Judgment of the Federal Supreme Court of 10 June 2022

Case reference : 4A_58/2022

Facts

On November 5, 2012, A (the “Seller”) and B (the “Buyer”) entered into a sale agreement (the “Agreement”), under which the Seller had sold its “online marketing” activities to the Buyer (asset deal). Under Article 2 of the Agreement, the purchase price consisted of a short-term cash payment and of subsequent payments in the form of sharing of revenues. The short-term cash payment amounted to CHF 25,000, payable by March 31, 2013. The subsequent revenue share payments would be based on the net operating income relating to the sold activities. The amount due to the Seller depended on the amount generated within the first semester of a year, the second semester of a year or the full year. The Agreement did not provide for the duration during which the Buyer would have to pay a share of its revenues to the Seller, but stipulated that the maximum purchase price would be CHF 100,000, after which the revenue share expired.

On March 29, 2019, the Seller filed a claim against the Buyer before the Commercial Court of the Canton of Zurich (the “Commercial Court”), requesting the payment of an amount of CHF 52,059.88 with interests, or, alternatively, that the Buyer be compelled to provide the Seller, inter alia, with information on the turnover generated by some clients relating to sold “online marketing” activities since January 1, 2013, so as to allow the Seller to calculate its claim towards the Buyer. The amount claimed corresponded to the difference between CHF 100,000 and the amount that had actually been paid to the Seller.

By partial judgment of December 21, 2021, the Commercial Court held that the purchase price under the Agreement was composed of a fixed portion, in the amount of CHF 25,000, and of a variable portion, which depended on the turnover generated by the sold activities (the “Earn-Out”), knowing that the Parties had not contractually defined the term of the obligation of payment of this variable portion of the purchase price. The Commercial Court consequently held that there was a gap in the Agreement. It filled it by holding that the period during which the obligation of the Buyer to share its revenue was two years after the consummation of the transaction, namely from January 1, 2013 to December 31, 2014 (the “Earn-Out Period”). The Commercial Court thus compelled the Buyer to provide the Seller with information and documents on the turnover generated by the Buyer with the relevant business during the Earn-Out Period only in relation to certain clients.

The Seller filed an appeal before the Federal Supreme Court requesting that the Buyer be compelled to provide information on the turnover generated by the relevant business since January 1, 2013, in relation to all clients. In addition, the Seller did not agree with the findings of the Commercial Court because it considered the purchase price of CHF 100,000.00 to not be variable and was thus due in any event. It further challenged the duration of the Earn-Out Period of two years (as determined by the Commercial Court).

Issue

The Federal Supreme Court had to answer three questions: first, did the Commercial Court correctly qualify the revenue share as a variable portion of the purchase price instead of a payment modality of a fixed purchase price; second, did the Commercial Court correctly hold that the Agreement contained a gap regarding the time limit for the obligation of the Buyer to share its revenue (earn-out) and that such gap had to be filled; third, did the Commercial Court correctly set the duration of the Earn-Out Period to two years?

Decision

The Federal Supreme Court first confirmed the qualification of the revenue sharing mechanism made by the Commercial Court as constituting a variable portion of the purchase price. The use of “revenue share”, in particular by opposition to “cash portion”, implies a variable component. Such interpretation is confirmed by the mention of a “maximum” purchase price, set at CHF 100,000. If the parties intended the revenue share to be a modality of payment of a fixed purchase price, they would have drafted the provision so as to provide that “the revenue share amounts to CHF 75,000 and will be paid as follows”. Finally, the complexity of the mechanism to calculate the amount due under the revenue share, together with the information rights relating to the calculation thereof, would be unlikely in a situation where the parties had simply agreed on a fixed purchase price of CHF 100,000 and where revenue sharing would only be a payment modality thereof.

The Federal Supreme Court then confirmed the ruling of the Commercial Court which qualified the absence of a time limit for the revenue share as a contractual gap that needed to be filled.

The Federal Supreme Court presented the legal principles applicable to the circumstances at hand. A contractual gap exists if the parties have not, or have not completely, regulated a legal question relating to the content of the contract. Whether such gap needs to be filled must be determined by a subjective (or empirical) interpretation and, if inconclusive, by an objective (or normative) interpretation (ATF 115 II 484, cons. 4a). If a gap must be filled, the court must determine, in the absence of applicable legal provision, what the parties would have agreed in good faith had they considered the unregulated point. In determining this hypothetical intent of the parties, the court must be guided by the thinking and actions of reasonable and honest contracting parties, as well as by the nature and purpose of the contract (ATF 133 III 421, cons. 4.1). The result of this normative activity is reviewed by the Federal Supreme Court freely, but with a certain restraint (ATF 127 III 300, cons. 6b), since filling a gap in a contract is generally within the discretion of the cantonal courts (ATF 129 III 380, cons. 2).

Applying these legal principles, the Federal Supreme Court held that a variable purchase price component presupposes a limitation in time of the Earn-Out Period. The Commercial Court correctly stated that the influence of the Seller on the success of the business would diminish over time and, conversely, the Buyer would not be inclined to share with the Seller earnings that are attributable to its own successful management of the business for an unlimited period of time.

On this basis, the Federal Supreme Court held that the Commercial Court rightfully limited the Earn-Out Period to a duration of two years. The Commercial Court defined the duration of two years for the Earn-Out Period by referencing various provisions of the Agreement: first, the non-compete undertaking binding the Seller had a duration of two years; second, the Buyer was authorized to use an identification name owned by the Seller for a duration of two years. The Federal Supreme Court then confirmed that the duration set by the Commercial Court was within the usual earn-out duration mentioned by Swiss legal scholars. Given that the Seller did not make any convincing arguments in order to justify that the Earn-Out Period should be longer than the two years duration set by the Commercial Court, the Federal Supreme Court confirmed the ruling of the lower court.

On this basis, the Federal Supreme Court rejected the appeal filed by the Seller.

Key takeaway

Why did the parties end up in front of the court? Because they had not specified the period during which the earn-out was to be calculated in the Agreement.

The key takeaway of this ruling is the importance for parties to set, in the transactional documentation, the key terms of the earn-out and, more specifically, the earn-out period. Agreeing upfront on the terms of the earn-out and reflecting them clearly in the contract is essential in M&A transactions where an earn-out mechanism is use, as this will allow the parties to reduce post-completion litigation risks and avoid uncertainties deriving from the perilous exercise of gap filling by the courts.

In addition, this ruling gives some useful insight on how the Federal Supreme Court approaches contract interpretation and supplementation of contractual gaps. While another high court may have kept a certain distance with regards to the contract and remained on a high level of legal debate, the Federal Supreme Court took a pragmatic and “hands-on” approach to determine the hypothetical intent of the parties much like the Commercial Court. In particular, the Federal Supreme Court ruled out the qualification of the Earn-Out as a simple modality of payment of a fixed purchase price on the basis that the parties would have expressly provided for this in the Agreement had they desired such a purchase price structure. In this context, the Federal Supreme Court even suggested how such clause may have been drafted (“the participation to the turnover amounts to CHF 75,000 and shall be paid as follows:“).

Comments

On paper, earn-outs are pricing mechanisms that are generally beneficial to both parties: a portion of the purchase price is contingent on the future success of the target and the payment thereof thus deferred in time. For the buyer, an earn-out is a way to partially reduce the risk and uncertainty inherent to valuation exercises, and to partially finance the purchase price through future profits of the business. For the seller, an earn-out is a way to (potentially) obtain a higher price than what the buyer would (or simply could) have paid upfront (Rudolf Tschäni/Hans-Jakob Diem/Matthias Wolf, M&A-Transaktionen, Zurich (Schulthess) 2021, pp.172-173; see also Urs Schenker, Unternehmenskauf, Bern (Stämpfli) 2016, p. 250-251).

However, do these theoretical benefits pass the test of reality? The answer is (unsurprisingly) one a lawyer would have: it depends.

For example, when a transaction involves a drug development company, it is standard to tie the payment of a portion of the purchase price to the achievement of future regulatory or commercial events. In this context, milestone payments can typically be triggered by the start of a clinical trial, the obtaining of marketing approval from regulatory authorities (US Food and Drug Administration or the European Medicines Agency), and the first sale of a product in a given market. In the drug development industry, an earn-out is generally mutually beneficial as it enables the parties to reduce the negative impact on valuation deriving from the uncertainty inherent to the drug development process.

That being said, there is one principle that is generally acknowledged by practitioners: earn-outs tend to end up in court or arbitration proceedings (Tschäni/Diem/Wolf, p. 173; Schenker, p. 250). First, because the parties cannot foresee the future and anticipate all potential issues in the contract. When an unforeseen event happens after completion, two parties with interests that are not necessarily aligned will have different views. Second, because as from completion, the buyer is in charge of the target and may have a strategy that diverges from that of the seller’s. For example, whereas the seller may have had a conservative investment strategy, the buyer may wish to invest heavily in business growth, thus reducing the profit it generates. In other situations, the seller would have only considered the profitability of the target, while the buyer may decide to optimize the profit at group level, which may adversely affect the profitability of the target (Schenker, pp. 250-251). Third, because the parties, often having diverging interests after completion, may simply not agree on how the contractual provisions relating to the earn-out are to be interpreted. For example, in 4A_56/2017, the parties did not agree on the manner in which the earn-out was to be calculated, as well as which financial elements relating to the target were to be taken into account to determine the amount of the earn-out.

This empirical findings seem to be corroborated by the case at hand, although the litigation related to the existence of an earn-out (which is generally not debated) and its duration, rather than whether the buyer prevented the earn-out from becoming due (which is often disputed) or how the earn-out must be calculated (which was debated in 4A_56/2017).

There is one point to take away from this finding and the case at hand: if the parties to an M&A transaction decide, for whatever reason, that the purchase price will be variable and depend on future events, they must aim to draft a contractual provision that is as complete as possible and, if possible, include an example of how the earn-out will be calculated. This will reduce post-completion litigation risks and help avoid uncertainties deriving from the perilous exercise of gap filling by the courts. In the end, it’s better to be safe than sorry: anticipate, discuss and clearly express the agreement (even if it may be obvious). These elements are key to a successful transaction.

Judgment of the Federal Supreme Court of 5 July 2021

Case Reference : 4A_42/2021

Facts

A buyer bought a sponge sculpture (“Eponge bleue”) made by the late artist Yves Klein at an auction for a total of CHF 123,120. The sponge itself was created in 1961 and mounted on a metal structure after the artist’s death. It would appear that Yves Klein created many sponge sculptures during his lifetime and that he mounted some of them on a base himself.

The auction catalogue specified the dimensions of the sponge (6 x 6 x 6 cm), the fact that it was mounted on a metal structure and the total height of the structure (17.5 cm). It also contained a warranty exclusion provision, according to which the description provided in the catalogue had been done to the best knowledge and belief and that any liability for legal or material defects was excluded. These clauses were not only applicable to the relationship between the auction house and the buyer, but also to the relationship between the buyer and the seller of the artwork.

Having learnt that the sponge had not been mounted on the metal structure by Yves Klein himself, the buyer declared he was no longer willing to uphold the contract and argued that he never wanted to acquire a “patchwork”. He sued the auction house and the seller before the District Court of Zurich, claiming the payment of CHF 123,120 in exchange for the artwork. In support of his claim, the buyer invoked error, fraud as well as liability for defects.

After the District Court ruled in favour of the buyer and ordered the auction house and the seller to pay CHF 20,520 and CHF 102,600 respectively, the Court of Appeal admitted the appeal filed by the seller (the auction house had not challenged the judgment of the District Court). Contrary to the District Court, the Court of Appeal considered that the buyer had failed to demonstrate a significant difference in value between the sponges mounted on supports by Yves Klein himself and those mounted posthumously. It concluded that the seller had no duty to inform the buyer that only the sponge had been created by Yves Klein.

Issue

The legal question that arose was whether the seller had an obligation to inform the buyer on his own initiative that the sponge had not been attached to the support by Yves Klein himself, or whether the onus was on the buyer to seek more information himself.

Decision

Under Swiss law, an error (Art. 24 para. 4 SCO) is excluded if it concerns a feature for which a seller has validly excluded its liability. However, an exclusion of liability is invalid if a seller has fraudulently concealed a defect (Art. 199 SCO). A fraudulent concealment (Art. 199 SCO), as well as a deliberate deception (Art. 28 SCO), should be admitted if the seller failed to inform the buyer of a particular feature since a duty to inform exists. According to case law, such duty exists when a seller should assume that a fact he knows could impair or significantly affect the designated purpose, or be of importance to a buyer, because it might influence the decision to conclude a contract or the conditions under which a contract is concluded.

In the case at hand, the buyer had allegedly assumed, based on the catalogue description, that the sculpture in its entirety had been made by Yves Klein in 1961, which supposedly influenced his estimate of the price.

However, the Federal Supreme Court ruled that the only relevant question was to examine whether the difference between the actual and targeted features was substantial, resulting in an obligation for the seller to provide information. All features that are important in the decision-making process to buy, and not only those that have a negative impact on the sale price, are concerned by the duty to inform. The Federal Supreme Court specified in this context that mere allegations of the paramount importance of the authenticity of the artwork and the fact that the seller was a professional, were not sufficient. Moreover, the duty to provide information depends on the level of knowledge of the parties and the context of the sale. In particular, limited requirements apply to the descriptions made in auction catalogues, considering the high number of artworks up for sale.

In the case in question, the Federal Supreme Court held that the buyer had failed to demonstrate that the seller must have recognized that the authorship of the base was of particular relevance to him, this circumstance baring no significant weight on the price of the artwork. It also held that there was no reason to believe the seller had acted in bad faith. On the contrary, it would have been expected that the buyer ask questions about the authorship of the base if that point was so important to him.

Key takeaway

There is no fraudulent concealment when a seller of an artwork has no reason to believe that the difference between the actual and targeted features is substantial. The authorship of part of an artwork is in itself not substantial, as long as the seller has not recognized that this is of particular relevance to the buyer and is acting in good faith.

Comments

In sales, a seller may induce a buyer to purchase a good by explicitly misleading him. This unethical practice has long been sanctioned in the Roman-Germanic law system, in order to restore justice to the deceived buyer. More recently, the courts have begun to recognize that fraud can result not only from a deliberate act by the seller, but also from the seller’s mere passive behaviour, when he lets the buyer be mistaken or does not try to correct his mistake. This second way of acknowledging fraud (i.e. fraud by non-disclosure) is more difficult for the buyer to prove and is rarely admitted by the courts, especially in Switzerland. While French law has recently codified fraud by non-disclosure in its civil code (Art. 1137 para. 2: “There is also fraud if one of the parties intentionally conceals information which he knows to be of decisive importance for the other party.”), it is still the subject of case law in Switzerland, and therefore, remains largely dependent on the assessment of the judges.

The case commented here emphasises the importance for a buyer of an artwork to be proactive by obtaining information on the artwork and, more generally, the artist’s work. If the buyer would have done so in this particular case, he would have probably learned that the sponge may not have been assembled on the metal structure by the artist himself. This would have led him to ask the seller more questions about the auctioned sponge. By relying only on the lapidary description of the auction catalogue, the buyer lost the opportunity to invoke the warranty.

Other sources presenting the case

Oliver Dalla Palma / Hans Caspar von der Crone, Aufklärungspflicht, Freizeichnungsklausel und absichtliche Täuschung beim Kaufvertrag, in SWZ, 2021 p. 629.

Raja-Marie Achermann / Elia Kaufmann, BGer 4A_42/2021: Ein Urteil zu den Aufklärungspflichten beim Kunstkauf, in PJA, 1/2022, p. 56 ss.

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).