3 questions to smart minds
Photo: Daniel Wied

Breach of balance sheet guarantees

For this 3 questions to Dr. Daniel Wied

ARQIS Attor­neys at Law
Photo: Daniel Wied
9. Novem­ber 2016

In Mergers & Aquit­si­ti­ons (M&A) — purchase agree­ments, a balance sheet guaran­tee is found as stan­dard, because of which protra­c­ted nego­tia­ti­ons often arise. The ques­tion arises as to whether a “subjec­tively soft” or “objec­tively hard” balance sheet guaran­tee should be issued. The inter­pre­ta­tion and, above all, the legal conse­quen­ces of brea­ching balance sheet guaran­tees have been contro­ver­sial for years.

For this 3 ques­ti­ons to Attor­ney at Law and Part­ner at ARQIS Attor­neys at Law in Munich

1. Balance sheet guaran­tees ulti­m­ately serve to protect the buyer of a company. What is a balance sheet guarantee?

With a balance sheet guaran­tee, the seller assu­res the buyer that the (usually most recent) finan­cial state­ments, as estab­lished and audi­ted if neces­sary, are correct. The balance sheet ulti­m­ately reflects the net assets, finan­cial posi­tion and results of opera­ti­ons of the company sold as of the last balance sheet date. Espe­ci­ally in so-called locked box purchase agree­ments, the last (often audi­ted) balance sheet plays a decisive role in the purchase price calcu­la­tion, since a purchase price adjus­t­ment to the closing date is no longer possi­ble. In the mean­time, howe­ver, there have been repea­ted attempts to use the balance sheet guaran­tee as a gene­ral fall­back guaran­tee. Espe­ci­ally since the advance of the S+I insu­ran­ces, the viola­tion of the balance sheet guaran­tee is infla­tio­na­rily brought into the field, espe­ci­ally if the buyer cannot claim a viola­tion with regard to other guaran­tees, which would actually be thema­ti­cally closer. Indeed, almost any breach of an opera­ting warranty may have had an impact on the balance sheet.

2. What are the points of conten­tion in a balance sheet guarantee?

The charac­te­ristics of a balance sheet guaran­tee are mani­fold and ther­e­fore various points can be argued about. The follo­wing topics are typi­cally bargai­ning chips:

  1. Is it only based on the seller’s know­ledge when prepa­ring the balance sheet or on the objec­tive factual situation?
  2. Is it only based on the rules for the prepa­ra­tion of balance sheets?
  3. Is a certain amount of equity insured?

Above all, howe­ver, the legal conse­quen­ces of a breach of a balance sheet guaran­tee are dispu­ted because the annual finan­cial state­ments and the balance sheet — unlike other brea­ches of guaran­tee — always have an influence on the purchase price calcu­la­tion. The main area of dispute can be summa­ri­zed by the keywords “balance sheet reple­nish­ment” vs. “purchase price reduc­tion”. The latest court rulings point dogma­ti­cally more in the direc­tion of purchase price reduc­tion and open up new lines of argu­men­ta­tion for the buy-side. Howe­ver, the parties can of course also speci­fi­cally regu­late the legal conse­quen­ces in the contract and opt for the dogma­ti­cally ques­tionable balance sheet reple­nish­ment. The outcome will depend on the situa­tio­nal bargai­ning power of the parties. It remains to be seen to what extent the calcu­la­tion of dama­ges based on multi­ples, which is often ruled out at least in conti­nen­tal Europe, will be able to assert itself more stron­gly in the nego­tia­ti­ons (at least in the case of so-called recur­ring EBITDA items).

3. What needs to be conside­red in an M&A contract to avoid ending up in court later on?

On the one hand, the latest court rulings have brought clarity to how various formu­la­ti­ons are inter­pre­ted. Ther­e­fore, care must be taken to use clear language and nuan­ces in the formu­la­tion. A few words can make a big diffe­rence here. On the other hand, there are massive uncer­tain­ties with regard to the legal conse­quen­ces of a breach of the balance sheet guaran­tee. Ideally, these uncer­tain­ties should be resol­ved directly in the purchase agree­ment, despite the leng­thy nego­tia­ti­ons that are likely to ensue with regard to this point, because other­wise you may end up in long post‑M&A dispu­tes that, in case of doubt, are of no use to either party and conti­nue to cost money.

About Daniel Wied

Dr. Daniel Wied joined ARQIS’ Munich office as a part­ner in 2016 and supports Chris­toph von Einem’s well-known venture capi­tal prac­tice in advi­sing start­ups and venture capi­ta­lists. Mr. Wied regu­larly advi­ses on company forma­ti­ons and finan­cing rounds from the concept deve­lo­p­ment phase to the growth phase. — Dr. Daniel Wied also specia­li­zes in mergers & acqui­si­ti­ons with a focus on private equity tran­sac­tions (also in the real estate environment).

Daniel Wied studied at the Univer­sity of Regens­burg, comple­ted his legal clerk­ship in Nurem­berg and London, and earned his Magis­ter iuris degree at the Univer­sity of Oxford, England. From 2014 — 2015 Daniel Wied was with DLA Piper UK LLP, Munich, prior to which he was with Ashurst LLP (2013 — 2014), Munich and with Kirk­land & Ellis Inter­na­tio­nal LLP, Munich and New York, USA (2009 — 2013). 

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