Evrim Uygur Yamaner and İrem Özbay of Gled Partners consider seller liability in providing representations and warranties when transferring shares
In merger and acquisition (M&A) share transfer agreements, it is common to include statements and representations assuring that there are no encumbrances on the shares and that the company was properly established, legally compliant and possesses required permits and licences.
However, the law lacks specific regulations on liability related to representations and warranties in share transfer agreements. Consequently, the Turkish Code of Obligations No. 6098 (TCO) provisions concerning a seller’s liability for fundamental defects are also applied to share transfer agreements. However, these statements’ applicability and scope in such agreements are debated. As a result, in practice, transferees may request separate representations and warranties from transferors on various matters1.
In this article, the legal nature of representations and warranties included in share transfer agreements will be examined, and the legal liability of the share seller arising from these representations and warranties will be discussed.
General overview of share transfer transactions
The transfer of shares in a capital stock company involves the transfer of ownership rights in the company, rather than the transfer of the company’s operations or assets. In this regard, the legal nature of a share transfer is more akin to a transfer of rights rather than a transfer of property.
Necessary legal procedures for a share transfer vary depending on the type of the company, the type of shares, and whether the transfer of shares is restricted or not. In the case of shares of a privately held joint-stock company that are in bearer form, as per Article 489 of the Turkish Commercial Code No. 6102 (TCC), the transfer of shares will be effective through notification to the central securities depository by the recipient of the shares. If the shares are in registered form, the transfer process will be completed through endorsement and transfer of possession of the share certificate, in accordance with TCC Article 490.
Under the TCC, there is no requirement for a separate contractual agreement nor a separate binding agreement. It is sufficient to simply follow the transfer procedures prescribed by the law to effectuate the transfer of shares.
However, in practice, share transfer agreements are commonly used as binding agreements with the aim of transferring and acquiring the entirety of the economic rights and interests.
Representations and warranties in share transfer agreements
Legal nature of representations and warranties
In the case of contracts relating to the sale of shares that constitute binding agreements, there is no specific regulation in the TCC. Therefore, the seller’s liability arising from the share transfer agreement will be subject to the general provisions of the TCO.
Share transfer agreements focus on the sale of shares, yet buyers also wish to acquire the company’s operations. While the TCO’s general provisions for sales contracts apply, they are often seen as insufficient in this case. Consequently, these agreements usually contain detailed clauses related to representations and warranties and are particularly crucial in M&A.2
The list of representations and warranties varies depending on the nature of a company, but specific ones are found in most transfer agreements. In this context, first, representations and warranties relating to the joint-stock company whose shares are being transferred are included and the following may apply:
- information provided about the company is accurate;
- company has been legally established and exists in compliance with laws;
- it possesses the necessary permits and authorisations;
- it is not in a state of insolvency;
- there are no ongoing legal actions against the company;
- the balance sheet which will be prepared when the share transfer agreement is executed will comply with accounting principles and legal requirements;
- identification of the company’s shareholders and the characteristics of their shares;
- proper maintenance and storage of all accounting records, books and financial records in accordance with the law and regulations;
- allocation of necessary reserves;
- absence of any significant contracts entered into other than those known by the transferee;
- customary insurance coverages;
- existence of intellectual property rights as represented;
- non-violation of any third-party rights;
- proper declaration and payment of taxes;
- absence of any lawsuits or proceedings initiated against the company other than those disclosed to the transferee;
- absence of similar pending risks; and
- compliance with legal obligations related to employees.3
Regarding representations and warranties for company shares, they may include assurance of all shares issued and in circulation; fulfillment of capital contribution obligations; absence of authority to increase the company’s capital; absence of bonds issued; no purchase or pre-emption rights in articles or agreements; and seller’s ownership and transfer authority. Additionally, the seller often assures that the execution of the contract does not violate any other agreements or obligations the seller has entered into with third parties.4
Difference between qualification statements and guarantee commitment
In practice, there is debate about whether the provisions used under the title of representations and warranties fall within the scope of ‘quality notification’ under Article 219 of the TCC or ‘guarantee commitment’ according to the general provisions of the TCC. In legal doctrine, the fundamental reason for this debate is the use of the terms ‘representation’ and ‘warranty,’ influenced by the Anglo-American legal system.
We examine the differences in the table below. In summary, commitments within the seller’s control provided retrospectively (typically at contract signing) generally imply quality notices and result in defect warranties if breached Conversely, assuming risks unrelated to the company’s nature and condition at the time of damage (closing) indicates a guarantee contract.9
|Undertakings that the corporation to be transferred has certain positive qualities or does not have certain negative qualities at the time the transfer agreement is concluded, or sometimes from the time the agreement is concluded until the time the transfer takes place (at closing), including the time in-between.5
|Commitments that guarantee that the statements made by the transferor are accurate and that the transferor would pay compensation for damages if the risks specified in the contract arise.
|Could be made in relation to the actual situation at a particular moment.
|Commitments for future events should be treated as guarantee commitments. However, statements of qualifications regarding future events are not invalid and are considered as guarantee representations.7
|In doctrine, it is accepted that they are subject to the provisions of warranty for defects regulated in the TCO.
|Considered as independent debts in the doctrine, and in the case of breach, general provisions on breach of obligation shall apply.8
|The statute of limitations according to the defect provisions is two years.
|The statute of limitations is a general limitation period of ten years.
|They may be related to the current status of the activity carried out by the company whose shares are subject to transfer, its business, existing assets and/or other economic values.
|Could be about other matters.
Scope of responsibility arising from declarations and warranties in share transfer
The need to include declarations and undertakings in share transfer agreements should be discussed. If the transfer does not change the partnership’s control, the transferor is responsible for share ownership rights and certificate validity unless explicitly stated10. If the transfer changes control, the transferor is accountable even without specific statements, and they are liable for substantial legal defects and asset deficiencies.11
As the applicability of general defect liability provisions does hinge on the shift of control from the seller to the buyer, each specific case should be assessed, guided by definitions in the TCC, competition law and capital markets law.
How due diligence affects liability for defects
In corporate acquisitions, the buyer conducts a thorough examination, known as ‘due diligence,’ before signing the contract. This includes assessing various aspects of the target company, such as its incorporation documents, permits, intellectual property, assets, litigation and shares being sold. Due diligence arises from the buyer assuming risk and the Anglo-American legal system’s principle that the buyer must safeguard the acquisition’s potential consequences.
The buyer’s legal examination determines the seller’s liability for defects. According to Article 222 of the TCO, the seller is not responsible for defects that the buyer knows or should have known during the pre-agreement inspection, which includes obvious defects. However, hidden defects remain the seller’s liability. Article 222/2 of the TCO also excludes the buyer’s knowledge of defects when they fall within the scope of representations and warranties. (The seller is liable for defects that the buyer could find through proper inspection only if the seller has stated there are no such defects.)
In share transfer agreements, commonly encountered in M&A processes and not explicitly regulated by law, detailed lists of representations and warranties are typically included. This practice aims to facilitate the takeover of the target company’s operations alongside the share transfer. The legal nature of these representations and warranties is debated, with varying consequences and seller responsibilities depending on the distinction. Depending on the specific case, these provisions can be referred to as ‘quality statements’ or ‘warranty representations’. The seller’s liability depends on the legal nature of these provisions, and whether the share transfer changes control of the target company also factors into this responsibility. Therefore, it is crucial to align representations and warranties with identified risks and due diligence in these agreements.
1. İdil Alaeddinoğlu, Share Transfer Agreements in Joint Stock Companies, Ankara, 2022
2. Kästle, Florian and Oberbracht, Dirk, Unternahmenskauf-Share Purchase Agreement, 3. Auflage 2018, s1
3. Alaeddinoğlu, p135
4. Alaeddinoğlu, p136
5. Buz, Vedat: ‘Ortaklık Paylarının Devrinde Ayıba Karşı Tekeffül Hükümlerinin Uygulanabilirliği Sorunu’, Banka ve Ticaret Hukuku Dergisi, Cilt 35, Sayı 3, 2019, s71-72
6. Türkyilmaz, p165-166
7. Buz, s73-74
8. Buz, s72
9. Zahide Altunbaş Sancak, ‘The Seller’s Liability in Company Acquisitions’
10. Pasli, s273
11. Poroy, Reha; Tekinalp, Ünal and Çamoğlu, Ersin, Corporate Law, 2014, s556