Compensation for breach of disclosure obligations

The coronavirus crisis presents companies who are currently in an M&A process with numerous challenges. It is particularly critical if, shortly before notarisation of the SPA (share purchase agreement), potential business markets collapse, the order book situation significantly worsens, delivery chains are restricted and/or the prepared forecast for the current financial year is demonstrably no longer achievable. Against the backdrop of potential liability risks, the vendor always has to deal with the question of to what extent they must disclose circumstances that potentially reduce value, and what are the consequences of a breach of such a disclosure obligation.

General duty of disclosure by the vendor

There is no duty in principle on the contracting parties to disclose all the facts without being asked. However, the Federal Court of Justice (BGH) has consistently ruled that the contracting parties must voluntarily disclose circumstances which could frustrate the purpose of the contract, and that are therefore of fundamental importance for the decision by the other contracting party. In the case of acquisitions, the vendor bears an enhanced duty of disclosure and care, due to the economic value of the sale of a company.

If there is any intentional or fraudulent breach of the duty of disclosure, the vendor is liable; this liability cannot be waived. The BGH will assume fraud if the vendor responds incorrectly by plucking answers “out of thin air” to questions that are obviously significant for the purchaser. “Out of thin air” means that the vendor provides unsubstantiated statements.

Special duty of disclosure owing to the Coronavirus crisis

The obligation on the vendor to disclose information increases in scope due to the current coronavirus crisis. Special circumstances that arise due to the coronavirus crisis can have an immense economic impact and thus affect the purchase price.

Some examples could be the following:

• (potential) customer losses due to the economic situation or due to cost-cutting measures by customers;
• there are significant bottlenecks in supplies to the company, because the supply chains or suppliers can no longer meet demand;
• the company to be sold is threatened with insolvency, or it has not yet filed an application due to the suspension of legal obligations.

Although the purchaser will most likely perform his own due diligence to check for potential or existing risks/loss of income due to the coronavirus crisis, the due diligence process will probably not be able to discover all risks. For example, it is not always immediately discernible to the purchaser whether significant customers of the company have filed for insolvency. However, the risks and failures must be correctly priced in by the purchaser, making them extremely relevant to the level of the purchase price.

If the vendor decides to whitewash the impact or fails to disclose information, this may result in liability. In addition to a reversal of the contract, it is also conceivable that the purchaser may demand compensation equal to the difference in value had the vendor made sensible disclosures (residual trust damages).

Calculation of residual trust damages

The calculation of the residual trust damages is made on the basis of the difference in the value as enhanced by the deception and the value without the deception. The enhanced value is the hypothetical value that is derived from the vendor’s deception. The value net of deception, on the other hand, is the value excluding the deception. As part of the claim for compensation, the purchaser must prove in two steps how high the difference, which means the added value due to the deception, actually was.
In step 1 questions of valuation procedure are clarified to allow calculation of the residual trust damage. Here, the discounted cash flow approach is used to determine the distorted value and the value net of deception. The state of knowledge at the time of signing is decisive.

What is important is that this is viewed from the purchaser's perspective. However, synergy effects or planned corporate concept changes can be considered, but only to a certain level. The lower limit of the value of the purchaser company is the amount for which the purchaser could have resold the target of the transaction to a third party (market value). This is particularly relevant if, for example, a deception relating to planned corporate concept changes would greatly increase the company's value, and if they prove impossible to implement would significantly reduce the value of the company well below the market value.

In step 2, the residual trust damage is calculated from the market value or, if higher, the deception-free company value. Arbitration courts or normal courts have to make assumptions in these cases, as to how the parties would have behaved in a hypothetical alternative scenario where there was no deception. To do this, the negotiation procedure is simulated working under the assumption that good faith and fairness are maintained in dealing with each other, and the purchaser applies rational behaviour in making decisions. Due to the necessity to reconstruct a situation in which there was no deception from the start, no effect for loss of trust may be included in the price determination.

At the end of the day, the court has to decide whether when reducing the agreed purchase price, the purchase price paid is reduced by applying the ratio of the reduction in the value of the company (new purchase price = old purchase price x (company value with no deception / company value including deception) or whether the company value reduction is simply deducted in full from the purchase price. Proportional reduction is suitable in those cases where the deception affects circumstances which are not of equal value to both parties (such as facts that affect the future profits of the company). If the purchaser has only paid an average value for these circumstances and not the purchaser company’s value, the difference to the purchaser company’s value may not be used. However, if the disputed fact has approximately the same value for the purchaser and the vendor (e.g. a liability that was not mentioned, or non-operating real estate), these items are considered to be reflected to a 100 percent level in the purchase price. These should therefore be included in full in calculating the residual trust damage.

Conclusion

The Vendor must inform the Purchaser about such things as the loss of customers and/or suppliers or insolvency risks, and not only in times of Corona. In case of a breach, there is a risk of the reversal of the SPA (share purchase agreement) or a claim for damages for the amount of the residual trust damage. Purchasers should keep copies of the information received during the transaction, e.g. in the form of meeting minutes and data room contents. They form the core evidence in M&A disputes.