When performing an M&A transaction in the Netherlands, Anglo-Saxon deal-makers may be caught at a surprise by the principles of ‘good faith’ and/or ‘reasonableness and fairness’. Since this Dutch surprise may not always be pleasant, we decided to highlight two consequences of these principles in respect of M&A transactions. First, we will discuss the pre-contractual ‘good faith’ in relation to breaking off negotiations. After that we will focus on the complex relationship between the ‘duty to disclosure’ versus the ‘duty to investigate’ in a sales transaction.
Pre-contractual good faith and breaking off negotiations in the Netherlands
When parties enter into negotiations with a view to entering into any agreement, such parties are considered to be in a ‘special legal relationship’. This special relationship implies that even during the pre-contractual phase, the parties have to take each other’s reasonable interests into consideration. Based on this ‘pre-contractual good faith’, the parties may not always have the right to unilaterally break off negotiations. The obligations imposed by this ‘pre-contractual good faith’ are not laid down in legislation, but have been developed in case-law.
Under the Dutch Civil Code, parties to an agreement are obliged to observe the principles of reasonableness and fairness in their relationship. This implies that they are under a duty to take into account each other’s reasonable interests when exercising their contractual rights. In case-law, this principle of reasonableness and fairness has been applied to parties who are negotiating an agreement: the pre-contractual phase. Traditionally, the Netherlands literature and case-law tried to define the ‘pre-contractual good faith’ by creating three separate pre-contractual stages: (i) the first stage, during which the parties are entitled to break off negotiations without any consequences; (ii) the second stage, during which the parties may terminate the negotiations, if the terminating party reimburses the non-terminating party’s costs and expenses; and (iii) the third phase, during which the parties may not terminate and if a party does so nonetheless he may be ordered to (a) not only reimburse the non-terminating party’s costs and expenses, but also his lost profits and/or to (b) continue negotiations. Unfortunately, there are no clear-cut rules that separate these three phases.
However, the Supreme Court has recently ruled that in principle a party has sole discretion to break off negotiations, unless (i) the non-terminating party had the justified expectation that an agreement would be reached or (ii) such break-off would be unacceptable, taking all relevant circumstances into consideration. The extent and the way the terminating party contributed to the existence of said justified expectation and the justified interests of the non-terminating party are also relevant factors that should be considered. In this respect, it may also be important to verify if any unforeseen circumstances occurred and if so, and the negotiations have continued, what the influence of such unforeseen circumstances was on the justified expectations and the course of the negotiations. The Supreme Court ruledthat the above stringent rule must be applied reticently. In its recent decision, the Supreme Court did not shed any light on the distinction between the above-mentioned three separate pre-contractual stages. However, one can assume that the Supreme Court supports that if a party was not entitled to break off the negotiations, the non-terminating party may choose between claiming compensation of costs, re-negotiations and/or lost profits, depending on the factual circumstances.
Under common law, if the parties desire to have discretion to break off negotiations, such is usually achieved by simply inserting ‘subject to contract’ in drafts of purchase agreements. However, such ‘save harbour’ does not exist in the Netherlands. Bearing the above Supreme Court decision in mind, if the parties desire to have discretion to break off negotiations, it is advisable to clearly define what the parties may expect from each other in order to avoid that one party may obtain the justified expectations that an agreement will be concluded. And of course, such should be well documented, which is usually done in a Letter of Intent (LOI). For instance, an LOI may expressly state that (i) it is non-binding; (ii) the parties have sole discretion to withdraw without becoming liable; (iii) the final agreement is subject to satisfactorily due diligence and certain further conditions. However, even such non-binding LOI may not fully prevent a party from obtaining said justified expectations, because the assessment whether the other party has such expectations is a factual assessment made at the time of the break-off of the negotiations and not at the time of entering into the LOI. In a certain matter, a Dutch court ruled that although the LOI included that the entry of a final agreement was subject to the consent of the banks and such consent had not been obtained, the terminating party was liable for certain damages, as it had given the other party the impression that such consent would not be a problem and thereby given the other party the justified expectation that an agreement would be concluded.
In other words, if the parties desire to have discretion to break off negotiations, it is necessary not only to explicitly agree this by inserting certain specific clauses into the LOI, but also to explicitly reiterate such conditions during the negotiating process, in order to avoid that the other party will obtain justified expectations that an agreement of some sort will be reached.
Duty to disclose versus the duty to investigate the target in the Netherlands
Like in many other jurisdictions, it has become common practice in the Netherlands to perform a due diligence investigation on the target company prior to entering into a purchase agreement. In fact, acquiring a company without performing a proper due diligence investigation may lead to personal liability of the responsible managing directors due to mismanagement.
Common law generally expects a purchaser to be responsible for his own investigation, based on the principle of ‘caveat emptor’, or ‘buyer beware’. A purchaser is not likely to be protected when he could have discovered a problem related to the target oneself.
In the Netherlands, this is not so clear-cut. The special pre-contactual legal relationship referred to above, which implies that the parties have to take each other’s justified interests into consideration during the pre-contractual phase, also plays a role here. In respect of due diligence investigations, the pre-contractual good faith results in a complex relation between the duty of the seller to disclose relevant information and the duty of the purchaser to investigate the target. Unfortunately, it is, again, not laid down in legislation. But also here the Supreme Court has developed a subtle doctrine which takes a series of diverse circumstances into account.
The main principles are that: (i) the purchaser is obliged to adequately investigate the target and ask for information on any unclear matters, (ii) the seller is obliged to provide such information and (iii) both purchaser and seller must be able to rely on the correctness of each other’s statements. However, as said, the pre-contractual good faith prescribes that each party has to take into consideration the justified interests of the other party. This means that both seller and purchaser are, to a certain extent, obliged to prevent the other party from entering into an agreement based on incorrect assumptions. Therefore, the seller may be obliged to disclose certain information that the buyer never asked for, but that (in the seller’s reasonable believe) could be of material interest to the purchaser. The seller has a duty to verify that the purchaser does not have a false impression in respect of the target, notwithstanding the fact that the purchaser has an active duty to adequately investigate the target and ask for information on any unclear matters.
The Supreme Court also ruled that when the purchaser is a professional party, he is deemed to have extensive knowledge or at least able to obtain sufficient information by performing an investigation. Therefore, when a professional purchaser is involved, the purchaser’ duty to investigate is increased. However, one may conclude from a recent decision that even when a professional purchaser has carried out a due diligence investigation, the seller may still be obliged to disclose unsolicited but relevant information to the purchaser. The ‘non disclosure’ principle, that a party is not obliged to provide unsolicited information, is not an established legal concept under Dutch law.
It is essential to give careful consideration to the scope of the duty to disclose versus the duty to investigate. Because, e.g. if a seller has a certain duty to disclose and has failed to do so, the purchaser may, under certain circumstances, nullify the purchase agreement based on the fact that it was entered under the influence of error.
Also in this case there are no clear-cut rules determining the relation between the duty to inform and the duty to investigate. This remains to be decided on a case-to-case basis. Based on the decisions of the Supreme Court, certain rules of thumb have been formulated in Dutch legal literature determining the relation between the duty to disclose and the duty to investigate:
- In principle, both parties may rely on the information provided by the other.
- The purchaser always has a certain duty to investigate the target.
- After the performance of a due diligence investigation, the purchaser is in principle obliged to ask any further specific questions on any unclear matters.
- Whether a party is deemed a professional party and whether a party performed a due diligence investigation are important criteria to determine the relation between the duty to disclose and the duty to investigate.
- There is a further duty of the purchaser to investigate the target if he has reasons for not trusting the accuracy of the information.
- The seller may have a more extensive duty to disclose when it appears to him that thepurchaser has a false impression of certain essential matters of the target.
- If a purchaser is aware that a seller provided insufficient, inadequate or incorrect information and he nonetheless decides to conclude the agreement, he should be very careful. If the purchase price is decreased due to certain unclear matters, it is advisable for the purchaser to include the specific reasons for such decrease in the share purchase agreement. Otherwise, any additional unexpected disappointments may be for his account.
Can extensive warranties avoid uncertainty?
One could argue that the purchasercan avoid the above debate by simply asking extensive and very specific representations and warranties. However, the scope of such warranties may be restricted by imputed knowledge on certain facts and circumstances. If, in accordance with the above rules of thumb, the purchaser is deemed to have an active duty to investigate the target and to perform an adequate due diligence investigation and he has failed to do so, he cannot under all circumstance rely on the representations and warranties due to such imputed knowledge.
To a certain extent the relation between the duty of the seller to disclose relevant information and the duty of the purchaser to investigate the target are subject to negotiations between the parties. However it is not completely certain whether such arrangement will in all events be enforceable. Therefore, to play it safe, the seller should disclose any information that he believes or should believe to be of material interest to the purchaser, even if the puchaser has not asked for such disclosure. On the part of the purchaser, an extensive due diligence investigation is usually the best option to avoid any unpleasant surprises.
Finally, if a purchaser is, at the time of the entry of the purchase agreement, aware that a certain warranty is untrue, he may not be able to rely on that warranty since a Netherlands court may not assess the representations and warranties in an absolute manner but consider all specific circumstances. If the purchaser is aware that a certain warranty may be untrue, it is advisable to ask for a specific indemnity instead.
This article was first published in the April/May 2006 edition of WorldFinance