Energy & Infrastructure

“Hard” balance sheet warranties in M&A deals in the energy sector

ENERGY NEWS#8/2017   Information in annual financial statements is crucial when valuing a target company. For this reason, financial statements warranties in company acquisition agreements often end up being the subject of post-M&A disputes. This makes them a gateway for compensation claims by the buyer. An important recent decision on financial statements warranties by the Frankfurt am Main Higher Regional Court (judgment of 7 May 2015 – 26 U 35/12, NZG 2016, 435 ff.) has implications for how such warranties will need to be structured in energy company acquisition agreements in future.

  • The Frankfurt am Main Higher Regional Court’s decision shows that care should be taken when agreeing financial statements warranties for energy companies up for sale.
  • In a “hard” (or objective) financial statements warranty, if the seller is not liable for liabilities or contingent liabilities that were unknown as of the cut-off date, then the warranty must contain a subjective limitation (e.g. seller’s knowledge), according to the Frankfurt Higher Regional Court’s decision.
  • To date, there has been no clear direction to the legal consequences of a breach of financial statements warranties. To avoid the considerable interpretative leeway inherent in any dispute, it should be made clear whether “replenishment of the balance sheet” or the difference between the purchase price actually paid and a hypothetically lower one (compensation) should be paid.


Interpreting and wording the financial statements warranty in the company acquisition Agreement

In the case ruled on by the Frankfurt Higher Regional Court, the seller warranted that the financial statement had

“been prepared with the due care of a prudent businessman, in compliance with accounting principles according to statutory regulations and maintaining balance sheet and valuation continuity " and that it had communicated “a true and fair view of the assets, liabilities, financial position and profit or loss of the company”.

The Frankfurt Higher Regional Court considered this to be a “hard” financial statements warranty. This, the Court stated, is also breached if the target company has liabilities that “were not evident when the reference statement was prepared.”

There is no set definition of financial statements warranties (soft/hard; subjective/objective) in energy M&A practice or the legal literature. But most practitioners in this area would likely have interpreted this wording as constituting a “soft” (or subjective) financial statements warranty. In this view, the rough distinction between a “hard” and “soft” warranty would be that in the latter there could only be a breach of warranty if the events or liabilities in question had occurred or arisen before or on the cut-off date and were therefore known or at least could have been known. The Frankfurt Higher Regional Court’s Interpretation therefore comes as something of a surprise to energy M&A practice and indicates that this point should be explicitly clarified in financial statements warranties in future.

Experience shows that the relevant constellations are not a rarity in the energy sector. Again and again, case law has brought about fundamental legal developments which have led to fees being adjusted or tariffs being set by statutory law. If a financial statements warranty is looked at objectively, this can lead to a warranty breach because the corresponding provisions for increased fees or compensation of lower remuneration were not included in the balance sheet. One example of this is how the term “installation” (Anlage) has undergone changes in the German Renewable Energy Sources Act (EEG). Depending on how this term was interpreted, it was possible for it to refer to several installations, each of which did not meet the relevant thresholds for remuneration, thereby generating higher revenue than if they were considered to be one installation. Similar constellations can be found as regards the generation of electricity for self-consumption. Criteria such as how the operator’s legal status is structured and the proximity of an energy generation installation to the operator’s own industrial site consuming the electricity are treated in specific ways. Depending on this treatment, the EEG surcharge may or may not
have to be deducted for the installation.

In M&A transactions in the energy sector, sellers will want to avoid incurring a comprehensive duty to assume liability for any unknown or contingent liabilities because a warranty’s wording was (unintentionally) ambiguous. This applies in particular to liabilities that were not evident to the seller at the time the financial statements were prepared, even applying the due care of a prudent businessman. Otherwise, the seller would give a rather uncommon “no undisclosed liabilities” guarantee,. So sellers should aim for financial statements warranties that are only required to include events that were known as of the financial statement’s cut-off date.

Legal consequences of breaching a financial statements warranty

Borrowing from the statutory provision in section 249 German Civil Code (BGB), the parties agreed that upon a breach of the financial statements warranty

“the Buyer shall be given financial compensation such that it is in the same position as it would be if the corresponding warranty had been accurate.”

From this, the Frankfurt Higher Regional Court concluded that the buyer needed to be put in the position it would have been in if, knowing the correct financial statement, it had been able to conclude the company acquisition agreement for a lower price. So the Court assumed that if the buyer had known the correct balance sheet (item), it would have succeeded in agreeing on a lower price for the target company. Contrary to the view taken by the previous instance, the Frankfurt Higher Regional Court decided not to add up the difference of the individual incorrect balance sheet items when setting compensation, and rejected any claim on the buyer’s part to “replenishment of the balance sheet”. The differing views taken by the Frankfurt Higher Regional Court and the previous instance reflect the inconsistent and unclear line in other case law and legal literature.

Gleiss Lutz commentary

It is frequently difficult to calculate the lower purchase price that would have been hypothetically agreed, and therefore damages, as stipulated by the Frankfurt Higher Regional Court. Not infrequently in M&A practice in the energy sector, purchase price calculations are employed which generally assume that the most recent financial statements are correct. But such calculations do not explicitly include the statements in the formula for calculating the purchase price. Likewise, the purchase price may be marked up or down in the course of negotiations. Such increases or decreases in the purchase price may be made in the light of the disclosed balance sheets, but they have no mathematical relationship with individual balance sheet
items, and in some cases only reflect the competitive situation.

What does this mean for future M&A practice in the energy sector? The wording that usually covers the legal consequences of any breach of the purchase agreement is borrowed from section 249 German Civil Code. When a financial Statements warranty is breached, however, this wording offers a large scope of interpretation. To avoid potential disputes, it should be expressly stated whether the legal consequence of a breached financial statements warranty is a claim to replenishment of the balance sheet or compensation for the difference in value to the lower purchase price that would have been hypothetically obtained. In the latter case, the purchase price calculation should be broken down accordingly so that the lower purchase price can be calculated later without dispute.

Proposed citation: Topf/Schmidt-Bendun, The Frankfurt Higher Regional Court’s decision on “hard” financial Statements warranties and its impact on transaction practice in the energy sector, Gleiss Lutz Energy News #8/2017, 5 April 2017