the liability of the seller is pro forma retained, but reduced to a symbolic amount (for example, 1 Euro) (save for cases of fraud, wilful misconduct and, depending on the dynamics of the negotiations and the bargaining power of the parties, gross negligence), with the non-insured remainder of the indemnification amount being incumbent on the insurer where a payment event is triggered.
The structuring of a W&I insurance raises multiple questions and triggers multiple options to be addressed. The parties should decide who bears the financial burden of the insurance premium and which party has the benefit of the insurance. Furthermore, the parties might consider a statute of limitation period diverging from the one inherent to the share purchase agreement, as well as the inclusion of de minimis and basket thresholds into the share purchase agreement and/or a cap on the seller’s liability.
The popularity of W&I insurance is on the rise. There are already insurers on the market who specialise in specific areas, defined by location, branch of business or deal size. Larger deals tend to correlate with a higher chance that the parties resort to a W&I insurance.
In the absence of a tailored warranty mechanism as described above, there would under Luxembourg law still be some statutory protection for the buyer to fall back on (where the share purchase agreement is governed by Luxembourg law). The relevant grounds for remedy under the Luxembourg law of obligations would be duress (violence), fraud (fraude) or a mistake of value (lésion), whereas the Luxembourg contract law steps in with the guarantee of eviction (garantie d’éviction) – meaning the right to enjoy peaceful possession – and the guarantee of hidden defects (garantie des vices cachés).
Except for fraud, however, cases where the buyer can indeed rely on these in practice are rare. In addition, more often than not, the only solution provided by the default statutory provisions will be a complete annulment of the contract. As the buyer’s preferred outcome is in many instances a simple reduction of the purchase price, a complete annulment would usually result in more harm than good.
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