Transfer of Shares. Liability of the Seller for “Hidden Liabilities”

The inclusion of the so-called “hidden liabilities warranty” of the seller is an essential issue in the negotiation of most stock transfers. As discussed below, “hidden liabilities” must be conceptually distinguished from “undisclosed liabilities”. It is quite common that stock purchase agreements include a clause whereby sellers shall be held liable for unregistered liabilities whose cause goes back to a date which is earlier than the date of the stock transfer or any other date the parties might agree to. The purpose of this kind of clause is that buyers be held harmless from unregistered liabilities, irrespective of whether sellers failed to register such liabilities intentionally or acted negligently. Further, the warranty normally stands irrespective of any knowledge the buyer might have obtained through the course of a pre-transaction due diligence about the potential occurrence of a given hidden liability.

However, the scope of this type of clauses in a share purchase agreement might be subject to different interpretations, as shown by a recent ruling of the Argentine Supreme Court of Justice (“CSJN”, after its Spanish name).

In re “Pocovi, Osmar Miguel and others v. Brennan, Horacio Marcelo Santos and others”, the CSJN admitted the petition in error filled by the plaintiff against a ruling from the Commercial Court of Appeals that had narrowly construed a warranty clause in a stock purchase agreement, restricting – and almost nullifying– its scope. The appeal court had ruled that the “hidden liability” warranty might be triggered when the sellers were aware of the existence of a certain liability but failed to duly register or disclose it.

On January 8, 1985 the parties entered into a stock purchase agreement in connection with the shares of Compañía de Seguros Unión Comerciantes S.A. (the “Company”). Under this contract: a) the buyers stated that they had full knowledge of the assets and liabilities of the Company as of the day of execution of the agreement; b) without prejudice to the above, the sellers agreed to be held joint and severally liable for any hidden liabilities or non- existing assets as of the date of the agreement, all in accordance with an annex signed separately; and c) the sellers represented that they were not aware of any claim against the Company other than those detailed in an annex.

Plaintiffs filed a complaint to recover the amounts paid in respect of alleged hidden liabilities –consisting of claims that had not been declared in the annex to the agreement.

Tribunal E of the Commercial Court of Appeals rejected the claim. The Court of Appeals defined “hidden liabilities” as those that do exist and are known but are not registered on a company’s accounting records. To the Court of Appeals, this requires that the sellers must have known and willfully or negligently hidden such liabilities from the company’s accounting records. In other words, the “hidden liabilities warranty” would only be triggered in case of known but undisclosed liabilities.

The Court of Appeals found that the defendants had not incurred in any liability by not disclosing those claims in the agreement, given that it was not proved that those claims had been notified to the Company before the date of the stock sale.

On May 28, 2008 the CSJN found this ruling of the Tribunal E of the Commercial Court of Appeals to be arbitrary. The CSJN held that the meaning given by the Court of Appeals to the expression “hidden liabilities” was not grounded on the wording of the contract which, on the contrary, required a broader construction. Namely, in the absence of any express limitations, the “hidden liabilities warranty” exists and applies even for those liabilities unknown to the sellers at the time of the sale. Therefore, the CSJN reversed the lower court ruling and ordered a new ruling by the Court of Appeals.

Despite this ruling from the CSJN, on March 17, 2009 the Commercial Court of Appeals once again rejected the complaint. This time the Court of Appeals held that in order to render the warranty effective, the only date of consequence was when the insurer was served with the corresponding notice of process, and not the date on which a loss was reported to the company or the date when the complaint was filed. In any case, even though it was found that eight lawsuits had been omitted from the annex although the insurer had been served with the complaints prior to the transfer of the shares, the Court of Appeals held that it was inappropriate to enforce the warranty inasmuch as the buyers had not evidenced what percentage of the amounts paid had been recovered from the reinsurer.

The plaintiffs filed another appeal against this ruling that was rejected by the Commercial Court of Appeals. Finally they filled a new petition in error before the CSJN.

On May 24, 2011, the CSJN admitted the appeal and once again ordered a new ruling. The CSJN held, inter alia, that the requirement imposed by the Court of Appeals in order to enforce the warranty (i.e., evidence that the claims had been served before the share purchase agreement) implied an amendment to the agreed terms by incorporating a subjective factor (i.e. negligence) as a condition to trigger the “hidden liabilities warranty”.

It can be noted that the warranty clause for hidden liabilities might be subject to different constructions depending on its wording and the scope that the parties assigned to it during the negotiations of the agreement, as well as on their subsequent behavior. Therefore, it is of the essence that these clauses be very carefully drafted to adequately reflect the agreement of the parties and protect their relevant interests.