1. Background Information
The current Italian practice regarding stock purchase transactions shows many similarities to the practice followed in the U.S. for comparable transactions. This has specially become true over the last five to ten years, largely due to the adoption in the Italian market practice of share purchase agreements that were modeled on U.S.-style precedents.
Consequently, it is now common that Italian share purchase agreements include sections contemplating price adjustment provisions, representations and warranties of the seller, indemnity clauses and other provisions that are customary in a U.S. agreement.
One of the issues that are generally the object of negotiations between the parties is the duration of the representations and warranties of the seller or, more precisely, the point in time after which the purchaser is no longer entitled to submit a claim of indemnity due to a breach or inaccuracy in the seller's representations and warranties. Generally, in the Italian market practice, such duration period ranges between one and three years.
Obtaining adequate representations and warranties, particularly on the assets, liabilities and financial conditions of the target company, is extremely important for the purchaser of an Italian company, especially for the reasons indicated below.
Since the '60s, Italian case-law has deemed the sale of a company's shares merely as the transfer of title to such shares and, consequently, the transfer of the rights and obligations inherent to the capacity of the sellers as shareholders of the target company. This means that the direct object of the transfer is the title to the shares (and not to the assets of the target company) while the economic value of the target company is only considered as an indirect object of the transaction.
A consequence of the foregoing is that those warranties that are afforded to any purchaser by operation of Italian law (such as the ones on good title, absence of liens or third parties' rights, lack of defects and adequacy of the assets sold to their intended use) only operate in connection with the shares as such. Instead, any difference in the assets, liabilities or financial conditions of the target company compared to those that the purchaser took into account as the basis to determine the price for the shares does not give rise, per se, to any right of the purchaser to be indemnified by the seller unless the latter gave specific representations and warranties regarding the target company. Hence the importance for the purchaser to obtain from the seller adequate representations and warranties on the target company.
Articles 1495 and 1497 of the Italian Civil Code ("CC") provide for a short statute of limitation of one year of the date of delivery that applies to claims made by the buyer for defects or lack of quality of the asset sold. Such statute of limitation is a mandatory provision of law which cannot be extended by the parties, to the effect that any greater timeline agreed upon between the parties would be unenforceable.
The logical consequence of all of the above would be that the aforesaid one-year statute of limitation set forth in Articles 1495 and 1497 CC would only apply to claims made by the buyer for defects or lack of quality of the assets that are the direct object of the sale, which in our case are the shares.
Following the same logic, the representations and warranties of the seller that refer to the target company would instead be subject to the ordinary ten year statute of limitation applicable under Italian law to contractual obligations (with the understanding, however, that the parties may agree on a shorter deadline for the purchaser to submit claims of indemnity, such as the one to three year time frame indicated above).
2. The Decision Of The Court Of Milan Of January 27, 2000
In this context, a decision rendered by the Court of Milan in 2000 (Tribunal of Milan, January 27, 2000) significantly deviated from the practice followed so far in terms of duration of the seller's representations and warranties.
Such decision held that the aforementioned one year statute of limitation not only applies to defects or lack of quality of the shares sold, but also to certain of the representations and warranties regarding the target company.
The Court of Milan reached the aforesaid conclusion based on the following reasoning.
The Court classified certain warranties on the target company (and namely those on the financial statements and certain of the company's assets - see paragraph 3 below) as warranties concerning the quality of goods. More precisely, the Court held that any such warranty should be regarded as a warranty on specific qualities of the shares sold and consequently, it would be subject to the provisions set forth in Articles 1495 and 1497 CC.
Pursuant to the above mentioned provisions of law, in case of lack of quality, the buyer is entitled to obtain the rescission of the contract (assuming that the lack of quality be deemed material) and claim damages. Certain scholars maintain that the claimant could alternatively request a price reduction. In all cases, the relevant lack of quality claim or proceedings shall be started within the one-year statute of limitation discussed above.
It is clear how deeply the said decision of the Court of Milan affected, at least from a purchaser's perspective, the pre-existing Italian market practice regarding the duration of the seller's representations and warranties on the target company.
3. Distinctions Among The Representations And Warranties On The Target Company
As we mentioned above, not all the warranties on the target company can be characterized as warranties on the quality of goods and therefore be subjected to the one year statute of limitation. In particular, among the warranties on the target company, the Court decision at issue distinguished between (i) those concerning the accuracy of the financial statements as well as certain assets of the target company and (ii) those concerning the absence of extraordinary costs or misstatements of assets.
Based on such distinction, the Court held that only the warranties under point (i) above (the "Short Term Warranties") can be deemed as warranties on the quality of goods and therefore subject to the one year statute of limitation. On the contrary, the Court held that the warranties under point (ii) above may not be deemed as warranties on the quality of goods and they are therefore subject to the ordinary statute of limitation of ten years, unless the parties agreed on a shorter time limit.
4. The Scholars' Position
Notwithstanding the principles set forth in the decision of the Court of Milan, most Italian scholars, although on the basis of different theories, have opposed the characterization of the warranties on the target company as warranties on the quality of goods, and therefore their being subject to the one year statute of limitation.
In addition, the decision of the Court of Milan has been appealed and the relevant proceedings are currently pending. It will be important to see whether the Court of Appeals will confirm or overrule the decision of the Court of Milan.
In the meantime, however, despite the criticism raised by most of the scholars, it would be prudent for buyers of Italian companies' shares to take the principles set forth by the aforesaid decision of the Court of Milan into due consideration in the context of their negotiations with the sellers and in the drafting of the relevant share purchase agreement.
Particularly, a buyer should be aware that, unless the decision of the Court of Milan is overruled in the appeals proceedings, in case the parties agreed upon a term of survival of the representations and warranties of the seller on the target company that is longer than one year from the closing, the seller would be likely to prevail in court were the seller to challenge a claim of indemnity from the buyer that refers to Short Term Warranties and that is filed after the expiration of the aforesaid one-year statute of limitation.
More precisely, if the reasoning of the Court of Milan is upheld, the consequence of the application of the mandatory statute of limitation of one year to the Short Term Warranties would be that any clause in a share purchase agreement providing for a longer term of survival for such warranties would be considered null and void pursuant to Article 2936 CC (which sets forth that any agreement between the parties that is intended to modify a statute of limitation set forth by the law is null and void).
Given the aforesaid scenario, following are some of the practical approaches that a buyer of an Italian company could follow to tackle the issue posed by the aforesaid decision of the Court of Milan:
(i) the role of the due diligence is more key than ever and adequate time and resources should be set aside for that purpose;
(ii) a prudent approach would be for the buyer to agree to a one-year term of survival of the Short Term Warranties, at the same time being prepared to carry out a post-closing due diligence on the matters covered by the Short Term Warranties, with a view to identifying any breaches or inaccuracies within the first anniversary of the closing date;
(iii) obviously, a buyer would be well advised to factor the additional costs related to the activities described under (i) and (ii) above in the acquisition costs, possibly reflecting all or part of such extra costs in the price;
(iv) other alternatives can be explored, and the risks associated thereto be assessed, by a buyer with its lawyers in case the approach described in (i) to (iii) above does not suit the buyer's needs (for instance, the buyer could consider proposing a price adjustment provision tied to certain items of the financial statements of the target company which would be activated on an anniversary of the closing date later than the first, possibly coupled with a portion of the purchase price being kept in escrow until then).
Stefano Crosio is Partner in charge of the New York office of Gianni Origoni Grippo & Partners. Roberta Fabbri is an Associate in the New York office. They can be reached at (212) 957-9600.