Judgment of the Federal Supreme Court of 19 April 2022
Case Reference : 4A_29/2022

Facts

An individual (the Seller) entered into a sale agreement with two buyers (the Buyers) concerning the sale of several plots of land (including a house, barn and pastureland).

The notarized agreement was executed in October 2019, but provided for a deferred transfer of title, which was meant to take place in March 2020.

In a text message dated February 2020, the Seller unexpectedly informed the Buyers that she wished to “cancel” the sale. In a follow-up letter from her lawyer, the Seller contended that she was the victim of a “fundamental mistake” when concluding the sale and therefore did not consider the contract to be valid and binding.

The Buyers sued for transfer of title, which was awarded by the first-instance court. The judgment was later upheld on appeal by both the Zurich cantonal court and the Federal Supreme Court.

Throughout the proceedings, the Seller argued that due to her physical disability, she had previously intended to convert her barn into a residential building with a lift but was unable to do so due to the agricultural zoning rules in place. In 2016, an employee from the relevant authority informed her that she would be unable to secure a land conversion permit due to ever-more stringent regulations. Yet, in January 2020, shortly after the agreement had been signed, the Seller learned that the local building regulations would soon be reformed, allowing for land conversion in her area. The Seller argued that had she known this at the time of concluding the sale, she would not have entered into the agreement with the Buyers.

Issue

The Federal Supreme Court had to determine whether the Seller could, in good faith, allege a fundamental mistake within the meaning of Art. 24 para. 1 (4) of the Swiss Code of Obligations (SCO) in order to refuse to transfer title to the Buyers.

Decision

First, the Federal Supreme Court recalled that a contract is not binding for the party who was labouring under a fundamental mistake at the time of concluding the contract (Art. 23 SCO).

A mistake is deemed fundamental namely when a party is mistaken about certain facts that it considered in good faith to be a necessary basis for the contract (Art. 24 para. 1 (4) SCO). In addition to the mistaken party relying subjectively on these facts as an indispensable prerequisite for concluding the contract, these facts must also appear objectively necessary to the parties’ agreement (i.e. from the standpoint of fair business dealings). The circumstances at the time of the conclusion of the contract are key.

Second, the Federal Supreme Court recalled that a fundamental mistake may be the result of fault or negligence on the part of the mistaken party. Art. 26 para. 1 SCO provides that a mistaken party who invokes its mistake to avoid a contract and whose mistake is attributed to its own fault or negligence, is liable for the damage resulting from the nullity of the contract, unless the other party knew or should have known of the mistake. Thus, while the negligent party may have to pay damages to the other party under Art. 26 SCO, its negligence would not, as such, prevent the mistaken party from relying on its mistake to avoid the contract or to refuse its performance.

This must be distinguished from the case where a fundamental mistake is relied upon in breach of good faith. Art. 25 para. 1 SCO provides that a person may not invoke a mistake in a manner contrary to good faith. In this respect, the lack of good faith would impede the mistaken party from invoking its mistake. Thus, for example, if a party fails to raise a fact or a question it considers important when concluding the contract, the other party may legitimately conclude that its contracting partner did not consider it a necessary basis for the contract. In this scenario, the mistaken party would be barred from relying on its mistake, since an attempt to do so would be contrary to good faith.

In the case at hand, the cantonal court considered the Seller’s mistake fundamental within the meaning of Art. 24 SCO. Despite this, it found that the Seller had invoked its mistake in breach of good faith.

While the Federal Supreme Court saw no reason to overturn these findings, it did add that the Seller’s mistake was due to its own negligence. In fact, the last steps undertaken by the Seller to clarify the zoning rules dated back three years prior to the conclusion of the contract. As a “fair, honest and conscientious contracting party”, she should have sought updated information before the sale, especially since legal norms are known to evolve. All in all, the Federal Supreme Court found that the Seller’s failure to seek up-to-date information, which would be fundamental to her, was negligent within the meaning of Art. 26 SCO.

Beyond this finding of negligence on the Seller’s part, the Federal Supreme Court ultimately confirmed that the Seller’s attempt to rely on its negligent conduct was contrary to good faith within the meaning of Art. 25 SCO. In fact:

• the Seller failed to raise the issue of land zoning during the negotiations with the Buyers; in particular, she did not mention that the lack of prospects for land conversion was the underlying reason for the sale;
• the Seller’s conduct did not otherwise demonstrate, in any recognizable way, that her decision to sell was based on her mistaken belief regarding the prospects of land conversion; and
• therefore, the Buyers could not have recognized the importance of this fact to the Seller. Rather, the Buyers could, in good faith, assume that the Seller had carried out the clarifications that were essential to her – especially since this was not an everyday transaction and the sale was not executed under strict time constraints.

Given the above facts, the Federal Supreme Court considered that the Buyers’ legitimate expectations should be protected. It thus upheld the decision of the cantonal court to deny the Seller the possibility to refuse performance of the contract on the basis of a fundamental mistake.

Key takeaway

This case illustrates the distinction between negligence (which relates to the cause of a mistake) and the breach of good faith (which relates primarily to the manner in which said mistake is invoked).

As a general rule, negligence is not an obstacle to invoking a fundamental mistake. Thus, a party who operates under a mistaken belief due to its own fault or negligence is still entitled to avoid the contract or to refuse its performance, but may be found liable to pay damages to the other party under Art. 26 SCO.

However, negligent conduct can become problematic if relying on the resulting mistake can be perceived as a breach of good faith. Notably, a party cannot claim to be the victim of a fundamental mistake when it failed to undertake any necessary clarifications prior to concluding a contract. In this scenario, and by application of Art. 25 para. 1 SCO, the mistaken party would be unable to avoid the contract or to refuse its performance on these grounds.

Comments

This decision confirms previous case-law on the notion of good faith in relation to fundamental mistakes. Indeed, the Federal Supreme Court had previously found that if a party negligently fails (or does not bother) to clarify a certain question when concluding a contract, even though it may be an obvious matter of fact, the other party may reasonably conclude that this question is not a “necessary basis for the contract”. Thus, negligent conduct may – in certain circumstances – entitle the other party to consider in good faith that the point in question is not fundamental to the deal (see case reference ATF 117 II 218, para. 4b).

While the Federal Supreme Court chose to deny the Seller’s defence in application of Art. 25 SCO in this case, it is interesting to note that the principle of good faith is also embedded in Art. 24 para. 1 (4) SCO itself (which relates to the very definition of fundamental mistake). Indeed, for a mistake to be deemed fundamental under Art. 24 para. 1 (4) SCO, it must be recognized or recognizable as such to the contracting party, as per the rules of good faith and fair business dealings. In this sense, the failure of a party to clarify a question prior to a transaction and to signal its importance to the other party may be regarded as relevant under both legal provisions.

Other sources presenting the case

Chernaya Viktoriya / Galli Dario / Vischer Markus, Fahrlässiger Irrtum und Verstoss gegen Treu und Glauben, in: dRSK, published on October 2022, available at: https://www.walderwyss.com/user_assets/publications/Fahrlassiger-Irrtum-und-Verstoss-gegen-Treu-und-Glauben.pdf

Judgment of the Federal Supreme Court of 14 October 2021

Case reference : 4A_92/2021

Facts

With a plan to relocate from Germany to Switzerland, A contacted B (the “Seller”), who is the sole manager and quotaholder of a Swiss limited liability company (LLC) offering tax services in Switzerland (the “Target”), to discuss the acquisition of the Target. On January 4, 2016, the Seller and a Swiss LLC, incorporated by A for the purpose of the transaction (the “Buyer”), entered into a share purchase agreement (the “SPA”), under which the Buyer acquired the Target’s entire quota capital for a price of EUR 480,000.00. The transaction was completed upon the execution of the SPA.

The parties entered into the SPA on the basis that the 2014 financial statements of the Target were the basis for the transaction and on the common understanding that the business volume for 2015 would develop substantially in the same way as in 2014. However, shortly after the closing, the Buyer became aware that the Target registered a loss of CHF 40,000.00 in 2015 compared to a net profit of CHF 65,000.00 in 2014, and that the Target’s turnover had dropped by 26% in 2015 compared to 2014.

Given the significant discrepancy between the 2014 and 2015 financial results, the Buyer served a notice to the Seller on August 9, 2016, in order to rescind the SPA with retroactive effect (among other claims). On May 31, 2017, the Buyer filed a claim against the Seller, requesting, inter alia, the reimbursement of the purchase price, against the retransfer of the Target’s shares. The Court of First Instance granted the Buyer’s request. The Seller filed an appeal, which was dismissed. The Seller then brought the case before the Federal Supreme Court.

Issue

The Federal Supreme Court had to determine whether the Buyer had acted under a fundamental error within the meaning of Art. 23 et seq. of the Swiss Code of Obligations (SCO) when it entered the SPA and was thus entitled to retroactively rescind the SPA.

Decision

The Federal Supreme Court first reminded the general conditions allowing a party to retroactively rescind a contract if it entered into an agreement acting under a fundamental error within the meaning of Art. 23 et seq. SCO. A contract is not binding upon a party which entered into it acting under a fundamental error (Art. 23 SCO). An error is fundamental, for example, if it “relates to specific facts which the party acting in error considered in good faith to be a necessary basis for the contract” (Art. 24 para. 1 no. 4 SCO). The facts at the origin of the error should also objectively appear, in view of, or according to the requirements of fair commercial dealings, as a necessary basis for the contract. This is the case of a false perception of a fact, which was, for both parties, consciously or not, and objectively, an essential condition for the conclusion of the contract.

The Federal Supreme Court further reminded that a party may not raise a fundamental error in breach of good faith (Art. 25 para. 1 SCO). This is the case, in particular, when the rescission of the agreement would result in an obvious imbalance of the interests of the parties. To assess whether the rescission resulted in an obvious imbalance of the parties’ interests, the Federal Supreme Court compared the consequences of the rescission of the agreement for each party. If the rescission entails only a limited advantage to the party invoking the fundamental error, but results in particularly negative consequences for the other party, invoking the fundamental error will be considered to be made in breach of good faith and will thus not be possible (ATF 132 III 737, cons. 3.1). Further, a party’s negligence in causing the error does not generally prevent it from raising the fundamental error and in rescinding the agreement. However, in such a case, the party has to indemnify its counterparty for damages resulting therefrom (Art. 26 para. 1 SCO). Nevertheless, if a party fails to clarify specific and obvious questions arising in the negotiations, the other party may in good faith assume that the party does not consider these unclarified facts as a necessary basis for the conclusion of the agreement. In such case, the party is prevented from raising a fundamental error with respect to the unclarified facts, because doing so would be contrary to the principle of good faith.

Applying these legal principles to the facts, the Federal Supreme Court first noted that the parties entered into the SPA on the common understanding that the Target’s financial situation in 2015 would be substantially similar to that of 2014. When executing the SPA, the Buyer thought that the Target’s financial situation in 2015 would be similar to that of 2014 and had no reason to believe this would not be the case. However, after the closing when the Buyer ultimately got access to the Target’s 2015 financial statements, it became aware of the Target’s actual financial situation: i.e. a loss of CHF 40,000.00 in 2015 compared to a net profit of CHF 65,000.00 in 2014, and a decrease of its turnover by 26% in 2015 compared to 2014. The Buyer however did not act negligently given that it had requested up to date financials for 2015, but was assured by the Seller that these were not yet available.

The Federal Supreme Court then deemed the profitability of a target in the year prior to a transaction as being objectively a decisive element for a prospective buyer. An average person would not have left its home and professional activity in Germany for a loss-making company in Switzerland.

The Federal Supreme Court further found that the retroactive rescission of the SPA by the Buyer had not resulted in an obvious imbalance of the interests of the parties. The Buyer would be paid back the purchase price. However, it would have to rebuild its professional activity after having spent four years managing the Target. On the other hand, the Seller would be reinstated as owner of the Target against reimbursement of the purchase price. The possible lower value of the Target would not change this balance of interests given that the Target was already making losses in 2015, and that the Seller had refused a quick and amicable reversal of the transaction by the Buyer in 2016 to avoid a subsequent litigation and any potential negative consequences thereof on the parties and the value of the business.

The Federal Supreme Court thus upheld the judgment handed down by the Court of First Instance, holding that the Buyer had the right to rescind the SPA on the grounds of a fundamental error within the meaning of Art. 23 et seq. SCO .

Key takeaway

This case constitutes an important reminder of how the principles of fundamental error under Art. 23 et seq. SCO can apply to M&A transactions with respect to an error about the financial health of the target company. As shown in this case, a buyer can rescind the SPA on the ground that the financial results of the target are below the legitimate expectations of the buyer.

Lessons learned: in order to avoid these types of disputes, the Buyer should have clarified more carefully and diligently the financial results achieved in 2015 and shouldn’t have relied on statements made by the Seller. The Buyer could have negotiated a system by which it would have adapted the purchase price depending on the actual financial results achieved in 2015.

In other circumstances, where the evolution of the target or its business activities in the (near) future is uncertain, the Buyer could negotiate a purchase price structured with a fixed component and a variable or conditional component. The fixed component is paid at the closing of the transaction and the variable or conditional component may be due at a later stage, depending on whether milestones specified in the SPA are met. This component can be fixed, meaning that a fixed amount is due if the milestone is met. It can also be flexible, meaning that the amount of the additional consideration will depend on the extent to which the milestone is met. The milestones can be set based on the financial performance of the target, or depend on the achievement of specific R&D, operational or commercial objectives (as this is common for transactions in the life sciences industry).

Comments

This ruling implicitly raises the question of whether the remedies provided for by the Swiss legal system offer satisfactory resolutions to M&A disputes. Here, the issue was whether a retroactive rescission of the SPA, half a decade after its execution, was a satisfactory outcome for the parties. In the case at hand, it might be satisfactory. That said, in most circumstances, it probably is not. On the one hand, a seller, by selling its company, shows its desire to get out of its former business activities. On the other hand, as long as the litigation is not finally resolved, the buyer has to manage the company, but certainly does not do it with its initial impulse because it ultimately desires to return it to the seller.

If the principles relating to fundamental errors generally apply to M&A transactions, the parties can contractually avoid its – sometimes undesired – effects: they may contract around it and waive in advance their right to retroactively rescind the contract on the basis of a fundamental error or because of a default in various way. These tools may be used individually but also cumulatively within a single transaction.

First, the parties may limit the legal remedies available to them in the transaction agreement. This can be achieved by including a “sole remedy” clause, which substantially provides that the legal remedies set forth in the agreement are the only remedies available to the parties (see Tschäni Rudolf/Wolf Matthias, Vertragliche Gewährleistung und Garantien – Typische Vertragsklauseln, in Mergers & Acquisitions VIII, Zurich (Schulthess) 2006, pp. 94 ff., pp. 119-120). The effect of such clause is to prevent the buyer from rescinding the SPA based on a fundamental error or terminating the agreement for a breach by the seller. The only remedy available to the buyer under the SPA will be a reduction of the purchase price, to the extent required to compensate the damage it suffered from the seller’s breach.

Second, the parties may specify that the representations and warranties (“R&Ws”) provided for in the acquisition agreement are the only R&Ws given by a party to the other, to the exclusion of any R&W non expressly set forth therein. If a fact is not covered by the R&Ws, a party implicitly acknowledges that such fact is not a necessary element to the party’s decision to enter into the agreement. Accordingly, that party may not raise a fundamental error with respect to facts that are not part of the R&Ws (see, for example, Tschäni/Wolf, p. 109 or Schenker Urs, Risikoallokation und Gewährleistung beim Unternehmenskauf, in Mergers & Acquisitions VII, Zurich (Schulthess) 2005, pp. 240 ff., pp. 263-264).

Third, the buyer may carry out a due diligence on the target or – especially in the context of auctions – the seller may make a vendor due diligence report available to the potential buyers. Given that a fundamental error presupposes the misrepresentation of a fact, the buyer will not be able to claim it would fall under a fundamental error as long as the information provided to the buyer is true, complete and not misleading (see Tschäni Rudolf/Frey Harold/Müller Dominique, Streitigkeiten aus M&A-Transaktionen, Zurich (Schulthess) 2013, pp. 16 and 120).