HOW REPRESENTATIONS AND WARRANTIES ARE TREATED UNDER SERBIAN LAW, AND IS SERBIAN LAW PRO OR ANTI SANDBAGGING?

Although this might sound a bit strange, I have to admit my personal fascination with M&A, going back to 2010 or so, when I did my first SPA. Although this is not as normal and usual as, for instance, fascination with cars, airplanes or machines, I do find M&A, and in particular, SPA’s similar to such items in terms of its complexity and mechanism. A lot of things have to be aligned to function, and as such, this is an intellectually stimulating exercise. And yes, crashes can happen here also.?

Now, in order to be able to properly start off this story, and make it more approachable to non-lawyers, and indeed, lawyers who do not engage in M&A (Mergers & Acquisitions), or draft SPA’s (Share Purchase Agreements), defining things is in order.

REPRESENTATIONS AND WARRANTIES

Representations and Warranties are Common Law institutes, and they represent a part of a purchase contract - SPA. If this purchase contract is for something minor, then Reps&Warranties are not really necessary. However, since M&A transactions deal with, well, huge sums, the Buyer really wants to make sure that it has as much protection as possible.

Now, being a Serbian lawyer, I would not presume to explain the difference between a Representation and a Warranty. I will just note that, unfortunately, I have encountered differing explanations. To give a short explanation, the purpose of Representations and Warranties is to provide protection to the buyer, by the seller giving a number of statements in the SPA that the Buyer can rely on, which are, essentially, the buyer’s assumptions when entering into a certain transaction. If they turn out to be untrue, the Buyer is entitled to compensation from the Seller, and, perhaps, to rescind the SPA. For more ease of reference, I will be just using the term “Warranties” from now on. Again, I have encountered somewhat differing explanations on the Representation vs. Warranty issue, and I do not want to spend too much time on it, particularly as I am not a US or English lawyer, and as I have the impression that differences are in practice being phased out. I am happy to hear explanations, of course.

SANDBAGGING

The Google dictionary indicates that this is: deliberately underperform in a race or competition to gain an unfair advantage. It seems to be linked with people filling socks with sand to engage in, ahem, morally questionable behavior. In any case, in the M&A context (which we all know is always morally upstanding? and above board): “sandbagging” typically refers to a situation in which the buyer is or becomes aware (through its own diligence or superior knowledge, either as of signing or between signing and closing) that a specific representation and warranty made by the seller in the acquisition agreement is untrue, signs and/or closes the transaction despite his or her knowledge of such breach, and then seeks to hold the seller liable for such breach post closing. (Glenn D. West and Kim M. Shah, Debunking the Myth of the Sandbagging Buyer: When Sellers Ask Buyers to Agree to Anti-Sandbagging Clauses, Who Is Sandbagging Whom?)

Based on my experience, the idea that the buyer would intentionally engage in this scenario is quite fantastic, and I agree with the idea expressed in this article.

Quite the contrary from the notion of the unethical buyer, sandbagging warranties are sometimes included as a desperate attempt to save the transaction, and provide a shred of security to the buyer.

SERBIAN LAW

A few words on Serbian Law are now in order. Serbian Law is firmly in the Civil Law family, and as such, has written rules on (most) issues. The main rule governing contracts in Serbia is the Law on Obligations, or Law on Contracts and Torts (the former is the more literal translation, the latter a bit more easier on Anglo-American ears – for easier reference and search, I will be using the more literal one).

A thing that should be noted that Mergers and Acquisitions are pretty much pure capitalism, while our Law on Obligations was adopted in Yugoslavia 1978, during the waning years of communism. Being market-friendly was not exactly a first priority, but then again, by that time it was mostly understood that private initiative is King. Also, Yugoslavia and Serbia were generally under Western European legal influence, and the law was prepared by some very good lawyers. That is why it has endured up to this day, with minimal amendments.

One of the major principles of Civil Law, of course, is that most rules are written onto laws. Court precedents, while relevant, are not given the importance they have in Common Law. Given this, the Serbian Law on Obligations defines the basic contractual rules, and also defines most important commercial contracts in use. However, the Law on Obligations especially shows its age when the subject matter moves to Warranties.

SERBIAN LAW RULES ON LIABILITY OF THE SELLER – LEGAL, MATERIAL (AND OTHER?) DEFECTS & WARRANTIES

The rules governing the liability of the Seller are found in the Sale Contract provisions of the Law on Obligations. Any Warranties given by the seller to the buyer should be interpreted in line with those clauses.

However, there are three major parts of the rules on liability: liability for material defects, producer’s warranties, and liabilities for legal defects.

Right off the bat, producer’s warranties are not something that is relevant in the context of M&A. This is important for the sale of technical goods.

Also, we can immediately see that liabilities for legal defects are extremely important for M&A context, because it deals with the rights of third parties on the sold item that exclude, diminish or limit the buyer’s right. In essence, these are the Title Warranties, dealing with guaranteeing the ownership right and lack of encumbrances. Pretty fundamental things in any transaction.

However, Title Warranties, while quite important, are only a part of the whole seller Warranty package.

Things become somewhat unclear on what are the rules applicable to these, “Other” Warranties.

One interpretation that I have encountered is that the rules on material defects apply to the Other Warranties. However, “material” in terms of the wording of the Law on Obligations, and its preceding rules, pretty much point to “physical”. And these are mostly not applicable to M&A, aside from the context of an Asset Purchase Agreement (as opposed to a Share Purchase Agreement). In case we have an Asset Purchase Agreement, then yes, it is clear that the rules on material defects of the sold Asset(s) would apply, and be highly relevant.

However, in the context of a SPA (Share Purchase Agreement), the buyer is acquiring shares in companies (I will not go into the shares in a Serbian joint stock company vs shareholding interests in a limited liability company – they are both referred to as “shares”). Physical aspects of shares are irrelevant. What is important is the aspects of the company that is owned through those shares. The Seller warrants that such a company does not have disputes with employees, applies certain accounting practices, has all relevant licenses, etc. I have encountered interpretations that these Warranties can be interpreted using the material defects rules, but, strictly speaking, these Warranties do not deal with either legal or material defects. These, Other, Warranties should properly fall under the general rules on free will of the parties to arrange their contractual relations.

The situation is then as follows:

• Rules on legal defects: govern Title Warranties;
• Rules on material defects: govern physical Warranties (in case of an Asset Purchase Agreement);
• Rules on material defects, or simply will of the parties: govern Other Warranties.

It should be noted that the Law on Obligations recognizes both price reduction and damage compensation, as separate types of claims the buyer might have against the seller.

AND WHAT ABOUT SANDBAGGING?

Since we have identified the relevant rules, let’s answer our question from the beginning: how does Serbian Law see Sandbagging in M&A?

First of all, Title Warranties. They are governed by rules on legal defects, which are relatively clear:

Art 510: (4) However, if the buyer, at the time of concluding the contract, knew of the possibility that the item would be taken away from him, or that his right would be reduced or limited, he does not have the right to compensation for damages if that possibility is realized, but he has the right to demand a refund, i.e. a price reduction.

So definitively a loss for actual caricatural Sandbagging unfair buyer, but, for an actual buyer, who is simply trying to protect itself, these rules are pretty fair – he would receive the money back. Given the propensity of most transaction to limit the amount of compensation from seller to buyer to the amount of the share purchase price, and thereby exclude additional punitive damages, the rules are pretty protective towards the buyer, even in case he knew of a potential legal (title) defect.

Even better for the buyer:

Art 513 … (2) If at the time of the conclusion of the contract the seller was aware or could not remain unaware of any defect in his right, the provision of the contract on the limitation or exclusion of liability for legal defects is null and void.

So the seller cannot avoid its liability for the legal defects it was aware of, even if the parties agreed.

All in all, pretty buyer-friendly.

On to Other Warranties.

As discussed, here we are on a bit more unstable ground.

Since there is a possibility that the Other Warranties are considered as something that is completely up to the parties, the buyer and seller really should clearly define what is their agreement.

If the Other Warranties are considered as something that falls within the scope of liability for material defects, then the rules are as follows:

Art. 479: Material defects occur: …

3) if the item does not have properties and characteristics that are expressly or tacitly contracted, or prescribed;

Art 480:

(1) The seller is not responsible for defects from point … 3) of the previous article, if they were known to the buyer at the time of the conclusion of the contract or could not remain unknown to him.

(2) It is considered that those defects could not have remained unknown to the buyer, which a careful person with average knowledge and experience of a person in the same profession and profession as the buyer could easily notice during a normal inspection of items.

(3) However, the seller is also responsible for defects that the buyer could have easily noticed, if he declared that the item has no defects or that the item has certain properties or characteristics.

Hence, the rules are that the seller is not responsible for defects that are easily noticeable (so, definitively a nod in the direction that a due diligence of the target company is necessary), but if the seller declares (or represents, or warrants) that there are no defects, then the buyer can rely on it. The formulation is not fully conclusive (could have easily noticed vs. actually noticed), but in practice, close enough.

The buyer has the option to request to ask for the cure of the defect, reduction of price, or even to rescind the contract. Plus claim damages.

Again, even if Other Warranties are something that is unregulated by either legal or material defect rules, such rules are the closest proximity, and the court would probably use them as guidelines.

TO CONCLUDE…

The above rules indicate that Serbia might be Pro Sandbagging. I would not go quite that far, as the culture places equity in high regard, and I do think it is highly unlikely that a court would award damages to the buyer that knew something was wrong. But in terms of protecting the buyer, it does look promising. One would wish for a bit more court practice in this regard, but, alas…

Again, one should never just rely on a Warranty as a primary solution to an identified problem (or any significant problem, for that matter), but it might just work as a last-ditch option.