M&A Sell-Side: How to Reduce Liability Risks Due to Breach of Disclosure Obligations

published on 8 February 2023 | reading time approx. 3 Minutes

When buying a company, the buyer always buys a "pig in a poke". This is because the relationship between seller and buyer is typically characterized by the fact that the seller has an information advantage over the buyer, which cannot be fully compensated by information memoranda, management interviews, due diligence, etc. German case law compensates for this disparity by imposing disclosure obligations on the seller. In order to ensure compliance with these obligations and to reduce liability risks, the seller should enter "transaction mode" in good time.

Principle of self-responsibility vs. duty of disclosure in negotiation situations

According to the principle of private autonomy, the buyer must inform himself about the company to be acquired and decide whether the contract is to his advantage or not. However, according to German case law, this principle is limited by the fact that during contract negotiations each party has a duty to inform the other party of such circumstances as may frustrate the purpose of the contract (of the other party) and are of material importance to the other party's decision, provided that in accordance with the prevailing view of the market the other party can expect to be informed (BGH VII ZR 192/94). Accordingly, in the course of the purchase contract negotiations, the seller may be obliged to disclose certain circumstances to the prospective buyer without being asked. In the context of a company purchase, the seller has an increased duty of disclosure in this respect, whereby a strict standard of care is applied (BGH VIII ZR 32/2000).

Circumstances to be disclosed in the M&A process

According to the aforementioned formula, a duty of disclosure requires the cumulative existence of several conditions, which, however, also narrow the scope in which the seller's duty of disclosure is defined.

First of all, a circumstance is required, i.e. an external, objective fact of which the seller has knowledge. In some cases, however, circumstances of which the seller was not positively aware but of which he should have been aware in the course of the sales process are also considered to be subject to disclosure. The seller can therefore not avoid his disclosure obligation by closing his eyes to such relevant circumstances.

Furthermore, a disclosure obligation presupposes that the circumstance must be suitable for frustrating the purpose of the contract pursued by the buyer. Thus, if a circumstance exists which would make the strategic objectives discernible impossible or undermine the characteristics of the company to be sold which are crucial to the buyer, this must be disclosed. In order to be able to assess this, the seller must obtain a picture of what purposes the buyer is pursuing with the acquisition project.

In addition, a circumstance is only to be disclosed if it is of material importance to the buyer's decision to purchase. In other words, there must be a risk - recognizable to the seller - on which the buyer's decision for or against the acquisition of the company under the given conditions depends. If a topic is not relevant for a prospective buyer in the context of the decision-making process, the seller does not need to raise it.

Finally, the prospective buyer must be able to reasonably expect that he will be informed about the relevant circumstance. This is not the case with mere assessments, valuations or analyses by the seller, for example with regard to the future earnings of the company to be sold. The seller does not have to inform the prospective buyer about the behavior of other interested parties as part of a structured sales process. He may also keep his assessment of the market and competition to himself.

In case of doubt, a disclosure obligation is to be assumed

Overall, there is a high degree of legal uncertainty for sellers due to the poorly defined criteria outlined above. A large proportion of legal disputes arising from alleged breaches of disclosure obligations are either dealt with and settled before the arbitration tribunals. There are only a few published decisions by German state courts on corporate acquisitions and also on real estate transactions; these decisions are often characterized by particular facts and the course of the proceedings and are therefore of little general significance. Due to the high degree of legal uncertainty, in case of doubt, the seller should always assume that there is an obligation to disclose.

How to make the disclosure

As far as the manner of disclosure is concerned, clear recommendations for action can be derived from case law: as a rule, disclosure must be made by means of an oral or written explanation, and can only be replaced by the handover of documents in exceptional cases. This is because - according to German case law - by handing over documents, the seller of a company only fulfills his disclosure obligation if he can expect that the prospective buyer will specifically look through these documents from the point of view in question. For due diligence, this means that the Virtual Data Room is not one big basket where everything can be in any place. Rather, misclassified information subject to disclosure is considered undisclosed. Information should be structured in the data room so that it is sorted where the buyer or its advisors would look for or expect to find it. In case of doubt, separate disclosure should be made and documented, for example in a disclosure letter.

Conclusion: "Transaction mode" of the seller to reduce risk

In practice, it is advisable to deal with legal uncertainty in a professional manner and to implement appropriate measures for the purpose of risk avoidance, which could include the following:

• In the run-up to the transaction, the seller should enter a "transaction mode" and adapt the internal processes to the upcoming sales process. He should ensure organizationally that relevant information is passed on to the internal and external deal team.
• The seller and its advisors should make a serious effort to find out the particular interests of the prospective buyer and take them into account in the disclosures. Important issues subject to disclosure should be raised with the buyer-principal and their disclosure should be documented or recorded.
• To identify disclosable circumstances, the seller should consider conducting a legal, tax and financial investigation of the business being sold and, on that basis, prepare factbooks for prospective buyers.
• In view of the unclear requirements for the prerequisites for a disclosure obligation, the seller should, in case of doubt, always make a disclosure in the event of a critical circumstance. It is not worthwhile to conceal important information from the prospective buyer.
• The virtual data room to be set up as part of normal due diligence processes should be well structured and checked by consultants for content, completeness and systematics before it is opened.
• Finally, the implications of the case law on disclosure obligations must be taken into account when drafting the share or asset purchase agreement.