Due Diligence and Concealed Flaws
due diligence

It seems unnecessary to point out the relevance that a seller’s liability has in the field of sales contracts and even more should these contracts concern any acquisition of shares or equity interests.

Over negotiations, liability is usually defined in an extensive and detailed way in contracts. Therefore, the Civil Code expressly excludes the systematic implementation of liability. However, sometimes, for matters that were not established contractually, a subsidiary system would be implemented.

In any case, it may be interesting to briefly note what our legislation provides for this matter, for all sales. Hence, we wonder:

Does a Due Diligence report impede the determining of evictions?

 

Introduction

Within the framework of an M&A operation, Due Diligence seeks to satisfy the buyer’s contractual demands.

The Spanish Civil Code (article 1474 et seq.) set up two basic obligations for any seller in all sales: (1) (the seller) is liable for the legal and peaceful possession of the thing sold (Eviction of Hidden Flaws); and (2) for the hidden vices or defects that he/she could suffer (Eviction of Concealed Defects).

 

Eviction of Hidden Flaws

Eviction of Hidden Flaws (Saneamiento en caso de Evicción) arises when the buyer is deprived of the thing acquired by final verdict, due to, the purchase right was actually held by a third party previously over the acquired thing.

As for the seller, he/she is liable in these situations even though nothing was established in the contract. Despite that the parties may increase, decrease or eliminate this legal obligation.

Such obligation could only be eliminated if the seller is not found to be acting in bad faith. If so, only the corresponding price of goods, at the time the eviction is bound to be occurred, will be returned to the buyer (unless the buyer had waived this right with full knowledge of the risks that could incur).

 

What can the buyer demand from the seller in case of eviction of hidden flaws?

When the obligation of eviction has been established or nothing has been arranged, the buyer may demand:

  • The restitution by the price of the good at the time of title transference.
  • The derived yield of the good concerned.
  • The costs of the lawsuit that took place.
  • The expenses of the contract if in the moment that the buyer was satisfied with it.
  • Damage, interest and voluntary expenses if the sale was conducted bad faith.

If the eviction of hidden flaw causes partial loss of the good, the termination of the purchase contract may be requested. This loss must be of such importance that, without it, the buyer would not have acquired it.

 

What is the limitation period for eviction?

Regarding the limitation period, it will be 15 years, since the object of sale concerned is delivered.

 

Eviction of Concealed Defects

A latent or concealed defect are defects of the good sold that were difficult to perceive at first sight and that obstructs the good for the use that it is intended. It can also decrease the good’s value.

Such, if the buyer had known these defects, he/she would not have acquired the good. Or he/she would have paid a lower price in accordance to his/her willingness-to-pay.

The seller is liable, by legal requirements, of the latent defects. However, the seller is not liable for patent defects. Neither of these defects presented as evident should have been easily known by the buyer, such as, when the buyer is an expert or expert because of his trade or profession.

 

What does a Due Diligence report do?

Indeed, one of the main risks for the buyer is the existence of a long period of negotiation. These processes are usually accompanied by a Due Diligence report. And from the analysis of this report, the buyer can familiarize with the good concerned. Or, at least, it places you in a position where it is possible to obtain such knowledge.

In this way, the buyer is in a paradoxical situation: he/she must choose between maximum protection by liability clause or getting as much information as possible about the state of the good.

To avoid this alternative, the declarations and guarantees have the virtue of allowing the buyer to accumulate information with protection via liability.

The seller declares the existence of a certain state of the good, guarantees for it and assumes the corresponding liability. The guaranteeing and assumption of liability are not mere deeds, but an obligation; regardless the subjective state of the buyer or if he/she has had the means and possibilities of knowing the truth.

 

What happens eviction of hidden flaw and of concealed defects if there was a Due Diligence? 

Next, we will analyze the different scenarios that may occur:

  • If the buyer does not know but had the chance to know by Due Diligence: the demonstrations and guarantees remove the seller from the risk of possible contingency. (Between ignorance and the express assumption of the truth of an affirmation, ignorance is preferable).
  • If the buyer was to be present any situation as a subsequent contingency: in which case, any corresponding declarations and guarantees made by the seller will comply with article 1284 CC. Thus, the presumption would be with the statements made, the seller has committed to neutralizing the contingency. However, this interpretation is not always possible. (Notice the assumption that it is not in the hand of the seller to take effective measures in this regard).

Given the above, when exists risk of uncertainty, it is convenient that the parties contractually assign this risk. For example, any risk assumed by the buyer does not reach what was not discovered by the buyer should be specified in such contract.

In addition, declarations and guarantees should be configured as assumptions of risk coverage rather than as damages for breach of contract.

 

Is there an obligation to evict for concealed defects if the seller ignores them?

The obligation of legal eviction is applicable even if the seller ignores such defects. Except that there is an agreement by both parties for otherwise.

In such cases, the buyer may choose between calling off the contract or lowering the purchase price. A contractual call-off would imply the return of the satisfied price. Additionally, if the seller acted in bad faith, compensation for damages could be claimed

 

What if the seller knew the concealed defects?

For such cases, the seller will have to refund the price sold and the expenses of the contract with damages and losses incurred. If they were not known to the seller, the seller will only have to pay back the price and the expenses of the contract that the buyer had paid.

 

Act of God or buyer’s fault

If the thing sold had a defect at the time of sale and was subsequently lost due to act of God or by the fault of buyer, the buyer may reclaim the price paid from the seller. Although, it must include the depreciation of value of the good had at the time of loss. Relevant to that, if the seller acted in bad faith, he/she must also pay the buyer damages and interests.

If several goods have been bought altogether, the defect of each will not be extended to the others. It will only be considered together in court when the buyer would not have bought one without the others.

 

Deadline to demand eviction of concealed defects

The limitation period of the eviction of concealed defects is 6 months from the delivery of the object of sale.

Finally, we propose the reading of two Supreme Court Judgments that we link below.

Ruling of October 14, 2013 

Ruling of December 21, 2009

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