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The Court of Milan has recently ruled, that breaches of representations and warranties on the target’s business and its assets (so called “business warranties”) cannot trigger the termination of the shares purchase agreement pursuant to section 1497 of the Italian Civil Code. This Section, generally applicable to any sale-purchase agreement, reads “when the goods sold do not have the qualities promised or the [implied] qualities essential for the intended use, the buyer has the right to terminate the agreement pursuant to the general rules on termination of agreements for material breach, provided that the lack of quality [is material]. Such right to terminate the agreement is subject to the forfeiture and statute of limitation per Section 1495 of the Italian Civil Code.” This Section gives a buyer the right to seek compensation for damages, and termination of the agreement or a reduction of the purchase price, within a mandatory statute of limitation of 1 year from the closing date, and subject to buyer notifying seller within 8 days from acquiring knowledge of such breach (note that although the parties may extend the 8 days term, the 1-year statute of limitation cannot be contractually extended).
The Milan ruling is consistent with the large majority of the Italian case law on this matter (please click here to read an analysis of a similar ruling of the Italian Supreme Court). However, some Courts have occasionally argued for the application of Sections 1495 and 1497 of the Italian Civil Code and have thus significantly restricted the buyers’ remedies in those litigations relating to breach of representation and warranties in M&A transactions.
This short note analyses the Milan ruling, and other relevant case law, and provides some high-level guidance on how to avoid the application of Sections 1495 and 1497 of the Italian Civil Code particularly when advising buyers.
2. The Milan Ruling
Ruling no. 5765/2020 by the Court of Milan relates to a dispute around the breach of “business warranties” by the sellers of an Italian corporation.
Deal was originally signed in October 2011 and closed on September 2012; the purchased corporation went bankrupt in 2014. The shares purchase agreement included “business warranties” on the financial and business position of the target and indemnification claims by buyer were contractually banned after December 31, 2013. Following closing the buyer identified breaches of the representations and warranties made by sellers and thus initiated a litigation before the Court of Milan seeking (i) termination of the shares purchase agreement (such termination was requested on generic terms and it was qualified by the Court during the litigation as a request made pursuant Section 1497 of the Italian Civil Code); (ii) termination of the shares purchase agreement for wilful misconduct and error; and (iii) award of suffered damages.
The Court of Milan dismissed the case arguing, amongst the others and in accordance with the prevailing Italian case law, for the inapplicability of the general rules on sale-purchase agreements to the breach of “business warranties.”
In particular, the Court argued that in M&A deals shares purchase agreements deal directly with the transfer of title on the sold securities; and only indirectly with the underlying assets which are covered by the “business warranties.” Consequently, argues the Court, representations and warranties relating the financial and business position of the target business are autonomous and constitute separate indemnification undertakings which are independent from the sale-purchase of the securities regulated by the agreement. This qualification impacts directly on the regime applicable to indemnification claims, indeed these claims being based on the breach of autonomous indemnification undertakings do not qualify as breach of the sale-purchase agreement and thus the termination rights over the sale-purchase agreement regulated by Sections 1495 and 1497 of the Italian Civil Code would not be applicable. This has a twofold effect on the buyer’s indemnification rights: on the one hand, a buyer would not be entitled to request the termination of the shares purchase agreement and to seek damages for such termination, but, on the other hand, the statutory (and short) 1 year time limitation period to make a claim based on the breach of the “business warranties” would not apply and the buyer would be instead entitled to file an indemnification claim subject to the general 10 years statute of limitation.
Overall, this leads to a strengthening of the buyer’s position, as indemnifiable events could occur past the first anniversary of closing.
3. Other Italian Case Law on “Business Warranties”
As said, the Milan ruling is consistent with the large majority of the Italian case law on remedies for breach “business warranties.” The arguments used by the Court of Milan however had been recently challenged by a ruling by the Italian Supreme Court which in 2019 argued that equity interests constitute second-tier assets, not entirely distinct and separate from the underlying target’s assets and that thus the breach of “business warranties”, impacting indirectly on the value of the equity interest, may qualify under the Italian law as a material breach of the shares purchase agreement for “lack of the essential qualities of the sold good” (in this case not the securities, but rather the underlying business assets) which might trigger the termination of the shares purchase agreement pursuant to Section 1497 of the Italian Civil Code, subject to the short statutory 1 year statute of limitation provided by Section 1495 of the Italian Civil Code and subject to the buyer notifying seller within 8 days from acquiring knowledge of such breach.
In other word, although most Courts would argue for the applicability of rules which appear to be better suited to the needs of M&A transactions (and particularly of buyers), it is important, while negotiating/drafting the underlying transaction documentation, to keep in mind that some Italian Courts (including the Supreme Court) have in some instances applied laws that could materially impact on the indemnification rights of buyers.
In light of the Milan ruling and more in general of the Italian case law on this matter, it is advisable, particularly for buyers, to draft the transactional documentation in a way that reduces to the maximum extent possible the chances a Court argues for the applicability to the shares purchase agreement of the general rules on sale-purchase agreements, notably the one on remedy for breach of implied or express warranties.
Some example of clauses/drafting tips that could potentially reduce risk of application of the default rules on sale-purchase agreements are:
- clearly separating the “business warranties” section from the sale-purchase of the securities section. One could event consider dealing with the business warranties and relevant indemnification in a separate document attached to the shares purchase agreement;
- paying particular attention to the use of the word “indemnification” rather than “right to claim damages” particularly in the paragraphs dealing with indemnification rights;
- including an express qualification clause, by which the parties qualify the indemnity undertakings as autonomous and independent and expressly agree to derogate from the statutory limitation periods provided for by the law (in particular Section 1495 of the Italian Civil Code); and
- including an exclusive remedy clause, by which the parties provide that the indemnification obligations under the contract constitute the exclusive remedy in any case of breach of the representations and warranties, waiving any right to terminate the agreement.
- Yan Pecoraro, Partner
Compliments of Portolano Cavallo – a member of the EACCNY.