The negotiation of the guarantee catalogue plays a substantial role in the M&A process. The seller's liability is a key point of negotiation in every transaction. However, the definition of the term "damage" is given relatively short shrift and often falls back on a supposed standard compromise. Too little importance is attached to the interplay between guarantees and the concept of damage. From the buyer's point of view, this is remarkable, as the value content of the warranty catalogue is largely limited by the concept of compensable damage.
Definition of damages in the M&A context
In practice, it is not uncommon to see impressively long and detailed catalogues of warranty declarations that are intended to establish the seller's liability if they are incorrect. However, this is often combined with a comparatively narrow definition of the facts fulfilling liability, which significantly reduces the value of the warranty catalogue.
An essential element for the seller's liability on the liability-filling side is the definition of compensable damage. While the seller's first draft often attempts to limit the definition of damages to direct damages only, most sales contract negotiations result in a supposed standard compromise: (i) direct damages and (ii) indirect damages or consequential damages, insofar as these were reasonably foreseeable when the contract was concluded, should be eligible for compensation. In addition to many other items such as business interruption costs, internal administration costs or taxes, lost profits and wasted expenditure are also excluded.
Depending on the individual case, this standard compromise may represent an appropriate balance of interests between seller and buyer. The problem, however, is that few sellers and buyers are even able to explain which consequences of damage in the event of a breach of warranty are covered by the liability regime and which are not. The reason for this is not so much the lack of conceptualisation on the part of the headmasters, but rather the use of the statutory definition of damage (Sections 249 et seq. BGB) in combination with a large number of undefined legal terms. This makes the concept of damage in the M&A context difficult to grasp and leads to too little attention being paid to the interplay between the concept of damage and the catalogue of guarantees.
The main advantage of this method of determining the purchase price is that it is simple. However, this is also its biggest disadvantage. A company is "alive" and the key financial figures are always in flux. A fixed purchase price will regularly not be able to accurately reflect the enterprise value and financial position of the company at the time of completion. This can penalise either the buyer or the seller.
Overview of the concept of damage
The definition of damages in sales contracts is always based on §§ 249ff. BGB ("losses shall mean damages within the meaning of §§ 249ff. BGB [...]"). However, the subsequent distinction between direct, indirect and consequential damages is foreign to German law (unlike American law, for example). The legal starting point is rather in rem restitution:
"§ Section 249 (1) BGB: Whoever is obliged to pay compensation must restore the condition that would have existed if the circumstance obliging compensation had not occurred."
The condition to be established in this respect then depends on the respective basis of the claim and its protective purpose. A fundamental distinction is made here between (i) negative interest (loss of confidence), (ii) positive interest (loss of fulfilment) and (iii) integrity interest. In the M&A context and especially in the case of breaches of warranty, the Positive interest owed.
The positive interest is directed towards the condition that would exist if the contract had been properly executed, i.e. if the warranty in question had been correct. If this condition cannot be restored (which is usually the case), the seller must pay monetary compensation. This amount of money is then generally determined by means of the difference hypothesis. Put simply, a comparison is made: How would the buyer be positioned if the warranty had been correct vs. how is the buyer positioned with a breach of warranty.
As part of the positive interest, the following are generally eligible for compensation:
- Expenditure required to restore the legal status
- Reduced value of the company due to the breach of warranty
- Lost profit according to § 252 BGB
- Expenses incurred in vain according to § 284 BGB
In sales contracts, this statutory scope of damages is now regularly limited to the direct damage or the direct damage and the indirect damage, insofar as it was reasonably foreseeable.
While the terms "loss of profit" or "wasted expenditure" are still catchy or adequately defined, the distinction between direct damage, indirect damage and consequential damage often causes difficulties.
Direct damage vs. indirect damage
The distinction between direct and indirect damages is a purely contractual distinction that is unknown to the law. There is also no clear distinction between this pair of terms in literature and case law (see BGH, judgement of 8 June 1994, AZ VIII ZR 103/93). The terms are undefined and therefore only suitable to a limited extent for the legally secure limitation of the scope of damage!
The interpretation and delimitation of the two terms must be based on the regulatory purpose of the contract in question itself. According to the general understanding - both in legal terminology and in common parlance - there is much to be said in favour of understanding "direct damage" as damage caused to the protected legal interest itself. "Indirect damage" therefore refers to damage caused to other legal interests (see also BGH NJW 2003, 826).
In relation to breaches of warranty, direct damage therefore extends to the damage that occurs to the legal asset that is to be covered by the protective purpose of the respective warranty.
Simple exampleThe seller guarantees that certain assets are in working order at the time of signing. However, the guarantee is now incorrect because an asset is defective. The cost of repairing or replacing this asset is the direct loss.
Indirect damages in this case can be: (i) loss of use or loss of profit, (ii) reputational damage because delivery deadlines could not be met, (iii) obligations to pay damages to customers, and (iv) many other conceivable items.
However, it is more difficult to differentiate between direct and indirect damage in the case of other guarantees that typically occur in sales contracts.
ExampleThe seller guarantees (in simple terms) that the 10 customer contracts with the highest turnover are valid on the day of signing, that they have not been cancelled and that there are no breaches of these contracts that would entitle one party to terminate the contract. The guarantee turns out to be incorrect because the target company has acted in gross breach of contract and a customer has effectively cancelled the contract for good cause 5 days before signing.
In this case, it is more difficult to identify the direct damage. The guaranteed customer contract no longer existed at the time of signing. The direct damage could now lie in the effort required to re-establish the contractual relationship (if that is even possible)? Alternatively, one could focus on the effort required to re-establish a comparable customer relationship (if this is possible at all). However, it is possible that the parties are more concerned with protecting the sales or profit expectations linked to this contract. However, this would typically be categorised as indirect damage - similar to loss of use damage. And even if they were qualified as direct damage in this case, how would this relate to the fact that loss of profit within the meaning of Section 252 BGB is excluded from the definition of damage? § 252 BGB is regularly expressly excluded from the definition of damages?
The example illustrates that the definition of damages is not sufficiently clear, particularly in relation to individual warranties. This is decisive for the value of the guarantee catalogue, because if the sales or profit expectation from the relevant contract is not eligible for compensation, how valuable is the "Material Agreements" guarantee, which is usually regarded as one of the most important operational guarantees?
Another special topic that illustrates the difficulty of determining the compensable damage in individual cases is the discussion of the legal consequences of a breach of the balance sheet guarantee.
Compensation could be owed here in the form of so-called balance sheet replenishment. However, this is not always compatible with the principles of the law of damages according to §§ 249ff BGB. A claim that is wrongly recognised in the balance sheet does not automatically mean damages in the amount of this claim. This is not the case, for example, if the "debtor" is insolvent anyway. The same applies to a provision that was wrongly not recognised if the risk never materialises.
As the balance sheet is ultimately the basis for the buyer's valuation, the buyer may have to be treated as if it had acquired the company more favourably if it had known the correct balance sheet. However, this in turn typically collides with contractual clauses that exclude the defence that the purchase price was calculated on the basis of incorrect assumptions when determining the damages.
A discussion of this specialised topic would go beyond the scope of this article. However, many sellers would claim that the balance sheet guarantee is the most important of all guarantees. The uncertainties that typically exist with regard to the legal consequences are all the more serious.
Insofar as damages are generally compensable under the contract, there is a further vagueness if this is only to apply insofar as these damages were "reasonably foreseeable". A generally recognised definition of "reasonably foreseeable" does not exist. It can probably be assumed that completely atypical or completely unusual damage constellations should be excluded. However, it is also unclear when damage is reasonably foreseeable and whose standard should be taken into account.
Consequential damage
The term "consequential damage" is often mentioned in the same breath as the term "indirect damage". In fact, consequential loss is ultimately a subset of indirect loss. The legal distinction has practically no relevance in the M&A context.
The distinction presumably stems from a dogmatic legal dispute as to whether the buyer's interest in integrity can be asserted by way of compensation "instead of performance" or "in addition to performance". It is therefore a question of different bases for claims. In the M&A context, however, the basis of the claim is the same in each case, namely the no-fault guarantee promise.
If one nevertheless wishes to differentiate, one could understand the "indirect damage" as an impairment of the equivalence interest and the "consequential damage" as an impairment of the integrity interest.
ExampleThe customer buys a bicycle. However, the frame of the bicycle is defective. Indirect damage caused by the defective frame is now all damage that ultimately affects the equivalent of the purchase price, i.e. the bicycle. For example, any loss of use damage. However, if the customer falls with the bicycle and ruins their clothing, the damage no longer affects the equivalent interest, but completely different legal interests of the customer (so-called integrity interest).
In the M&A context, such consequential damages would theoretically be conceivable if not only the acquired target company is affected, but also an existing company or other legal assets of the buyer as a result of post-merger integration.
Implications for the purchase agreement
The statutory definition of damage in §§ 249 et seq. BGB is extremely broad. Therefore, a contractual restriction of the concept of damage is generally sensible. However, it is important that the buyer and seller are as clear as possible about which damage constellations are covered by the purchase agreement and which are not. The above examples illustrate that an abstract (standard) definition of the concept of damage alone is generally not sufficient to fully reflect the meaning and purpose of the warranties as intended by the parties. The concept of damage interacts closely with the guarantee catalogue and must therefore also be understood in the light of the guarantees and - where necessary - specified or adapted.
The restriction of the definition of damage to only direct damage represents a substantial limitation of the damage eligible for compensation. If indirect damages are not eligible for compensation, the guarantee catalogue will not be able to fulfil its purpose, where guarantees are naturally aimed at indirect consequences of damage. Here, the parties should consider opening up the definition of the term "damage" to such guarantee declarations, if not to the entire guarantee catalogue.
If the parties have certain consequences of damage in mind with regard to individual guarantees and these do not fall unequivocally under the abstract definition of damage, the relevant constellation should be described in the contract and expressly agreed as covered. It is advisable to mentally review the entire guarantee catalogue to determine whether the typical damage event is also unambiguously covered by the abstract definition of damage if the guarantee is incorrect.
Analysing the guarantees against the background of the definition of damage should also encourage the parties to question whether an issue can actually be meaningfully covered by a guarantee. It may also lead to the realisation that no meaningful remedy can be found in the event of a claim and that the parties should instead discuss how the claim can be reliably avoided (more detailed due diligence, closing conditions, closing actions or covenants as an alternative to the guarantee instrument).
The parties should also be clear as to whether the definition of damages applies only to breaches of warranty or also to other potential claims under the purchase agreement. In the latter case, the other possible provisions giving rise to claims should also be analysed against the background of the definition of damages.
Excursus: W&I insurance
In the context of larger transactions (but increasingly also in mid-cap transactions), the guarantees are covered by warranties and indemnities insurance (W&I insurance). As is well known, it is possible to synthetically improve the contractual conditions in relation to the insurer (so-called enhancements). A typical enhancement is the extension of the definition of damage to include indirect damage and loss of profit. If, according to the purchase contract, only the direct damage is otherwise eligible for compensation, this enhancement is a material gain for the buyer on the liability-filling side of the offence. The additional premium is regularly well invested here.
Conclusion
The legal definition of damages is too broad in the context of M&A transactions. However, the contractual restriction using undefined legal terms leads to conceptual uncertainties. With the help of their legal advisors, buyers and sellers should clarify which consequences of damage are specifically covered by the definition of indemnifiable damage. The warranty catalogue should be read and understood against this background. Only if the facts giving rise to liability (the warranty catalogue) are understood and negotiated in close interaction with the facts fulfilling liability (above all the concept of damage) can the understanding and intention of the parties be mapped with legal certainty.