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Legal uncertainties that exist under German law with respect to the ability of a seller to cap its liability for representations and warranties made in the context of negotiated mergers and acquisitions (M&A) may be eliminated if the German Parliament passes the draft bill (Drucksache 15/1096) as submitted to the house on July 3 2003.

When the German legislator reformed the law of obligations in 2002 it introduced, among other things, a new Section 444 to the German Civil Code, which provided that a seller may not cap or otherwise limit its liability for any guaranty relating to the nature or quality of the goods or other matters being sold. This provision is mandatory, meaning the parties do not have the ability to contract out of this provision. Due to the broad language of this new provision, the question subsequently arose whether this measure was intended to be limited to statutory guaranties and warranties or whether it was also intended to apply to contractual guaranties and warranties.

Since, by way of German thinking, M&A agreements for the sale and purchase of shares or assets equally qualify as sales contracts under the law of obligations, the further question arose as to whether this new mandatory rule should also apply to M&A transactions. Historically, German parties to M&A agreements have broadly opted out of dispositive Civil Code provisions on sales contracts, especially provisions dealing with warranties, because it was felt that while these statutory provisions may be suitable for the sale of individual goods and products, they did not really work in the complex world of M&A transactions. Instead, in the past, the parties would typically negotiate individual representations and warranties specific to the transaction, including matters relating to the scope of the representations and warranties as well as caps and other limits on liability. To ensure that the seller would be held strictly liable for a breach of any such negotiated representation or warranty, in other words that the purchaser would not be required to demonstrate culpable behavior on the part of the seller in the event of a breach, these negotiated representations and warranties were classified as independent guarantees (eigenständige Garantie) under German contract law.

A heavy debate began immediately after the enactment of the new Section 444 as to whether the German legislator really meant to affect M&A transactions so severely and limit sophisticated parties, such as they typically are in M&A deals, in delineating their liability and striking a negotiated deal. The majority opinion in legal commentary on this provision appears to be that Section 444 should not apply, for that very reason. Unfortunately, the position of the German Ministry of Justice on this remained unclear. While, in February 2002, the former Minister of Justice, Mrs Daeubler-Gmelin issued a formal statement to the effect that Section 444 should not apply to individual guarantees in M&A agreements, the current Minister of Justice, Mrs Zypries, cast doubt on this statement in January of this year. Although statements by the executive branch are not binding on the German courts, there is always the possibility that the courts could embrace this new position. Consequently, most legal advisors were forced to spend some creative thoughts on how to avoid the untenable consequences of Section 444 for M&A deals in Germany. Indeed, the idea was even propounded that parties to a purely domestic transaction should consider choosing English or US law to govern their M&A agreements.

Rather than allowing this debate and the uncertainty to continue and waiting for the many years that it would take to clarify this question in the German courts, a parliamentary faction has now taken the initiative to resolve the matter on a legislative level by submitting a bill to the German Parliament calling for M&A transactions to be excluded from the scope of Section 444. After a first reading in Parliament on July 3, the draft legislation has been passed on to the responsible parliamentary committees for further deliberation. In the interests of ending this unnecessary uncertainty, practitioners can only support this initiative and hope that this parliamentary process will not be derailed.

H Elizabeth Kroeger and Johannes Waitz

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